The refinancing is leverage-neutral and improves interest coverage slightly. The transaction will refinance the company’s most expensive debt and extend its maturity profile.
The rating on Shoreview, Minn.-based customized printed products provider Deluxe Corp. reflects the intermediate- and long-term risks the company’s business segments face. In Standard & Poor’s Ratings Services’ view, Deluxe has a “weak” business risk profile, based on our criteria,, principally because of the significant risk of continued secular declines and the keen competition in the check-printing sector. Check-printing accounted for 61% of its 2011 fiscal year revenue. We believe these trends will put downward pressure on Deluxe’s organic revenue and EBITDA margin over the intermediate term. Relative low leverage underpins our view of Deluxe’s financial risk profile as “significant” based on our criteria. In 2012, we expect revenue and EBITDA to grow at a mid-single-digit percentage rate, mainly due to a contract win, growth in small business services, and recent acquisitions that we expect will offset organic declines in check printing.
Deluxe is one of the largest U.S. providers of checks. The company has three segments: Direct Checks (DC), Small Business Services (SBS), and Financial Services (FS). We believe the decline in check usage due to the continued adoption of electronic payment methods will continue to affect all three segments. We expect check volume declines will continue at a mid-single-digit percent rate, in-line with recent trends. According to a Federal Reserve study released in December 2010, the number of checks written in the U.S. declined by approximately 6.1% per year between 2006 and 2009. We also expect the FS segment will continue to face pressure from consolidation among financial institutions.
Under our base-case scenario, we expect full-year 2012 revenue and EBITDA will increase at a mid-single-digit percent rate, respectively, reflecting a recent check printing contract win, growth in small business services, and benefits from recent acquisitions, partially offset by a continued decline in check orders .In 2013, We expect revenue and EBITDA to be flat to slightly up as benefits from the recent acquisition are offset by declines in check orders. Our rating incorporates our expectation of limited margin improvement in 2013 as we believe cost reductions will be more difficult to implement in 2013.
The company’s operating performance for the three months ended Sep 30, 2012 was above our expectations. Revenue increased 6.5%, as benefits from acquisitions, price increases, and growth in the small business service segment were partially offset by lower check order volume. We estimate that organic revenue increased by about 4%. For the same period, EBITDA increased 6.5% due to cost cutting and revenue growth. The EBITDA margin declined to 23.4% for the twelve months ended Sep 30, 2012 from 23.8% in the same period last year. The margin decline resulted from tough comparisons with the previous year, when the company received high-margin revenue from a contract settlement. Deluxe’s debt to EBITDA decreased to 2.1x as of Sep. 30, 2012 from 2.5x in the same period last year, mainly due to the higher EBITDA base and a lower debt balance. The company’s adjusted leverage is under the indicative debt-to-EBITDA financial risk ratio range of between 3x and 4x that characterizes a significant risk profile, based on our criteria.
Although we believe Deluxe’s leverage will stay below 3x over the intermediate term, leverage could drift higher in the event of acquisitions or if secular operating trends worsen. EBITDA coverage of interest increased to 8x for the 12 months ended Sep. 30, 2012, from 7.1x in the same period a year ago. Pro forma for the refinancing, interest coverage was in the high 8x area as of Sept. 30, 2012. Our base-case scenario indicates that the company’s credit metrics will improve for the full year 2012, incorporating our expectation of revenue and EBITDA growth and repayment of the notes maturing in December 2012. We expect leverage to decline below 2.0x by year end. In 2013, we expect lease adjusted leverage to remain largely primarily due to our expectation of relatively flat revenue and EBITDA growth. We expect interest coverage to improve to over 9x due to lower interest payments. The company converted 42.2% of EBITDA to discretionary cash flow for the fiscal year ended Sep. 30, 2012, and we expect it will continue to convert more than 35% of its EBITDA to discretionary cash flow in fiscal 2013. We believe Deluxe will use a meaningful portion of its discretionary cash flow for tuck-in acquisitions.
In our view, Deluxe has “adequate” sources of liquidity to more than cover its needs over the next 12 months. Relevant expectations and assumptions incorporated into our liquidity analysis are as follows:
-- We expect the company’s sources of liquidity over the next 12 months will exceed its uses by 1.2x or more.
-- We also expect net sources of liquidity to be positive over the next 12 months under a scenario of a 15% drop in EBITDA.
-- We believe the company will have sufficient covenant headroom for EBITDA to decline by 15% without breaching its covenants.
-- We view the company as having good relationships with its banks and a satisfactory standing in the credit markets.
-- Because of Deluxe’s access to its revolving credit facility, we believe it will be able to absorb low-probability, high-impact shocks.
As of Sep. 30, 2012, Deluxe’s sources of liquidity included $191.4 million of availability under its $200 million revolver, and $105.6 million of cash on hand. We expect discretionary cash flow generation of between $145 million and $160 million in 2012 and between $145 million to $165 in 2013. We anticipate capital expenditures of roughly $35 million and dividends of about $50 million in 2012 and 2013. Near-term debt maturities are manageable with cash flow and the revolving credit facility. About $85 million of debt matures in December 2012, which the company can repay with cash flow or with borrowings from its revolving credit facility.
As of Sep. 30, 2012, the company had an adequate cushion of compliance with its leverage and interest coverage covenants. The financial covenants do not tighten for the remaining life of the facility.
Deluxe’s guaranteed senior notes due 2015 and guaranteed senior notes due 2019 have an issue-level rating of ‘BB-’ (the same as the corporate credit rating) with a recovery rating of ‘4’. The ‘4’ recovery rating indicates our expectation of average (30%-50%) recovery for noteholders in the event of a payment default. Deluxe’s senior notes due 2012 and notes due 2014 have an issue-level rating of ‘B’ (two notches below the corporate credit rating) with a recovery rating of ‘6’. The ‘6’ recovery rating indicates our expectation of negligible (0%-10%) recovery for noteholders in the event of a payment default. (For the recovery analysis, see Standard & Poor’s recovery report on Deluxe Corp., published on RatingsDirect on March 30, 2012).
The stable rating outlook reflects our expectation that Deluxe will maintain sufficient flexibility within its financial profile to accommodate potential weakness in operating performance and make additional acquisitions. Although unlikely over the near term, the rating could come under pressure if the company adopts a more aggressive financial policy, experiences significant deterioration in its operating performance or makes a sizable debt-funded acquisition that drives leverage over 4x. More specifically, a large, debt-financed acquisition, coupled with client losses, lower check volume and pressure on small businesses, could reduce Deluxe’s discretionary cash flow and elevate its leverage to over 4x, at which point we would likely lower the rating.
We would consider a higher rating if Deluxe successfully diversifies its business away from check printing and into a business with solid growth prospects, while preserving its EBITDA margin and credit metrics. We do not consider an upgrade likely over the near term.
Related Criteria And Research
-- Business Risk/Financial Risk Matrix Expanded, Sept. 18, 2012
-- Methodology And Assumptions: Liquidity Descriptors For Global Corporate Issuers, Sept. 28, 2011
-- Criteria Guidelines For Recovery Ratings, Aug. 10, 2009
-- 2008 Corporate Criteria: Analytical Methodology, April 15, 2008