Deluxe Corporation (DLX) is a relatively troubled stock. Traditionally in the check business, they have attempted through inorganic changes to transform into an online digital solutions company. We believe that the digital marketing suite and other services related to the transition of SMBs to e-commerce have not achieved enough results to justify the multitude of acquisitions due to too many people running commoditized marketing services, especially marketing gurus selling courses so you can do it yourself. But First American Payment Systems, the company they recently acquired, promises more meaningful change. Much like an Adyen discount (OTCPK: ADYEY), First American offers a complete solution for merchants. With digitalization still a major force accelerated by COVID-19, the acquisition makes sense and makes Deluxe more attractive to new shareholders, but leverage is the new challenge.
Third quarter results say it all
The third quarter results give us a fairly complete picture of the situation. First American generated about $80 million in revenue this quarter. With a 20% margin, that cancels out at $64 million EBITDA. The acquisition consideration was paid entirely in debt for nearly $1 billion EV. The multiple is around 15x EV/EBITDA for the company. Compared to Adyen, it’s very cheap, but Adyen is a dominant player that now benefits from network effects by targeting platforms and their vendor clusters. First American achieved a 12% year-over-year growth rate with 2020 being a tough competition, but Adyen scored above double digits. While a discussion of the multiple is interesting, what’s done is done, and now the results of this acquisition are what interests us.
The revenue breakdown and EBITDA breakdown are presented in the Q3 presentation. Deluxe is a high-margin business, and the segments are all fairly cash-generating with an operating cash-to-EBITDA conversion rate of around 50%. On a 9-month basis, payments increased primarily due to the contribution of First American, which was acquired near the end of the second quarter, contributing approximately $100 million over the 9-month period. But about 10% of the growth in payments comes from past initiatives. Cloud solutions were up a few points, including digital marketing, growing around 20% on an EBITDA basis. Promotional solutions, which include companies with higher exposure to physical materials that have ballooned, declined on an EBITDA basis, offsetting cloud EBITDA growth. Finally, checks declined significantly by 10% in EBITDA, which hurt EBITDA growth.
Where pre-acquisition annualized revenue might have been around $1.8-1.9 billion, with First American we should see around $2.2-2.4 billion. Payments currently represent about 25% of EBITDA, and 12.5% of total EBITDA goes to First American, with growth rates of about 12%. While First American accounts for 12.5% of EBITDA and shows growth rates of 12%, other payment products are also doing reasonably well, at around 10%. With the other segments being essentially growthless, we expect Deluxe to be able to achieve a profitable revenue growth rate of around 2% on an ongoing basis at best thereafter, or they will be able to maintain a steady profit line. At the point of profitable growth, it is important to see how one-time items, in 2020 from acquisitions and in 2021 related to transaction costs, have affected the finances. The reconciliation is below and explains why overall EBITDA was so low despite revenue growth.
Operating profit was down from a year ago despite the addition of First American, where management says 2020 benefited from COVID-19 savings that are no longer possible. In particular, the aforementioned declines in checks offset much of the favorable growth provided by First American. In addition, the growth in service revenues has been accompanied by disproportionate increases in service costs. Finally, the large debt incurred when acquiring First American means large interest charges, which has made the company less profitable for shareholders, which means a lower basis for EBITDA reconciliation. The company maintains that pricing power in some of its inflation-affected segments, such as checks, is possible and will help offset lower earnings in the coming quarters.
The fact that even stable EBITDA was achieved on a quarterly basis, despite Q3 2021 having $16 million stuck on it thanks to First American, is actually a great achievement. Debt is now very high, so getting there with this additional debt load is a good outcome, and demonstrates that for the most part the acquisition has added leverage and amplifies potential shareholder returns in the event where it is actually a successful personal LBO. However, we are dealing with very high debt levels. The debt burden has more than doubled and interest expense is now 4 times what it was in 2020.
Interest expense for the quarter implies just under a 5% rate, which is quite high and reflects the ND/Adjusted EBITDA of 4.3x. The risks are very clear on the balance sheet. Peter Lynch always said that you can’t lose 100% if you have no debt. Well, Deluxe has a debt. We believe its profile sufficiently covers check shortfalls, which is at least cash flow-generating, to be able to support and repay debt for attractive results for shareholders. However, checks could drop faster than expected, especially as COVID-19 accelerates trends that could support other Deluxe businesses. This is negative overall, as it hurts the segment which accounts for around 40% of the company’s EBITDA. Deluxe is still a check company, and while their transformation is underway, debt is now a sword hanging over their heads. Investors should be aware of this real risk and are essentially betting on a slower rather than faster death of checks. We think Deluxe is actually quite compelling, though, and the debt load is in principle manageable given historical rates. But leverage gives us pause, and while we view it as speculative buying, we wait to see what to do with our own money.