Deluxe Entertainment Services filed a pre-packaged Chapter 11 bankruptcy plan of reorganization earlier this month on October 3^rd.  In case a visual better highlights the import of the circumstances, included below is the notice for Deluxe’s bankruptcy proceedings published in the Wall Street Journal.

What is Happening?

To sum up the proceedings, Deluxe can no longer service its approximately $1.1 billion debt burden, $783 million of which was set to mature in February 2020.  Despite the management team’s best efforts during the first half of 2019, Deluxe was unable to generate a cash event sufficient to pay down the debt through any combination of equity offering, asset divestiture, or alternative debt raise. This bankruptcy restructuring will then exchange substantially all of the equity of Deluxe to the current debt holders in return for a forgiveness of a meaningful portion of the outstanding debt.

Upon exiting the bankruptcy process (hearing is set for Thursday, October 24^th), Management is anticipating a reduced debt burden of approximately $300 million and is forecasting the generation of $119 million on an adjusted EBITDA basis for the 2020 calendar year.  A much more manageable situation.

Why Bankruptcy?

To use Deluxe’s words from its bankruptcy filings:

“On October 3, 2019, the Company commenced these chapter 11 cases with a clear message to its customers and competitors: the Company and its future equity owners are implementing a financial restructuring that will allow the Company to emerge seamlessly and speedily from chapter 11 with an optimized capital structure and as a strong partner that its customers can continue to trust.”

Deluxe’s associated press release strikes a similar tone.  “This process will allow us to strengthen our balance sheet and gain the Financial Flexibility and resources to drive investment in key growth strategies with no disruption to our business and no impact to our employees, customers, vendors and other business partners” stated John Wallace, Chief Executive Officer.

For obvious reasons it is important to communicate stability to stakeholders when going through a bankruptcy restructuring.  In the case of Deluxe it is especially acute to maintain its business relationships because, as it made clear in the bankruptcy financial disclosures, the value of Deluxe is the relationships.

And this point is acknowledged explicitly by the Deluxe management team.  “Delivering this message is particularly important because the Company’s [Deluxe] business (and the industry it operates in, generally) is unique in that it runs on relationships and one-off projects, not long-term binding commitments)” reads an excerpt from Deluxe’s Chapter 11 Declaration submitted by Deluxe’s CFO Eric Cummins.

Deluxe has structured the bankruptcy efforts consistent with the above messaging. Management developed a plan prior to entering this process, communicated the plan to debt holders, negotiated the contemplated debt-for-equity swap, secured the funds to exit bankruptcy, and is maintaining (i.e. paying) all existing the claims of customers, employees, and suppliers.

To add some context to the size of those claims, Deluxe’s estimated payroll for the 30 days from the filing date (October 3^rd) is $30.4 million.

We will now transition the article into a discussion of the financial challenges leading to the need for a bankruptcy event.  Our attempt at a summary of the lengthy discussion is the following.  Deluxe has built a large, fixed cost structure to provide worldwide services at the scale required by large, global media customers.  Revenue has been negatively impacted by the secular shift toward in-sourcing by its customers and broad technology shifts have necessitated Deluxe to invest in a new cloud-based infrastructure, while maintaining its existing legacy infrastructure.  Unfortunately, new cloud-based pricing models (even if successful) provide a small, slow ramping contribution to revenue.

What led to Bankruptcy?

Deluxe is one of the largest technology suppliers in the media sector, “with a worldwide presence of more than 7,500 of the industry’s premier artists, experts, engineers, and innovators.”  The latter part of the sentence is excerpted from the filing.  Other filings cite the employee count at 2,924 employees and 490 contractors.  The Company’s history spans more than 100 years, having been founded in 1915.

Deluxe has two primary businesses:

• Creative – the Company’s visual effects and post-production services.  The division includes brands Method, Stereo D, Encore, EFILM, and Company 3.
• Distribution – comprises the Company’s localization (subtitling, dubbing), delivery operations (physical, digital, playout), and digital cinema services (mastering and distribution of content for cinema).  These business lines are supported by Deluxe One, a cloud-based platform announced at the 2018 NAB Show and launched in late 2018.  According to the Deluxe One collateral, content creators and distributors can use Deluxe One to integrate all their systems and vendors to manage virtually every step of the workflow from creation to delivery.

Deluxe’s journey into bankruptcy and its plans for emerging have been the subject of much speculation and a review of the circumstances are a great reference point for industry participants.  Further, by its nature bankruptcy filings are fact-based, plainly written, and largely free of marketing embellishment.

“Deluxe did not take the decision to commence these chapter 11 cases lightly and made substantial efforts to avoid this outcome.” The ‘substantial efforts’ were focused on reducing its debt load during the first half of 2019.  Primary among these efforts were an attempt to explore strategic alternatives for its Creative division.  In the first half of 2019 Deluxe was in advanced discussions with a joint venture partner for the Creative division.  The transaction would have resulted in cash receipts to Deluxe to pay down debt and provide working capital.  It didn’t happen.  The discussions around this potential joint venture accumulated a more than $9 million legal fee with well-known M&A law firm Skadden & Arps (the largest unsecured creditor noted in the filings).  Deluxe also engaged investment bank PJT on July 15^th “to seek additional sources of liquidity from various third-party sources.”  No sources were ultimately found.

When the Creative Services transaction ultimately fell through in the summer of 2019, Deluxe began to explore other deleveraging transactions with its creditors outside of bankruptcy court.  Based on the timeline established in the filings, these discussions were taking place in late August / early September.  Even out of court restructurings require some funding – to begin with lawyer bills, banking bills, and consultant bills.  Deluxe estimated an amount of $25 million to fund its restructuring. Those envisioned transactions were of the same nature: a debt-for-equity swap with debt holders.  When informed of the upcoming out-of-court debt exchange, S&P decided to further downgraded the rating on Deluxe’s debt.  That was on September 10, 2019.  The downgrade made it impossible for certain of its debt holders to participate in the $25 million funding.  Deluxe therefore proceeded with a more advantageous and larger $115 million debtor-in-possession (“DIP”) financing arrangement, through an in-court process.  Don’t read ‘advantageous’ in the previous sentence as cheap because the DIP instrument will incur $12 million of interest and fees through November 1^st of this year.

Backing up further from the specific events of 2019 is illustrative.  The current (and soon to be former) owners of Deluxe are MacAndrews & Forbes, an investment vehicle of Ron Perelman, one of the famed corporate raiders from the 1980s.  (Feel free to skip the next two paragraphs should you have no interest in the background of Perelman).

MacAndrews & Forbes, originally a chocolate wholesaler and producer of licorice extract, has been an active investor in the media technology for almost forty years.  One of the investment firms earlier deals was the acquisition of Technicolor in 1983 for $119 million.  After selling off six divisions of Technicolor, the core business was then sold to Carlton Communication for $780 million in 1988 (and then subsequently to Thomson).  Panavision, the well-known supplier of cameras and lens, was taken private by MacAndrews & Forbes in 2006, though MacAndrews & Forbes original investment in Panavision begin with an initial stake in 2001.  The firm continued to own Panavision until a debt restructuring in 2010, where it gave up its equity position. The events of Deluxe parallel the Panavision restructuring.  In the case of Panavision, the specifics were a $300 million debt balance, necessitating a $140 million debt forgiveness.  The new owner became Cerberus Capital.

More broadly, MacAndrews & Forbes has also owned Media properties such as Marvel Entertainment (bought for $83 million in 1989 if you can believe it) – now a part of Disney (2009 transaction for $4.24 billion) – and New World Entertainment, which became a part of News Corp, and its content library is now also a part of Disney.

Returning to the specifics of Deluxe, MacAndrews & Forbes purchased Deluxe in January 2006 from The Rank Group for a purchase price of £420 million or $750 million.  MacAndrews & Forbes contributed $152.5 million toward the purchase, borrowing the remainder.  For the calendar year 2005, Deluxe had revenues of £415.7 million (13.4% growth over annual revenue in 2004) and an operating profit of £65.7 million (15.8% operating margin).  The revenue multiple of the transaction was then around 1x annual sales.

It is worth keeping those figures in one’s mind as you read the remainder of the article.  At the time of its initial investment, Deluxe had a healthy operating profit and was generating double digit organic growth.  But while this is the same company and the same market, it was a long time ago in – for all practical purposes – a galaxy far, far away.

15 years, 16 M&A deals (see below table), almost $500 million of incremental debt later, and Management is projecting total revenue to reach $867 million for the 2020 calendar year.  The then sum total of organic and inorganic growth initiatives generated (or rather will generate) a compound annual revenue growth of just under 1% over the fifteen-year period, 2006 to 2020.

In real terms that doesn’t even represent growth since USD inflation has averaged just under 2.0% during that same time frame, equating to nominal pricing levels 30% higher in 2019 than 2005.  To cast in more intuitive terms, the cost of first class postage in the US grew at a rate of 2.87% per year and the price of a McDonald’s Big Mac grew 3.39% per year during the time frame 2005 – 2019.

Deluxe Acquisitions 2007 – 2019

(It is interesting to note how both the Atomic Fiction and Sixteen19 deals occurred after Deluxe had already started to take steps to restructure its capital structure.)

Of course, the revenue trajectory was not a straight line.  For instance, the Ascent Media deal added almost $300 million of annual revenue ($296 million for 2010) for a purchase price of $69 million.  Indicated in Deluxe’s public comments and various debt rating disclosures is revenue at times exceeded $1.3 billion before settling at today’s levels.

The above portrait is unfair to Deluxe management since it omits much of the change in the media technology landscaped over the past decade-plus.  Consider the following examples of the state of the industry in January 2006 (timing of the MacAndrews & Forbes original purchase of Deluxe):

• RED hadn’t even started taking pre-orders for the RED One (NAB Show 2006)
• The list price of Media Composer was $25,000 (Avid would announce a software-only version at the 2006 NAB Show for $5,000)
• A high-end solution of Da Vinci Resolve cost well in excess of $500,000
• AWS had yet to publicly launch (March 2006)
• Apple still attended media technology tradeshows (NAB Show booth of 9,900 square feet in 2005)
• The precedent businesses (now consolidated) of Grass Valley occupied nearly 42,000 square feet of NAB Show booth space (Grass Valley occupied less than 10,000 in 2019)
• US scripted original shows were around 200 produced a year (now almost 500 according to FX Networks Research)
• Disney spent $6.5 billion on television and film content in 2005 (through nine months of 2019 Disney has spent $13.6 billion)
• Chinese box office revenues were around 1/10^th of the United States (now similar in size)
• Netflix had 4.2 million DVD subscribers and 0 streaming subscribers
• The New England Patriots had yet to win a Super Bowl
• Eastman Kodak revenues were still comfortably above $10 billion annually (Kodak would enter its own Chapter 11 restructuring in 2012)
• And film processing was a majority of Deluxe’s revenue

The attentive reader will note one of the above is made up (hint: not the Deluxe revenue composition).

So the industry environment changed … completely.

The bankruptcy filings discuss Deluxe’s challenging financial performance under the heading of ‘Secular Market Shift and Company Response.’  In an ironic twist, Management cites the growth of consumer demand for content as the cause of Deluxe’s difficulties because it required a rethinking of processes and workflows.

Some reflections on this statement is appropriate – a significant increase in customer’s customer demand was a problem!

Those changes necessitated a ‘heavy’ investment in cloud-based tools, including the aforementioned Deluxe One, a reimagining of the content supply chain in a cloud-based platform (as described in a January 2019 press release).  Deluxe One has a Software-as-a-Service (“SaaS”) pricing model, where customers pay a recurring fixed fee for use of the platform.  According to the filings, the sales cycle for “this type of new product and model has proven longer than initially anticipated.”  Since Deluxe One was only announced at the 2018 NAB Show, one does wonder what exactly was the initial expectation for revenue from the product through the first 18 billable months?

In our reading of the filings, the discussion devoted to Deluxe One is more an explanation of why Deluxe One couldn’t prevent the bankruptcy.  The more impactful driver of financial challenges was – in Management’s words – the “significant infrastructure-related fixed costs associated with legacy workflows.”

During the Devoncroft Amsterdam Summit, the panel ‘Technology Supplier C-Suite’ discussed this very point.  Transitioning to a SaaS business model requires much, much more than billing in monthly increments.  Operations, and by extension operational expenditures, have to align with this product delivery practice.  Said differently, a company transitioning to a SaaS business has to reorganize its entire business to the model.  In the case of Deluxe, Management had to manage a cost structure and business organization built around delivering global professional services on an ad-hoc project basis to large media organizations.  Layering a SaaS offering on top of such a fixed cost structure is problematic (not possible?).

At the same time Deluxe was transitioning the technical infrastructure of its business, Deluxe’s market segment was impacted by the notable trend of media companies in-sourcing technology capabilities.  Management describes this as follows, “Advances in technology have also made it possible for many clients to ‘in source’ technology and services they once procured from Deluxe.’  Once media companies bring activities in-house, those revenues are no longer a part of the addressable market.

We have tracked this development for years in the Big Broadcast Survey.  It is interesting to note preferences for in-sourcing correlate with the size of a media organization and also with greater adoption levels of cloud-based infrastructure.  Those are not optimistic observations for suppliers hoping the trend toward in-sourcing will reverse given the continued consolidation of media organizations and the growing adoption of cloud-based infrastructure in the global media industry.  Putting a finer point on this discussion, we are unaware of any data point suggesting the trend toward in-sourcing will end in the immediate term.

A good example is found in the annual Big Broadcast Survey Trend Index (below is an excerpt from the Devoncroft Amsterdam Summit).  The least important trend cited in the 2019 Big Broadcast Survey Trend Index was ‘Outsourcing,’ which is of course the opposite of in-sourcing.  Reversing the previous sentence yields the more straightforward statement: there is limited interest in ceasing in-sourcing of technology infrastructure among global media customers.

(Incidentally the presentation materials from the 2019 Devoncroft Amsterdam Summit are now available to interested parties).

Not only does Deluxe cite in-sourcing as a challenge to its revenue, it is also cites Managements own decision to in-source software development as a potential risk to the business given the commercial reliance on those same software systems.  This is particularly ironic given the dual in-sourcing risks are cited two pages apart in the bankruptcy filing, beginning with “The Debtors’ [Deluxe] business lines rely heavily on in-house development of proprietary software, including to continue the evolution and development of the Debtors’ Deluxe One platform.” Followed by “The Debtors also face competition from their customers, who already have, or may develop, in-house capabilities to supply certain products or services which the Debtors supply, such as studios or OTT customers who have Creative services capabilities in house or OTT providers that manage their own localization services.”

There is clear a distinction between (i) Deluxe building its own supply chain software system as opposed to integrating third party solutions and (ii) media companies bringing creative service activities in house.  However, the rationale is the same: it is a strategic activity the organization believes it needs to own and control.

Review of Financial Disclosures

As part of the bankruptcy, a liquidation analysis was performed on Deluxe.  It is a necessary input into the deliberation because it offers a concise referendum on whether it is worth re-emerging from bankruptcy.  Even a quick review of the liquidation analysis performed on the business supports the observations that substantially all of the value of Deluxe is its relationships with a select group of large customers.

The associated commentary in the bankruptcy filings is supportive of this viewpoint. [quote]

“The Company’s long-standing customers can choose to terminate contract and move a project to competitors at any time and the Company’s master services agreements generally do not contain any exclusivity or minimum project or volume requirements…Given the stability and quality customers demand, and the risk that competitors and/or customers may misperceive or mischaracterize this process as a liquidation, it is imperative that the Company demonstrate from day one of these cases that this refinancing process will be completed very quickly and is a positive step forward for the Company, that the Company is not liquidating, and the customers and employees can continue to rely on the Company.”

The top 15 customers of Deluxe account for a majority of its revenue.  These are the largest of the largest customers of post-production and distribution services (studios, advertising agencies, …).  Given the level of concentration, it would only take a couple of customers to revisit their relationship with Deluxe to cause a meaning negative event for the business.

Though the value is in the existing relationships, the nature of accounting doesn’t capture this value on Deluxe’s balance sheet since it was created through organic initiatives.  Even the intangible assets –brands, customer lists, contracts, relationships, and trademarks – ascribed a value on Deluxe’s balance sheet only have an estimated recoverable value of less than 12% of stated value.  Such a low realizable value owes as much to how any such assets would be sold in a liquidation scenario.

Moving through the balance sheet accounts further highlights how much of Deluxe’s value rests with the relationships as opposed to identifiable assets.  There is a negligible real-estate footprint (the majority of offices are leased).  In fact, the liquidation analysis puts the entire recoverability of its Property, Plant, and Equipment assets (“PP&E”) at between 2% – 24% of book value (amortized cost).  PP&E includes all media technology equipment and software – including capitalized software built internally such as Deluxe One.  The tremendous investment in cloud-based infrastructure – mentioned above – hasn’t yet materialized into much of a valued accounting asset.

In the best-case scenario of a liquidation, the sum of recoverable assets (current plus longer-term) is estimated at $159 million (keep in mind cash and account receivable balances are $160 million).  This means in the best-case scenario the vast majority of debt holders would get nothing.  In the contemplated plan, the debt owners of the term loans (maturing in February with outstanding principal of $783 million) are expected to receive 27% of the value of their current stated debt holdings.

The 27% stems from the receipt of a 65% equity interest in the going-forward Deluxe business.  The balance of the equity will go to other debt holders and the management team.  To establish the value of the equity of Deluxe upon re-emerging from bankruptcy, the Company’s bankers performed a valuation analysis to determine the Enterprise Value (Equity Value + Cash – Debt) as of September 30, 2019.  The conclusion of the valuation analysis is an Enterprise Value between $500 million and $700 million, equating to revenue valuation multiples of 0.6x to 0.8x versus expected 2020 revenue of $867 million.

The details of the valuation exercise are not included in the filing because

“The preparation of a valuation analysis is a complex analytical process involving subjective determinations about which methodologies of financial analysis are most appropriate and relevant and the application of those methodologies to particular facts and circumstances in a manner that is not readily susceptible to summary description.”

Rejoining to the above, I respectively disagree.  You may not want to summarize, but you certainly can summarize.  It is commonplace to summarize asset impairment testing or the pricing of stock options within regulatory filings by citing the assumptions used (discount rate, exit multiples, etc …).  As a general rule, if you cannot summarize an argument, then don’t expect others to believe it.

We are tempted to devote some space here to performing such a valuation analysis based on Management financial projections, comparable M&A comparable transactions, comparable public trading multiples, and related factors.  We won’t as a concession that any such discussion is an academic exercise and a distraction.

Depending on your personality, you could describe this situation as either the best option or the only option (both are equally true).  Put succinctly even if the valuation were $100 million less, the debt holders should still take the deal.  All other avenues of restructuring and capital raise have been explored, bankruptcy or an equivalent restructuring was the only option, and in a liquidation scenario the debt holders get approximately nothing.

This is it.

Who are the New Owners?

MacAndrews & Forbes is relinquishing all of its equity ownership in Deluxe as part of the bankruptcy.

The new owners of Deluxe are the former debt holders, who are investment firms having a focus on below-investment grade corporate debt (‘junk’ debt).  Deluxe’s term loans have received below investment grade ratings since inception.

More specific, new Deluxe will have five board seats, selected by the following firms:

1. Sound Point Capital Management (prior debt position $115.7 million)
2. CION Investments (prior debt position $25.2 million)
3. CIFC Asset Management (prior debt position $114 million)
4. INVESCO (prior debt position $71m)
5. The remaining holders of Deluxe’s current debt

There is a saying in sports that ownership is the biggest source of competitive advantage.  This applies to technology suppliers as well.  That isn’t intended to pass judgement on the new owners, but rather to draw attention that the contributions and motivations of the new owners will matter.

These organizations have the best opportunity to maximize their investment position in Deluxe through this restructuring.  That is the appropriate lens to view the investment.  The incorrect way is to measure success against the historical investment basis.

The term loans totaling (at least outstanding principal) in the amount of $783 million are a great example of the above point.

Those $783 million term loans are now a 65% ownership position in Deluxe.  Ignoring time value of money, a future exit to fully recover the cash value of the original $783 million would require an equity value of $1.2 billion.  The valuation analysis included in the bankruptcy filing had a midpoint valuation of $600 million of the enterprise.  Based on a net debt position of ($288) million ($301 million of debt less $13 million cash), this equates to an equity valuation of $312 million.  An exit at an equity valuation of $1.2 billion then requires an almost quadrupling of the current equity valuation of Deluxe.  Some combination of the usual levers of revenue growth, profitability improvement, and valuation escalation (and of course patience) would need to drive such an increase in value.  The task is made more challenging given the considerable size of Deluxe.  The bigger the business the harder it is to generate growth substantially above overall market growth levels.

The Future?

The lone comment we would register about the valuation analysis (noted above) is in regard to the management supplied financial projects expecting growth of 6% in 2021 and 5% in 2022.  Those growth rates are well in excess of Deluxe’s historical growth rates, the historical growth rates for the market segments where Deluxe is active in the media technology sector, and further are in excess of the industry consensus industry forecasts for those same segments (see IABM DC Global Market Valuation Report).

This would suggest Deluxe believes it will gain market share.  My reading of the valuation analysis text suggests a valuation of Creative Services separate from Distribution.  Presumably Distribution would then receive a higher valuation.  The bankruptcy filings are thin on discussion of why the Distribution business or Deluxe One will grab meaningful market share.  187 exhibitors at the 2019 IBC Show indicated they provide ‘Cloud Services’ and a further 194 indicated they provide ‘Software as a Service.’

Deluxe One was only announced at the 2018 NAB Show.  As such, the public collateral remains light.  The announcement press release at the 2018 NAB Show cited four partners and no customers.  At the 2019 NAB Show Deluxe One announced it would go all-in with AWS, bringing the total partner count to five – where it stands today.  There are still no customer testimonials.  However, a January 2019 press release by Andy Shenkler, Chief Product Officer, cites Deluxe One’s management of more than 488,000 titles/versions and 130,000 assets.

Perhaps the closest to a firm data point provided on the commercial adoption of Deluxe One is the amounts owed to AWS identified in the bankruptcy filings.  AWS is owed a bit more than $800,000 as an unsecured creditor.  AWS is a supplier – and presumable the largest supplier – into Deluxe’s cloud activities.  We would leave it to the reader to extrapolate the $800,000 figure (based on payment terms) to an annual total, and then further extrapolate to commercial revenue based on cloud COGS within a cloud-based offering to end-customers.

We can appreciate the decision to keep the discussion of future business planning brief and unspecific given the more pressing matters of emerging from bankruptcy as quickly as commercially possible.  Looking forward to seeing the Deluxe team emerge from bankruptcy and begin to execute on a new plan, unburden by a frightening debt load. The Confirmation Hearing is set for October 24^th.

Stay tuned.  (And if you read the entirety of this post, then thank you very much for your attention).

Related Content: 

Deluxe Press Release about Restructuring

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