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Deluxe Corp. (NYSE:DLX)

Q2 2008 Earnings Call

July 31, 2008 11:00 am ET

Executives

Terry Peterson - VP of Investor Relations and Chief Accounting Officer

Lee Schram - CEO

Rick Greene - CFO

Analysts

Charles Strauzer - CJS Securities

John Kraft - D.A. Davidson

Jamie Clement - Sidoti

Mike Hamilton - RBC

Atin Agrawal - Longbow Research

Beth Lilly- Gabelli

Operator

Good day ladies and gentlemen and welcome to the second quarter 2008 Deluxe Corporation earnings conference call. My name is [Alicia] and I'll be your coordinator for today.

I would now like to turn the presentation over to your host for today's conference, Mr. Terry Peterson, Vice President of Investor Relations and Chief Accounting Officer. Please proceed sir.

Terry Peterson

Thank you, Alicia. Welcome to Deluxe Corporation's 2008 second quarter earnings call. I'm Terry Peterson, Deluxe's Vice President of Investor Relations and Chief Accounting Officer. Joining me on the call today are Lee Schram, Deluxe's Chief Executive Officer and Rick Greene, Deluxe's Chief Financial Officer. Lee, Rick and I will take questions from analysts after the prepared comments. At that time the operator will instruct you how to ask a question.

In accordance with Regulation FD, this call is open to all interested parties. A replay of the call will be available via telephone and Deluxe's website. I will provide instructions for accessing the replay at the conclusion of our teleconference. Before I begin, let me make this brief cautionary statement.

Comments made today regarding financial estimates and projections and any other statements addressing management's intentions and expectations regarding the company's future performance are forward-looking statements as defined in the Private Securities Litigation Reform Act of 1995. As such, these comments are subject to risks and uncertainties which could cause actual future results to differ materially from those projected. Additional information about various factors that could cause actual results to differ from those projected are contained in the news release that we issued this morning and in the company's Form 10-K for the year ended December 31st, 2007.

In addition to the financial and statistical information that will be reviewed during this call is addressed in greater detail in today's press release which is posted in the Investor Relations section of our website, www.deluxe.com and was furnished to the SEC on the Form 8-K filed this morning. In particular, any non-GAAP financial measures are reconciled to the comparable GAAP financial measures in the press release.

Now, I'll turn the call over to Lee Schram, Deluxe's CEO.

Lee Schram

Thank you, Terry and good morning everyone. We are disappointed with our revenue performance in the quarter and the resulting impact on earnings per share. We are not immune from the very challenging economic conditions and the impact that this is having, particularly on our Small Business Services segment. In spite of this, our updated EPS outlook, although reduced because of the weakening economy, still reflects an improving second half over the prior year.

There are a tremendous number of positives in the quarter that tend to go unnoticed in challenging economic times and because of these positives, we remain extremely optimistic about the continued transformation of Deluxe.

We had a very successful Knowledge Exchange Expo with our financial institutions which has already led to new check and non-check business wins, added several new leaders to our executive and senior management teams, further stabilize margins in our check businesses, continue to deliver on our $225 million cost reduction program and made planned investments in e-commerce, verticalization, merchandising, loyalty, retention and monitoring and protection solutions.

At the end of the quarter we released the first version of our new state-of-the-art customer facing e-commerce platform called ShopDeluxe. We also have completed four strategic acquisitions so far this year in the custom full color, logo, web and business networking services spaces. All areas we expect double-digit revenue growth in the future. These acquisitions are also helping reposition Deluxe strategically from not just the leader in printed products but overtime to a leader in higher growth, business services as well.

In a few minutes I will discuss in more details around our recent progress, next steps and strategically where we are positioning the company, but first Rick will cover our financial performance.

Rick Greene

Thanks, Lee. Earlier today, we reported diluted earnings per share for the second quarter of $0.63 in line with our previously communicated outlook. Revenue for the quarter came in at $367.7 million below our most recent outlook, primarily due to lower than expected volumes in small business services as the challenging economic environment continue to impact this segment.

Despite the revenue shortfall in SBS, our core check businesses met our expectations. Solid operating margins for the quarter benefited from continued execution on our cost reduction initiatives with savings inline with our expectations and from a reduction in our performance-based compensation. Operating cash flow in the quarter totaled $37 million, which again was slightly better than our expectation for the quarter.

In the second quarter of 2007, we reported diluted earnings per share of $0.69, which included the benefit of higher revenue, partially offset by higher performance-based compensation last year and additional cost savings in the 2008 period.

Company-wide revenue in the second quarter totaled $367.7 million down 8.1% from 2007. As noted, one of the primary drivers in this year-over-year decline is lower volumes in our Small Business Services segment, as economic conditions worsen during the quarter and continued to impact several of our core products, including checks and forms.

Direct check volume was also down and lower revenue per order affected Financial Services. Gross margin for the quarter was 62% of revenue, down 2.3 points from 2007. Improvements in manufacturing productivity, as a result of lean initiatives and direct spend reductions were more than offset by lower prices in Financial Services, an unfavorable shift in product mix, and higher delivery related costs, mostly from fuel surcharges.

Selling, general and administrative expense decreased $23 million in the quarter, and was 45.3% of revenue, compared to 47.4% in the same period last year. Lower performance-based compensation, benefits from continued execution on our cost reduction initiatives and lower amortization, all contributed to the improvement. As a result, operating income in the quarter was $61.3 million, compared to $67.5 million last year.

Let's now shift our focus to a few highlights in each of our three business segments. In Small Business Services, revenue of $211.5 million was down 8.1% versus 2007. Revenue in this segment was unfavorably impacted by economic softness in the quarter, particularly in our core checks and forms products. Operating income in this segment was $29.1 million or 13.8% of revenue, compared to $30 million in 2007.

In Financial Services, revenue was $110 million, down 6.7% versus the second quarter last year. While check order volumes remain strong with only 1.3% decline year-over-year, lower revenue per order, which was previously anticipated was the primary driver of the overall decline. Financial Services operating income was $18.8 million for the quarter or 17.1% of revenue, down from $23.2 million in 2007.

Finally, Direct Checks revenue totaled $46.2 million, down 11% on a year-over-year basis due to continuing declines in check writing plus a search engine's decision to limit our internet impressions based on their revised advertising policies. These reductions were partially offset by higher revenue per order from price increases. Operating income in the segment was $13.4 million for the quarter or 29% of revenue, up slightly on a percentage basis compared to last year.

Turning to the balance sheet and cash flow statement, total debt at the end of the quarter was $837 million compared to $844 million at the end of 2007. Cash provided by operating activities for the first six months was $57 million. This decrease from last year was due to a higher 2007 related incentive compensation payment earlier this year and lower net income, partially offset by lower income tax payments and progress on our working capital initiatives. Capital expenditures in the quarter were $9.4 million and depreciation and amortization expense was $15.6 million.

Earlier, we announced that we've closed the Hostopia acquisition for approximately $100 million net and that we purchased PartnerUp, a small business social networking company for $3.8 million. For the balance of the year, we expect that these companies will contribute approximately $15 million in revenue, $2 million of EBITDA, and a diluted loss per share of $0.08 due to the estimated amortization associated with purchase accounting and interest expense.

Looking ahead to the third quarter of 2008, we expect revenue to range from $367 million to $374 million. Diluted earnings per share are expected to range from $0.56 to $0.60. There are several key factors in addition to the impacts of the recent acquisitions that distinguish our 2008 outlook in comparison to the third quarter of 2007, including continued economic softness in the Small Business Services segment, and declines in the personal check businesses, driven primarily by fewer checks being written.

In addition, lower revenue per order in Financial Services and weaker advertising response rates in Direct Checks will also be contributing factors. Lower delivery related costs in Financial Services because we absorb the impact of the mid-May 2007 postal rate increase, since we did not begin implementing our flat check delivery package until the end of the third quarter last year, and continued execution of the $225 million cost and expense reduction initiatives net of investments.

For the full year, given the continued economic challenges impacting our Small Business Services segment, the pressure of lower check usage on our core check businesses and the recent acquisitions, we expect consolidated revenue to range from $1.515 billion to $1.535 billion. In addition, we expect an EPS range from $2.52 to $2.62. There are several key factors in addition to the impact of the recent acquisitions that contribute to our 2008 full year outlook.

Despite modest contributions from the ramp of our e-commerce initiatives and verticalization work, we expect that current economic conditions will continue to adversely affect our Small Business Services segment and thus drive a mid single-digit decline in revenues.

In Financial Services, we expect the continuation of 4% to 5% declines in check writing, with the related revenue pressure being partially offset by a previously planned price increase early in the fourth quarter. And we expect the revenue declines in Direct Checks to be more in the high single-digits driven by declines in check usage.

Other factors contributing to our 2008 earnings per share outlook include continued progress with the previously announced $225 million cost and expense reduction program and a full year effective tax rate of approximately 35%. Although the third quarter rate will be lower as a result of settling tax contingency matters.

We expect operating cash flows to range between $195 million and $205 million for the year, reflecting lower earnings, partially offset by continued progress on our working capital initiatives. We expect contract acquisition payments to be approximately $20 million.

Capital expenditures in 2008 are expected to be approximately $30 million and depreciation and amortization expense is expected to be approximately $65 million, including $28 million of acquisition related amortization.

To conclude, let me comment on our capital structure. We funded our acquisitions through cash and drawals on our current credit facilities. The capital structure we have in place today provides a great deal of flexibility to execute the transformation strategy that we believe will create a vibrant value creating Deluxe for the future.

Our priorities for uses of cash remain investing both organically and in small to medium size strategic acquisitions to augment growth and we also proactively evaluate other opportunities to create shareholder value. In the quarter, we did not repurchase any shares. We are focused on driving the proper balance between investment to drive long-term value and near-term opportunities the market may present. To the extent we have excess cash after these priorities we intend to paydown the remaining balance on our credit facilities.

I will join Lee and Terry in taking your questions in a few minutes, but first, I'll turn the call back to Lee.

Lee Schram

Thank you Rick. I will continue my comments with an updated clarified perspective and where we are strategically positioning the company, then highlight each of our three segments and close with the progress updates on our cost takeout program. At the enterprise level, our strategic intent remains the same, becoming the best at helping small businesses and financial institutions grow.

We will continue to target three customer segments, including small business, financial services and consumers where we plan to offer a suite of lifecycle driven solutions including personalized printed products and a growing suite of business services, including logo design, payroll, and other human resources services, all designed to help our customers run their business.

Fraud monitoring and security solutions to protect our business partners and their customers and hosting web services, promotional, loyalty, market intelligence, business networking and e-commerce services to help our customers grow their business.

Our growth will come from fulfilling underserved needs by leading with higher growth business services, using a scalable, unified web enabled platform acquired through Hostopia, as a cornerstone of our strategy to drive a greater portion of revenue from annuity-based services.

With this unified services delivery platform, we are better positioned to provide a pull-through for printed products, including checks, forms, business cards, full color, digital web-to-print, imaging and other printed products. We will also be in a position to provide our financial institution and small business customers with market intelligence, Collaborative forms and private-label business networks to improve customer connections, loyalty and retention.

We look to provide simple, easy to use, complete, innovative solutions, focused on fulfilling customer needs while using continuous improvement principles to operate on a daily basis. Repositioning Deluxe's brand continues to be an important growth enabler.

Also critical to our growth is the key intersection between financial institutions and small businesses in expanding relationships and in helping us reach vertical industry segments more deeply. Key vertical segments include retailers, contractors, professional services providers and banks and credit unions.

In order to insure we execute well and align key leaders and capabilities. Our go-forward plan is focused on five key areas. First, financial institutions and our core check capabilities, plus growth outside of checks in loyalty, retention, market intelligence and fraud monitoring and protection offers.

Second, direct to the consumer and growing check share, plus adjacency growth through other products and services that consumers can buy directly from us.

Third, small business core business products sold through enhanced e-commerce capabilities and an improved vertical customer focus. Fourth, higher growth business services, including logo design, payroll, human resources, business networking, hosting, and web services.

And fifth, cost reductions and simplification, where we expect to continue the solid work already underway as part of our $225 million cost reduction initiative but where we also see opportunity to improve processes and reduce costs further through order management system rationalization, pricing simplification, product set rationalization, and just-in-time product and services personalization.

Now shifting to our segments, in Small Business Services, as expected, economic softness had an impact on our business, but the impact in the quarter was even more pronounced than we expected, especially late in the quarter.

Given the trends we have seen driven by the challenging economy that we now project will continue well into the second half of the year, we have reduced our revenue forecast accordingly. The most significant second quarter shortfalls were in checks, forms, banking supplies and retail signage and packaging materials.

However, we had revenue growth in full colored products and payroll services. We also saw an initial ramp in the EZShield check protection service and expect even more growth in the second half of the year. We released the first version of our new state-of-the-art e-commerce shopping site called ShopDeluxe at the end of the quarter.

We will continue to add content and capability here throughout the second half of the year. And we will begin promoting the new site in our catalogs and through other media. We added new Safeguard distributors and will see more of a ramp as their business grows and as we leverage them where opportunities exist with financial institutions.

Now for some additional color on our acquisitions, we are off to a successful start with Logo Mojo, our logo design services acquisition, leveraging personalized logo design capabilities and a differentiated simplified way into our product portfolio. Driven by conversion rate success from our web services partnership and the stickiness that high growth web services provide for our customers, we closed the Hostopia acquisition yesterday.

We are extremely excited about this acquisition, as we believe Hostopia brings an innovative, entrepreneurial team that culturally is a strong fit with Deluxe. In addition to being focused, just like we are, on small businesses below 20 employees. It also brings us web hosting capabilities, but is much more than just a hoster. With web services, e-mail marketing, fax to e-mail, mobility sync and other offers, plus a presence outside of North America with an emerging European customer base.

Finally and critically important, Hostopia provides a unified scalable services delivery platform which can serve as the cornerstone of our strategy to obtain a higher portion of revenues from annuity-based business services.

We are creating a framework, using Hostopia's technology architecture that will easily connect ShopDeluxe and also provide a web services broker for Logo Mojo, PartnerUp and other business services that we continue to evaluate based upon our customer's needs. We expect Hostopia to be accretive on an EBITDA basis for the balance of 2008 and on an EPS basis in 2010.

Finally, PartnerUp, from our Knowledge Exchange Expo Collaborative work in the last several years and from market research, we have learned that financial institutions and small businesses desire more information, more market intelligence and more of an opportunity to drive relationships with each other.

Similar to Hostopia, PartnerUp first brings smart innovative entrepreneurial people. They also bring market intelligence tools, collaborative building capabilities, business networking tool and a small advertising revenue stream

We see these three are giving us capability to partner with both financial institutions and small businesses in bringing private-label and community building networking capabilities to improve customer connection, loyalty, and retention.

In the human resources services area, in addition to our current payroll services capability currently deployed in Canada, in late July we initiated a pilot with HireRight, that we expect to extend over 90 days to test employee background screening services for our small business customers.

Shifting a bit. The following addressable market statistics linked to our current revenue base will allow you to better understand market sizes and growth potential and give you a sense of why our strategic acquisitions and partnerships dating back to the Johnson Group are so important to our future Small Business Services success.

Nearly 50% of our current small business revenue today comes from a $1.5 billion check market declining 3% to 4% a year. Approximately 40% comes from a $7.3 billion business products market which we estimate is declining 1% to 2% a year. Under 5% comes from a $16.5 billion color digital web to print market growing at 10% to 15% a year.

Under 5% comes from a $6.9 billion imaging and promotional market growing at 5% a year. Less than 1% comes from a $9 billion human resources services, including payroll services, background screening, training, education and personnel administration growing at 6% a year.

Virtually none of our current revenue to date comes from a $5.1 billion web services market growing at 22% a year. And none of our current revenue to date comes from a $1 billion market for ad services within the business networking space growing at 20% a year.

It will take some time to build out and integrate all of these high growth acquisitions and partnerships, but they create the potential for Deluxe to bring more innovative, thought leadership business services to our customers. In addition to our already leading personalized printed products, where we believe with better e-commerce capabilities and a clear verticalization focus we can gain share of wallet.

In Financial Services, we continued again this quarter to proactively extend several check contracts. We now have only two large contracts left to extend through 2009. Completing these extensions, helps lock in positive annuity-based check revenue streams. It also allows us to focus now on winning several competitive national accounts which will be starting their RFP processes in the near future.

Again this quarter, we continue to see strong overall new acquisition rates, especially in the credit union space. And our retention rates also remain strong in excess of 90%. We continue to simplify our processes and take complexity out of the business while reducing our cost and expense structure.

Starting early in the fourth quarter, we will also be rolling out our regular planned price increase that will drive both revenue growth and operating income. In addition to our strong core check revenue, we made progress in the second quarter, in advancing new non-check revenue growth opportunities. We grew revenue sequentially over the prior quarter and over the last year in our non-check loyalty retention and fraud monitoring and protection solutions.

Building off of the Knowledge Exchange Expo financial institutions visits to our Phoenix call center, we had our highest number of Deluxe calling wins of any quarter. And the pilot with a very large national account of our Welcome Home Tool Kit onboarding solution successfully finished and now we are beginning to plan for a larger rollout.

Although we continue to see momentum building in these new non-check revenue initiatives, we also see decisions by financial institutions taking longer with more approval levels and a focus on spending less.

In Direct Checks, our revenue was slightly lower than expected driven by a search engine's decision to limit our internet impressions based upon their revised advertising policies and by a sales tax law change in the State of New York which negatively impacted our affiliate internet program. We had another solid operating margin in the quarter coming in at 29%.

As mentioned earlier, we see opportunities in the direct-to-consumer segment to provide other products and services, in addition to checks and related accessories to our consumers. We initiated some extensive research in the quarter to better profile our customers and their propensity to purchase.

One of the opportunities we uncovered is that a high percentage of our customer base take photos frequently, and tend to be do-it-yourself crafters. Given this, we work with the partner and created an exclusive arrangement from a patent protected process where we will provide starting in the middle of the third quarter, the ability for our customers to customize high quality matted photo greeting cards suitable for all occasions and seasons.

This is one example of a product opportunity outside of checks created by our innovative team using findings from our research. We are not sure how big this opportunity will be, but this and several others being assessed could contribute to revenue streams in the future.

In addition to these actions in each of our segments, here is an update on our cost and expense reduction initiatives. The plan continues to target at $225 million reduction through 2009 or $70 million is expected to be realized in 2008 on top of the $105 million already realized from 2006 and 2007. We've not yet completed a thorough enough assessment of the additional cost reductions associated with the simplification initiatives that I mentioned earlier but these will begin contributing additional savings in 2009.

Overall, we had another solid quarter, delivering to our target levels against the $70 million expected this year. As we have consistently indicated, the 2008 reductions again will not necessarily be linear through the quarters, with over 60% of the reductions in the second half of the year. Also, approximately 50% to 60% will fall to the bottom line. However, the percentage was lower in the second quarter and first half, as we more aggressively invested in new non-check revenue solutions and key enablers.

Here are some highlights of the key cost reduction activities for the second quarter and continued areas of opportunity as we move forward. These are in addition to the ongoing savings that are occurring each quarter from previously implemented actions.

In our go-to market sales and marketing, our focus continues to be on realigning sales and marketing backend operations and on refining our channel management structure through process centralization, simplifying business processes, platform and tool consolidation, and leveraging e-commerce and vertical segmentation capabilities.

During the quarter, we announced an August closure of our Flagstaff call center. And we also completed smaller reductions in several other call center locations. Our externally led review of our call centers mentioned on the first quarter call with the objective of continuing to improve our productivity, also continued in the quarter.

For fulfillment, we had a strong quarter with lean productivity improvements and direct spend reductions. Given small business volume declines, we have recently initiated a deeper review of our small business cost structure. As such, the culmination of this review may trigger charges later this year and additional cost savings, neither of which are included on our current outlook or our $225 million cost reduction target.

Throughout the remainder of 2008, we also continued to invest in automating our flat check package processing and we expect to continue our lean product standardization and indirect spend reduction initiatives, plus advance our work on realigning to a common manufacturing platform. We also plan to initiate more strategic supplier sourcing arrangements and enhanced value stream mapping improvements and efficiencies.

Finally, for shared services infrastructure, we continue to make good progress in information technology, driven by data center cost reductions and other system utilization, networking and voice communication efficiencies, as well as in finance, human resources and real estate. For the balance of 2008, we expect to continue to reduce costs in all areas as opportunities exist to centralize, streamline, standardize and improve efficiencies.

As you can see, although our revenue was disappointing, driven by challenging economic conditions, we again progressed in the second quarter on our cost reductions. But more importantly in creating and starting to build out a framework for revenue growth through new organic and business services offerings.

Unfortunately, we saw deterioration in the economy as the second quarter matured and we now expect this impact to continue at this level in the second half of the year. So we have reduced our revenue outlook to reflect this.

In the second half, we still expect continued strong execution on our cost reduction initiatives, stability in our core check revenues, more meaningful revenue contributions from new non-check revenue offers and key enablers and some revenue from our logo, web services and business networking acquisitions.

Looking ahead, we believe that our portfolio is becoming better positioned to deliver sustainable future revenue growth opportunities and higher operating income and cash flow. Using market growth and decline rates against our updated portfolio creates a roughly flat topline.

Adding to that, existing organic initiatives such as ShopDeluxe and verticalization, plus higher response and penetration rates and strategic additions in other business services spaces creates a topline that can grow solidly into the mid single-digits over the medium term. Also importantly, dependency on checks and small business products and accessories declines to 45% and 25%, while business services grow to 30% and we achieved a better balanced overall portfolio.

Now Rick, Terry and I will take your questions.

Question-and-Answer Session

Operator

(Operator Instructions)

Your first question comes from the line of Charles Strauzer with CJS Securities. Please proceed.

Charles Strauzer - CJS Securities

Hi, good morning.

Lee Schram

Hi, Charlie.

Charles Strauzer - CJS Securities

If we can talk a little bit about, simplifying a lot of information that you just gave out on the acquisitions and the game plan, when you think about your 4 million plus small business customers and the Hostopia and how that fits in. What is the real simple kind of attack plan for introducing those 4 million customers to these new services?

Lee Schram

Charlie, this is what we are really excited about. I think the first thing you have to remember is that Hostopia brings their own, more telco wholesale model where they get their small businesses today. So they bring that. We don't think there is a significant same customer base there. So we first of all get that.

The second thing that we get is right away out, next week, as we officially get this transaction closed, we are ready to go with basically being able to introduce our customers into the Hostopia platform. We already have a process that we've built with Hostopia to be able to do that. So, we open up right away to what we saw is demand for web services from the partnership that we had started.

Now we see, not only what we created with that partnership but really being able to expand, because what Hostopia brings is a tremendous platform, not just hosting as I said, they bring web services, e-mail marketing, they purchased a mobile company so they bring that They have a fax to e-mail capability. So all the services we see coming to our small business customers and they are asking for these services. So I think that is important.

The other thing really critical for us is, there is a lot of the hosting companies are out there gobbling up other web services companies and they have all these despair platforms. What the Hostopia team has done is they have created just a fantastic unified platform. They have some patentable technology that they have got in terms of what they've created and it is a single platform. We see the ability to really add-on a lot of the other acquisitions and other services that we have already and just creating an easy go-to market and a simple go-to market platform for our customers.

So, there is a lot here, Charlie as you have said and as we get more overtime and being able to explain more and more of this, I think you will start to sense the same excitement that we have about the Hostopia play.

Charles Strauzer - CJS Securities

Got it. Then when you look at the lowered guidance and when you look at the back half of this year, specifically Q4, you are looking at a pretty meaningful jump year-over-year in margins when you backend to the numbers. Can you give us a little bit more color into what gives you the confidence that you can continue to achieve those margin expansion goals?

Lee Schram

Charlie, I think you got to look back to what Rick and I talked about in our comments, there is a lot there. First of all, you have got some seasonality in our small business segment around the holiday greeting card lines and around the stored value gift cards. That brings us a natural, positive spike in the fourth quarter. Even in tough economic times, we still believe there is going to be, our small businesses out there that will clearly have plays in that space.

We start to get late in the quarter to some tax form ramp as well and then we also have the ramps that we talked about. We saw success with the EZShield fraud solution in the second quarter. We believe we're going to see that ramp continue and get even stronger as we get into the fourth quarter.

We saw distributors shoot up through the Safeguard plays that we have made. We also believe that the continued content and capability that we are adding to the initial release of ShopDeluxe is going to help, as well as a lot of that verticalization targets in focus that we have as well.

I don't want to underestimate. A lot of people say was it there all along? It was there all along that we did have a planned price increase in the check area early in the fourth quarter and that obviously will bring us positive revenue and operating income play.

Then the other thing you have to remember, Charlie as I said in the script is that we also have the cost takeout, which not only is more in the third and fourth quarter, but it's also where we expect more to actually stick to the bottomline.

So, I think those are the big pieces that you need to think about which is why we have some confidence, even with the reduced guidance that reduced forecast that we think we are in good shape.

Charles Strauzer - CJS Securities

Great, thank you very much.

Lee Schram

Thanks, Charlie.

Operator

Your next question comes from the line of John Kraft with D.A. Davidson. Please proceed.

John Kraft - D.A. Davidson

Good morning, gentlemen.

Rick Greene

Hi.

John Kraft - D.A. Davidson

Can I just follow up on that last question if I could? I don't want to beat a dead horse here, but as you talk about or as you think about your guidance and you come up with your forecast, presumably you talked to various division groups and salespeople and sort of take a guesstimate at what they think they can do.

And maybe you discounted by a certain percent out of conservative, is this current guidance maybe discounted even more or I guess maybe you can talk about your methodology for coming up with that range?

Lee Schram

John, here is the basic bottomline. I think what we saw as Q2 matured, we started to see more of depth in the small business segment and what they were buying. By the way, sometimes you say it was more retail targeted, it was more across the board.

So, we are always trying to get better at our forecasting in all of our segments, but yes, we sit down with our team and we have a very thorough and very rich process where we do a build-up. We look at all sorts of indicators from mail drops to traffic coming through our call centers, to traffic coming through our e-commerce sites and we sit down and we assess it.

Basically, given the trends that we saw in the second quarter, and the expectation that everything out there that you read because we've gone later this quarter than about a week that we normally do, just wrap in the acquisition stuff. You've read it everywhere. We are seeing it and because of the trends that we've seen, we just said, look, this is where we see things right now.

In spite of all the good initiatives that we have and that we believe in and I believe it will help us tremendously as we move forward, that was our best view and our best visibility that we had. So, that was the way we thought through it in the process that we took.

John Kraft - D.A. Davidson

Okay, that is fair enough. Lee, on the four acquisitions you specifically mentioned expecting that there should be double-digit growth rates in the future, what would be a ballpark estimate for what all four of those are doing right now?

Lee Schram

Well, I think if you go back to the market information that we put out there, and we've been asked to everywhere Rick and I and Terry seem to go, give more color on that. So that is what we tried to do here. So, I think the way to think about it is, Hostopia on their own put out about a 20% to 24% in their fiscal year for '09 which ends in March of next year and we said about 22% was the market. So I think that is probably a good way to think about that one right now.

As far as the business networking, it's such an entry play right now. We think it is such a great strategic opportunity for us and just the ad market alone, we believe is growing north of 20% and logo is clearly growing, probably a little lower than that, but growing at a tremendous double-digit rate as well. Then again I mentioned full color, the digital, and the small acquisition we did earlier in the year that added to the Johnson Group play, we see growing in the 10% to 15% space.

John Kraft - D.A. Davidson

Okay, so not really expecting particular acceleration. Sounds good. Then Rick, maybe I missed, I didn't hear you specifically when you were talking of uses of cash. I didn't hear you mention the dividend. Has there been talk about what you might do with that?

Rick Greene

Well, John, the dividend is something that we review with our board on a quarterly basis in looking at that as a possibility for use of cash. At this point in time, we do not anticipate changing our dividend policy. We are certainly continue to focus on our main priorities around investing organically, as well as small to medium sized acquisitions to augment growth, and we've executed on that here in the quarter and continue to focus on that and then look at other potential opportunities like share repurchase and the dividend, but at this point in time, we do not anticipate changing our dividend policy.

John Kraft - D.A. Davidson

Okay. Then last question, the contract acquisition payments I think you said $20 million for the year, that's a tick-up from certainly what you've been doing so far. Is that ramp already spoken for? Or are you just keeping that ready for some of these larger national accounts that you mentioned, Lee?

Lee Schram

It's really based upon the fact that we have had some success here in the first half of the year in extending some of our large accounts and locking those up for a longer period of time that is creating that small uptick here for the year.

John Kraft - D.A. Davidson

So if you are able to win some of these national accounts that could even be bigger?

Lee Schram

Yes, we wouldn't see that until maybe early '09.

Rick Greene

I don't know, it would probably be this year, by the '09. Yes, we would have to look at obviously where we are heading as we get into 2009. And if we locked up, John, as we've said, [all but two] and we got that in our runway here, in terms of being to look at it, we would have to rethink of a restart as you get into 2009.

John Kraft - D.A. Davidson

Got you. Okay, thank guys.

Lee Schram

Thanks, John.

Operator

Your next question comes from the line of Jamie Clement with Sidoti. Please proceed.

Jamie Clement - Sidoti

Good morning, gentlemen.

Lee Schram

Hi, Jamie.

Rick Greene

Good morning.

Jamie Clement - Sidoti

Most of my questions have actually been asked and answered. One thing that I did want to ask you about is, this has come up on the last several conference calls, it is always the income statement balance of your moving costs and reinvesting for the future and that sort of thing. Obviously, it sounded as if the first half of 2008 was going to be one where the balance was probably going to be a little bit more weighted on the reinvestment side.

As you look out a couple of years, and I know you have these acquisitions that you made. I know that you need to support the plans that you have, I mean are there costs that you see that you are spending this year that are going to be out of the system at some point in 2010, 2011, whatever the right timeframe is as you get more efficient. What is the right way to think about the balance here?

Rick Greene

I think you've got to go back to what we committed on the 225, Jamie. So, the 105 through '06, '07 and the 70 this year, the 50 next year, and then clearly in the prepared remarks that we said is that we've got some other areas that we're now going to get after as well. Some of which we think can start giving us benefit in '09 as well. So I think that is the runway that I am comfortable with giving.

Jamie Clement - Sidoti

Right. Lee, obviously the stocks have been down, and it is down an awful lot today. I got to tell you I think maybe I'll just offer you the opportunity to respond to this. When the cost savings were announced, the base Deluxe business was kicking off x $100 million of EBITDA. Obviously economic conditions have gotten tough and we understand that, but even if the investment spending balance was balanced with the cost savings.

I think what probably scares investors here is, you are talking about a potentially a huge organic decline that has occurred over the last 18 months. From where I sit, I don't think that is necessarily the case. It seems to me like there are costs here that related to reinvestment that are not necessarily going to be with you guys for the long-term.

Lee Schram

Yeah, I think the way you need to look at it, there is a tremendous positive base right now on the core check business. I love the aggressiveness of what our sales teams have been doing in working with the financial, and aggressiveness around not more price reductions but just getting out there and getting in front of our financial institution accounts offering not only great check program, but also a great non-check additional services. So I think that is really big.

I think that is being missed by a lot of people right now to your point. I think that clearly the economic piece is biting us and obviously you guys can look at what it is doing to others as well. Yes, I think the plays that we got, the articulation of where we are now going in terms of bringing the services out, the ability to take market information and then add to that with initiatives that we already have underway today and being able to see some sustainable opportunities to get some revenue growth.

And then, yes, on a better overall cost structure to what you're really getting that as we move forward. Absolutely that is the play without getting into '09 and 2010.

Jamie Clement - Sidoti

Right.

Lee Schram

That's the way to think about it.

Jamie Clement - Sidoti

A follow up question to one of Charlie's and I think you addressed it. Really specifically from Hostopia perspective, but as you have these acquisitions, can you talk a little more Your response to Charlie seem that it was a little more near-term.

Longer term, how do you aggregate the new service offerings and really bring them to your customers? Can you give us a sense of what the master marketing plan is down the road?

Lee Schram

What we are trying to do right now is bringing them altogether. We are trying to make sure that the play that we have is around using Hostopia is that core master unified platform from a technology standpoint, we believe we've sorted out how we get the linkage to the ShopDeluxe e-commerce platform and we've got some really smart people that we've brought into the company that have built that all up, and then think of it as being able to both on PartnerUp and Logo Mojo and some of the other service offerings that we have organically and then other areas that we're continuing to look at.

Bringing that altogether and then driving more and more revenue per unit thinking off of a very stable fixed cost based platform that is not complicated, simple again, easy, for our customers to be able to use and easy for us to be able to administer and running creates that annuity stream.

So I think that's the best I can give you right now until we get more into all the acquisitions and how we're trying to bring all those things in. Again Jamie that's relatively new at this point.

Jamie Clement - Sidoti

No, that's very fair. Let me just ask one last question. You guys offer a lot of printed products to small businesses, but you don't offer everything and from what I gather, you've got no desire to offer everything.

When you think about the kinds of products that you don't offer that might be a little bit more commoditized, might be a situation where you have ramped overcapacity in the printing industry, you've talked about partnerships, are there opportunities for you to expand via partners that hold the assets, basically the distribution in more printed products. You got lot more services. You got a ton of customers. You don't necessarily offer anything. Is there an opportunity for that down the road?

Lee Schram

We're always looking for ways that we can solidify both, the core small business products base and we talked about that without trying to get too far into this, I think the biggest play is, how do we get stronger at that focused on verticalization and bringing more to those vertical retail contractors, professional services markets and then how do we play the ShopDeluxe and the e-commerce better end of that. That doesn't necessarily mean it's all our stuff, is that what you are alluding at, that's just bringing more content to the small business.

Jamie Clement - Sidoti

No, that's exactly what I was talking about. Thank you very much for your time.

Lee Schram

Thanks.

Operator

Your next question comes from the line of Mike Hamilton with RBC. Please proceed.

Mike Hamilton - RBC

Good morning.

Lee Schram

Hey, Mike.

Mike Hamilton - RBC

Just wondering if you could give the year-over-year change in incentive expense in the second quarter?

Terry Peterson

Mike, this is Terry. We don't actually publish that number precisely, but we do list that as certainly a contributing factor in the results for year-over-year. So it is a significant contributor, but we don't actually publish that number.

Mike Hamilton - RBC

Would you be able to isolate what costs you've laid out in your gross initiatives year-to-date?

Lee Schram

No, we haven't done that either, Mike. The way I would frame it is we spent money on all the programs that I mentioned around verticalization and ShopDeluxe and the financial institutions spaces around non-check in the loyalty retention and in the fraud and security space but we've not given a specific number. The way to think about it is, we spent more in the first half of the year than we're planning on spending in the second half of the year.

Terry Peterson

I would also add, Mike, that on a year-to-date basis we've spent $15 million in capital expenditures. A good portion of that has been in support of a number of the growth initiatives, particularly our e-commerce platform that we're continuing to invest in and some of the other growth initiatives there.

Mike Hamilton - RBC

Then last one, I assume on direct, given the changes in the search engine that you drop some market share in direct in the quarter. What opportunities do you have to be able to respond to that?

Lee Schram

We already have jumped on this thing and I think we got through the New York affiliate issue pretty quickly here. So we don't expect that to have any impact in the balance of the year. We expect some additional impact in the search engine decisions but we think we've been able to figure out a clear and a new way to be able to work our way through that, which will basically, we believe will impact us favorably again, or get us back to where we were in the fourth quarter.

Mike Hamilton - RBC

Thanks very much.

Lee Schram

Thanks, Mike.

Operator

Your next question comes from the line of Atin Agrawal with Longbow Research. Please proceed.

Atin Agrawal - Longbow Research

Good morning, guys.

Lee Schram

Good morning, Atin.

Atin Agrawal - Longbow Research

I think most of my questions have been answered, but I just have one question for you. Apart from the recent acquisitions that you've made, I know that you've done other investments in e-commerce area. Would you be able to provide some color as what kind of revenue benefits would you expect in the second half of the year from the other e-commerce initiative.

Lee Schram

We haven't provided that yet at this point in time and we won't at this point. I think the words that Rick used in the script where we expect some modest contributions from verticalization and the new ShopDeluxe focus.

But it's too early at this point in time to really get into where we see this all playing out, and especially given in this market and this economy right now. I think as we get out further in '09 and overtime and this thing starts coming we will be able to give you a little better color around that. For now, it's not something that we're going to disclose.

Atin Agrawal - Longbow Research

Okay. Well, thanks. That is all the questions I had.

Operator

Your next question comes from the line of Beth Lilly with Gabelli. Please proceed.

Beth Lilly- Gabelli

Good morning, Lee, Rick and Terry.

Lee Schram

Hi, Beth. Good morning.

Beth Lilly- Gabelli

I wanted just to talk for a minute about the acquisitions you've made, and if you could provide a little insight into what you paid for them as a multiple. Then who is the competition that you are up against in terms of these businesses that you bought? Who you considered to be the other players in the market?

Rick Greene

I think Hostopia, you can go out and do the math around if we paid net of 100 and the forecast that Hostopia put out for their fiscal 2009, we paid about three times revenue. There is one way to look at it. There are double-digit EBITDA returns that they're driving that they put out. You can look at that.

We looked at it from what is the drive with and without synergies on hurdle rates, and cost of capitals and all that. What I would tell you is without any synergies, this gets above our internal hurdle rates, and then when we get the synergies it's just plays on it at even more.

So I think that's the biggest one out there. I mean there is not a lot out there right now in the business networking space. I mean we think we found a company that is probably at the forefront of being targeted at the small business, social or business networking space. So I don't think there is a lot out there to frame that one.

As far as the logos, there are other logo companies out there today and other businesses that are bringing that on, but I think the way to think about it is that forget the other competitors, I'll let you figure out who those all are. It's what our customers are really asking from us. They are asking us not only to be a great personalized printed products provider, Beth, but they're also asking us, you got to help us grow our business.

In order to help them grow, the way get out of small business is through their brand, their logo, their website, and then their ability to sale web services or drive revenue. So, we started listening, and the other thing we started hearing is there are opportunities in the human resources area, not only in the payroll services space. We're going to test this employee background screening and in other areas.

So I think that's the way we're looking at it is we've got to bring more of what our customers are asking us and more of what we think we need to be providing and obviously there are areas in the market that are growing as well, which is obviously exciting for us.

Beth Lilly- Gabelli

So what happens to the margins as you're transitioning the business model for these faster growing businesses or you're adding them? Now, you've got a $1.5 billion revenue base, and these are small in the scheme of things. But what happened to your margin structure?

Lee Schram

I think what you will see overtime, where Jamie was heading is, as we these things in, build the revenue base and platform over the chart that we put out, as we're doing the prepared comments today.

I think we would be able to see that growing. Then, being able, as I said in my prepared remarks to drive with our cost takeout and where we're going to be able to drive improved operating income and improved operating cash flow as we go forward.

Beth Lilly- Gabelli

Okay, so will your margins expand?

Lee Schram

The bottomline is I think we expect revenue to grow, and I think we expect some margin expansion, but I don't want to put an exact numbers out there at this point in time. Yes, we expect it to improve. Yes, we expect operating cash flow to improve as we get these things in and integrate it into the company and into our selling process and integrate it with our customers.

Beth Lilly- Gabelli

Okay, and Lee, longer term you talked about, it's a flat topline growth company. Then with better marketing and improving your offerings, you're going to see mid single-digit growth, correct?

Lee Schram

Yes, here is the way I would look at. What we try to do is frame, if you just look at what the market or rates of growth are declining on our portfolio mix today that would get you to that plus or minus 2%.

What we've talked about is initiatives that we're driving, and then higher response rates and penetration as we integrate and get synergies here that's when you get into this idea of being able to get mid single-digit growth.

Beth Lilly- Gabelli

Okay, and is that something you envision for 2009?

Lee Schram

I think the way we place it out there, is medium term. What we've got to do, is some of the themes behind the questions that we're getting here today, and the good ones are as you bring these acquisitions and bring all of these pieces together, what we've got to do and we're going to work hard on the second half of the year, Beth, as bringing them in, expanding them as far as what we think the synergistic capabilities are in bringing them all along.

And obviously, we would not have done them if we don't think that these things are going to help us a lot, which they will. Just to get the pace and the flow, then look back at what is going on with the economic situation, as we work through the second half of the year and give us a lot more clarity. Yes, we absolutely believe sooner rather than later, strategically, Beth that we can start getting some topline growth.

Beth Lilly- Gabelli

Yes, because it is interesting, for this quarter your revenues declined 8% and on a year-to-date basis they're down 7%. So you're talking about a pretty dramatic reversal.

Lee Schram

Fair enough.

Beth Lilly- Gabelli

And to Jamie's point, I think that's part of the problem with the market today. It sees a dramatic decline. You're telling us that you think longer term you can grow mid single-digit. So, we are having a hard time bridging that gap.

Lee Schram

Again, I think you've got the look at that. I would really study that chart. I would study that chart and say if this is their mix today which it is and this is what the market is expected to do. This gets you into a flattish opportunity plus or minus 2%.

As you mature, the synergistic capabilities that we talked about, get better response rates, add in the richer ShopDeluxe and verticalization play, add in some other services capability, or extensions on some of these testing things that we're doing, there is clearly an opportunity.

We understand we've got to go deliver on that. We understand that that's something that we've got to execute to. We think it's something that we do very well. We've got to go to work and get that done, Beth. It is the best way I can describe it.

Beth Lilly- Gabelli

Okay, that is great. Thank you very much.

Lee Schram

You're welcome.

Operator

I would now like to turn the call over to Mr. Schram for closing remarks.

Lee Schram

Let me just close by saying while we're disappointed with our revenue performance in the second quarter, we remained aggressive with our cost reduction initiatives, and also made several positive strategic moves to better position Deluxe for revenue growth in the future, which we are extremely enthusiastic about.

I thank you for your participation and questions today. We're going to get back to work and we look forward to providing a positive progress report on our next earnings call.

Terry Peterson

This is a reminder that a replay of this call will be available until August 7 by dialing 888-286-8010. When instructed, provide the access code 74753746. The company slides are archived in the Investor Relations section of Deluxe's website at www.deluxe.com. Again, thank you for joining us and have a good afternoon.

Operator

Thank you for your participation in today's conference. This concludes the presentation. You may now disconnect. Good day.

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Source: Deluxe Corporation Q2 2008 Earnings Call Transcript
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