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Mar 31, 2015

Cheque It Out!

This month we wanted to highlight one of our Canadian companies. We discuss why we decided to buy their stock for our portfolios and why we continue to own it today. This low-key company is not a household name, but almost every adult in Canada.

By CWB McLean & Partners Research Team

This month we wanted to highlight one of our Canadian companies. We discuss why we decided to buy their stock for our portfolios and why we continue to own it today. This low-key company is not a household name, but almost every adult in Canada has used its main product on a frequent basis over the years. Recently, the company was named one of the top 100 brands in Canada by Brand Finance. We will tell you the name of the company in a moment, but first let’s take a look at the history of the company and the due diligence our research team performed in the selection process in 2012.

The company was founded in 1875 and was privately owned for 126 years until it was listed publically in 2001. Historically, their core business has been the printing and sales of cheques for Canadian financial institutions. These institutions effectively outsourced the cheque management process (ordering, processing, printing, database management, reporting and delivery) to this company under long-term contracts. However, their core business model has evolved through the years, incorporating lending solutions and business solutions into their business model.

What initially attracted us to this company? When we reviewed the company in 2012, there were three things that piqued our interest. First, the company was out of favour with most investors since the cheque printing business was seen as a business in secular decline with no growth opportunities. Most investors believed that revenues for cheque printing would only decline in the future as consumers moved from cheques to debit/credit cards and electronic payments. As a result of being out of favour, the company’s dividend yield was high at 6.7%. Second, the company was not well-followed on the Street with only four analysts providing research. Third, the company’s market capitalization of $1 billion made it too small for many of the large mutual funds to buy.

Our next step was to see if the company met our six-step company selection process. Remember, this analysis was performed in 2012, so the data presented below was as it appeared to us in 2012:

  1. Does the company have a competitive advantage?
    The company’s proprietary software provides essential transaction processing services at a lower cost than in-house options. In addition, its long-term relationships with over one thousand financial institutions provide the company with a better understanding of how best to improve efficiencies for clients and for cross selling future services.

  2. Does the company have a strong balance sheet to withstand an economic downturn?
    Yes, the company has a strong balance sheet. First, earnings are significantly higher than annual interest expenses, which is evident through the ratio of earnings-before-interest and tax-to-interest expense of 5.2x. Second, total debt to EBITDA (earnings before interest, taxes, depreciation and amortization) is 1.95x which has declined from 2.49x at the beginning of 2011. In addition, the company has unused bank lending facilities of $147 million.

  3. Does the company generate free cashflow?
    In 2011, the company’s free cashflow was $121 million which constituted 18% of the revenue.

  4. What is management’s track record of creating shareholder value?
    Revenue per share increased by a compounded 10% per share over the last five-year period (2006 to 2011), while EBITDA grew at 7%.

  5. Does the company return capital to shareholders through dividends or share buybacks?
    The company has paid a dividend every year as a publicly listed company since 2001.

  6. Is the company trading below our intrinsic value?
    Our intrinsic value on the stock was just over $22, while the stock was trading for $18. Therefore, there was a 22% upside on the stock.

Our next step was to meet with management to better understand the business and whether investors were missing something in terms of growth opportunities. We initially met with the CEO and CFO of the company in February 2012 and then over the next month performed our due diligence. Although most investors labelled the company as a “one trick pony” singularly focused on the cheque business, the company was more diversified than investors appreciated. The cheque business (Payment Solutions) made up 41% of total revenues (down from 81% in 2008), while the company’s other lines of business were quietly growing organically and through acquisitions.

The other main businesses as a percentage of revenue were as follows:

  1. Lending Solutions – 54% of Revenue

    Loan Registration & Recovery Services – provides software for lenders in filing and searching public record registries of personal property. This service provides creditors with a simple and automated way to obtain and manage their security interests in personal, small business, and commercial loans. The large volumes processed are related to new and used car loans.

    Loan Servicing
    – administrates all aspects of the Canada Student Loan program on behalf of the federal and provincial governments, and financial institutions under long-term contracts.

    Mortgage Processing
    – Provides back office software solutions for over one thousand North American financial institutions regarding online, call centre, or in-person mortgage applications, underwriting, approval, monitoring, compliance, and discharge.

  2. Enterprise Solutions – 5% of Revenue 
    This segment provides business process outsourcing services such as claims processing for insurance companies, bill payment processing, and rebate and coupon processing. 

Our investment thesis was that investors were wrong to view this company as a pure play on the mature cheque business. In fact, despite the possibility of declining demand due to increased electronic banking, we viewed the cheque business as a cash cow that was spinning off significant cash which could be reinvested in the other businesses. We believed that management had a number of levers to offset the decline in the cheque business. Specifically, management could reduce the average number of cheques per order while keeping prices constant, effectively increasing the price per cheque. Also, management could increase the customization available for cheques with personal, corporate, and branded logos at a higher reorder cost to increase revenues. 

In terms of the software solutions business, we believed that there were many growth opportunities. First, due to the 2008-2009 global financial crisis, North American financial institutions were focused on cost reduction through improving productivity and efficiencies to strengthen their balance sheets. This would lead to increased demand for outsourced technology solutions. Second, management were shrewd capital allocators through six successful acquisitions between 2005 and 2011, which increased net income by 50% while reducing the reliance on the cheque business. Third, the company had a strong balance sheet to complete more acquisitions. Fourth, we believed that the company was really a financial software company and should be valued as such.

Did you figure out which company we are discussing? It’s Davis & Henderson, a company that recently rebranded its name as D+H Corporation. Over the last three years the company has successfully executed its strategy through two significant acquisitions and organic growth. Over the same period, D+H transitioned from sourcing 90% of revenues from Canada to 56% today (refer to ‘Revenue (%)’ in the following Metric chart). In addition, the number of financial institutions that D+H serves has increased from 1,000 to 7,000.

Today, D+H is a significantly different company than when we purchased it as shown below:

D+H Statement

We continue to own D+H since it still meets the criteria in our investment process. We view the company as a financial technology company that has become even more embedded within financial institutions across North America. We believe that D+H provides essential solutions to drive growth, improve the client experience, streamline operations, meet compliance requirements, and reduce IT infrastructure costs. Given its diverse technology solutions, we view the company as an investment in the growth of the Canadian and U.S. economies.

We believe that D+H has successfully transitioned its competitive advantage into an “economic moat” given the company’s depth of products, relationships with many financial clients, and that its software is now embedded into the technology of its clients. Therefore, high switching costs for its clients ensures that D+H software will continue to provide a recurring revenue stream and an opportunity to further cross sell new products and services into its existing client base.

D+H Corporation has become an integral part of the North American financial landscape and is:

  • The leader in broker-originated mortgage software-as-a-solution (SaaS) which connects brokers with over 80 banks/lenders and processes over $80 billion worth of transactions in the Canadian housing market. 
  • The software of choice (SaaS) for over 7,000 U.S. lenders for mortgages, consumer and commercial loans through multiple distribution channels.
  • The leading solution provider for the Canada Student Loan Program, which has over 1.7 million students and a $22 billion loan portfolio. Given the new Canada Apprentice Loan, it is estimated that 26,000 students per year will apply for over $100 million in loans.
  • The market leader in Canadian cheque-based payments for 20 million personal accounts and two million small businesses and offers credit monitoring and identification protection services.
  • The market leading loan documentation compliance software used by over 3,300 U.S. financial institutions. 

In summary, our investment thesis has borne fruit over the last three years, with stock appreciation from $18 in 2012 to $39 today, and a growing dividend income stream. The key to finding and acting on these opportunities is to have a consistent investment process, which involves proper due diligence and understanding what other investors may not recognize. To quote Wall Street legend, Peter Lynch:

“Investing without research is like playing stud poker without looking at the cards.”