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Rating Action:

MOODY'S LOWERS DELUXE CORP.'S RATINGS (SR UNSECURED TO Baa3 from Baa1); OUTLOOK IS NEGATIVE

13 Jan 2006
MOODY'S LOWERS DELUXE CORP.'S RATINGS (SR UNSECURED TO Baa3 from Baa1); OUTLOOK IS NEGATIVE

Approximately $1 Billion of Long-Term Debt Securities Affected

New York, January 13, 2006 -- Moody's Investors Services downgraded Deluxe Corporation's ("Deluxe") senior unsecured ratings to Baa3 from Baa1 and commercial paper rating to Prime-3 from Prime-2, concluding the review for possible downgrade initiated on November 7, 2005. The downgrade results from increased business risk and deterioration in the revenue base because a loss of volume and market share are intensifying pricing pressures in the company's check printing business. Moody's recognizes the company's plans to offset these pressures by growing its small business services (SBS) segment but perceives execution risk in an unproved business model. In Moody's opinion, these operating risks will challenge management's ability to reduce leverage from the high levels it achieved over the past five years. The rating outlook is negative.

Ratings affected include:

Senior unsecured notes -- to Baa3 from Baa1

Senior unsecured shelf -- to (P)Baa3 from (P)Baa1

MTN program -- to Baa3 from Baa1

Commercial paper -- to Prime-3 from Prime-2

Consolidation among financial institutions and the erosion of printed check unit volumes due to the ongoing shift in financial transactions to electronic from paper-based formats is increasing the business risk in the check-printing industry and putting severe downward pressure on revenues and earnings in Deluxe's financial services (FS; 32% of revenues) and direct check (DC; 15% of revenues) segments. Moody's is concerned that the decline in physical check demand (unit volumes are currently contracting by 4-5% per year) will continue and ultimately accelerate erosion of the revenue base. Declining check usage and financial institution consolidation also create significant downward pressure on check product prices. Deluxe is attempting to counteract these pressures by focusing on its SBS segment (53% of revenues) -- a strategy shift that prompted the June 2004 acquisition of New England Business Service (NEBS) to broaden the SBS product line.

The SBS segment has lower margins than Deluxe's FS and direct check segments and presents operating challenges due to the print-based product line and significant churn in the customer base. Business checks are the largest product in the SBS segment and are vulnerable to the same demand pressures facing the FS and DC segments, although to date the pace of decline in business check usage (1-2% per year) has been slower than that of consumer checks. Other SBS product offerings, which include business forms, packaging, promotional products, envelopes, labels and tags, and greeting cards, are commodity-like with usage tied to the small businesses economy. Customer acquisition costs are considerable given the churn in the SBS client base resulting from a high percentage of firms that do not become repeat customers after the first order, which is characteristic of direct marketing companies, the high rate of small business failures (averaging approximately 10% per year), and the tendency of small businesses to shift to electronic from certain paper-based products as they grow.

Moody's rating anticipates that management will continue to focus on debt reduction in 2006 and 2007 in an effort to lower the company's high leverage (debt-to-EBITDA was 3.0x for LTM ended September 30, 2005 incorporating operating leases, pensions, and Moody's other standard adjustments). However, Deluxe's financial profile has become more aggressive at a time when business risks are increasing. Total debt has risen considerably over the last five years to fund acquisitions and share repurchases. The rating agency is concerned that the heightened level of business risk will limit the company's ability to reduce debt-to-EBITDA leverage and could lead to further strategic leveraging transactions over the intermediate term.

The ratings are supported by the company's leading market position in core businesses, good cash flow capabilities and adequate liquidity. In the SBS segment, Deluxe can leverage its relationships with financial institutions to provide a more cost-effective means of acquiring new customers than is available to competitors, which rely more heavily on direct and relationship marketing. SBS customer leads also increase the value of the financial institution relationship to Deluxe, affording some flexibility to price aggressively in the FS segment.

The expanded small business product line resulting from the NEBS acquisition positions Deluxe to increase wallet share and improve customer retention by becoming more of a one-stop supplier for all client printed material needs. This should benefit customer retention over time. Integration of NEBS is also yielding cost synergies through plant rationalization, headcount reductions, and from increased manufacturing scale economies and buying clout.

Integration of NEBS into resource planning and order capture systems and investment in additional sales staff will allow for more coordinated product offerings in the SBS segment and a shift to a more proactive sales approach based on the specific product, distribution channel and order frequency needs of various customer segments.

Deluxe's low cost status in the check printing industry should sustain the company's leading market position. The company continues to rationalize its plant footprint and non-union employee base to keep pace with lower unit volumes and benefits from its greater buying clout than competitors with paper suppliers. Moody's believes Deluxe will utilize the cash flow from its check-printing businesses to invest in its SBS segment growth initiatives and reduce debt.

Moody's does not anticipate the company's strategic, operating and capital structure plans will change in the near term under the interim CEO. Moody's will evaluate any changes to the company's plans that a permanent CEO might implement once the search process is completed.

The negative rating outlook reflects the potential for additional erosion of the revenue base and resulting elevated level of event risk. Moody's expects that Deluxe's strategy will allow for modest growth in the SBS segment but that price and volume declines in check printing will continue to pressure consolidated revenue. Moody's believes cash flow is likely to benefit in 2006 from smaller outlays on contract acquisition payments, capital expenditures and accrued liability paydowns relative to 2005. Moody's anticipates that Deluxe can maintain debt-to-EBITDA in a 2.75-3.25x range in the near term by utilizing free cash flow to reduce debt and that debt-to-free cash flow will decline from its current high level (18x for LTM September 30, 2005) to an 8.0-10.0x range.

Debt-to-EBITDA exceeding 3.25x or debt-to-free cash flow exceeding 10.0x due to earnings deterioration or a leveraging event could negatively affect the ratings.

Renewed revenue growth, margin stability and debt reduction that leads to sustainable debt-to-EBITDA and debt-to-free cash flow in a range of 2.75-3.25x and 8.0-10.0x, respectively, could favorably affect the rating or outlook.

Deluxe Corporation, headquartered in St. Paul, MN, provides checks and related products to consumers and small businesses through financial institutions, direct marketing, and retail channels.

New York
John E. Puchalla
Analyst
Corporate Finance Group
Moody's Investors Service
JOURNALISTS: 212-553-0376
SUBSCRIBERS: 212-553-1653

New York
Julia Turner
Managing Director
Corporate Finance Group
Moody's Investors Service
JOURNALISTS: 212-553-0376
SUBSCRIBERS: 212-553-1653

No Related Data.
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