DM – Long

The Dolan Company (DM:NYSE) is a small holding company with massive SOTP value and a catalyst to unlock it via restructuring. The price is down from $10 a year and a half ago to $2 today, but the value has not been hit nearly as hard. The fall has come mainly as a result of the drastic downturn in the mortgage default processing unit (NDeX), and concerns about the debt burden. However, prudent actions are being taken to restructure NDeX and deleverage the balance sheet. As the overhang from NDeX and the debt abates, the quality of the parts will become more visible and I expect the stock to re-rate closer to fair value.

Now lets take a look at those parts….

Litigation Support Services

Discovery Industry

Discovery is the process by which a defendant discovers relevant files to produce in order to respond to a document request from a plaintiff (or government investigation). An e-discovery/document review shop reviews the defendant’s files/data and sorts out/prioritizes the relevant documents. A full service e-discovery firm will process, host and review a client’s data and sometimes utilize predictive coding in review. Predictive coding is a process that involves machine learning where a human reviewer trains software to understand complex concepts and replicate the sophistication and accuracy of the human’s process. E-discovery shops with strong technology offerings are on the right side of two strong secular tailwinds:

1) As the volume of ESI (electronically stored information) has grown rapidly (and is expected to continue to grow at a ~40% CAGR for the next 5+ yrs) the need to process, host and review the data for discovery has grown with it. It has also made it more difficult (and expensive) to respond to requests with in house teams (either at the company or at their law firm). Thus, outsource e-discovery shops are getting a bigger part of a bigger market.

2) Predictive coding is taking share from traditional discovery and more primitive keyword based e-discovery. It is far superior to the legacy methods in speed, accuracy and cost. Traditional linear review still has major share because predictive coding is new and there is still some concern about how defensible it is in court (meaning a judge will accept it as a reliable discovery process). In a recent survey by eDJ, half of their participants used predictive coding last year, but almost half of that group was just trying it out, for now. Predictive coding is statistically more reliable than legacy methods (accuracy rate is in the high nineties in most cases).  It is less man-hour intensive, which makes it both cheaper and quicker. And as precedents have been and will continue to be established, it is proving to be defensible. It seems likely that it will continue to gain prevalence and grow at high rates in the foreseeable future. Although this will lead to less traditional review business, it will be more than offset by growth in technology offerings for firms like DR.

DiscoverReady (DR)

DR has a strong competitive position in the discovery industry and in their technology processing offerings in particular. They have a great reputation (and track record) as a top-tier end-to-end e-discovery firm and a captive client base of fortune 500 customers. They have a well-regarded process and proprietary technology that has won them the title of best provider of predictive coding in 2012 by NYLJ (the readers were the ones who voted them the best). Also, DR is one of only a handful of shops that have the capacity/footprint to handle big corporate clients with many terabytes of unstructured data and giant discovery needs. This is important because things like predictive coding are especially useful for big projects. The more data that needs to be reviewed the smaller the amount of manual review (in order to teach the program to replicate) is as a % of the total.

DR is a good business. Margins are high because of switching costs and quality concerns that make client relationships stick. The sticky client base also creates a barrier to entry. The only capital needed to run the business is for working capital and minimal fixed assets (really just office equipment, software and datacenter equipment). b-t-e + high-margin + low-capital requirement = high ROIC firm that can sustainably make allot of money (and grow!) without having to spend allot of money on replacing (or buying new) fixed assets to do it.

The b-t-e protecting DR’s high returns emanate from its reputation/track record and sticky clients that are not inclined to defect to a new entrant or existing competitor.

Once a client has their data processed and hosted with a review shop, the initial investment of processing/assembling/organizing the data is spread over future discovery projects. The incremental cost of bringing matters that are related and/or based on the same data (as previous matters handled by DR) is smaller (and much lower risk). When a client has a vendor that they work well with, who has a process that they trust and a good track record, they are not inclined to take the risk of trying a new firm. A new firm could potentially be: unreliable, unable to satisfy deadlines, have a process that is not defensible in court, do a poor job of ranking/prioritizing files (in order for client’s council to strategically review the most relevant documents the opposition is likely to build a case on), or release privileged information to opposing council (because they failed to id it and separate it out). In many cases the potential cost savings an aggressive competitor might offer a client are simply not worth the risk/headache.

Risks

The biggest risk with this business is the customer concentration. B of A is responsible for ~40% of their business. Their relationship is very good (many senior people at DR are B of A alumni) and they have awarded DR more business pretty consistently throughout the last three years. They have become increasingly more entrenched in B of A’s business over the last five years and they provide a very complex, crucial service. Although I don’t believe it is very likely, if they were to leave or go in-house it would be pretty painful for the bottom line considering the operating leverage from the SG+A.

Another risk is if DR were to mess something major up for a major client, it could seriously damage their credibility/competitive position.

And finally, this is a technology driven service. There is always the risk that someone comes in with way better tech/process. However given that this is at least as much (if not more) relationship/trust driven as it is tech driven, I don’t think it’s likely that this would be devastating.

DR management is very competent and well regarded in their field. They’ve got the option to put their NCI to Dolan next year. If they were to cash out and leave that could certainly be a problem.

Counsel Press (CP)

CP is the other part of the segment; it’s a 75-year-old business with a very strong position in its little niche. It represents around 16% of segment top line, they do not disclose EBITDA contribution but based on talks with the company, margins are in the same ballpark as DR (they said usually mid 20s EBITDA margin but wouldn’t get more specific). It is the number one provider of appellate services, assisting law firms in preparing and filing appeals at the state and federal level. The Industry is very segmented, but CP has the dominant position in the bigger, more complex appeals. A 2008 survey by The American Lawyer showed that 85 of the Am Law 100 firms used CP. Quality is generally more important to clients than price as the cost of the service is a small portion of the total cost of an appeal; and the cost of a screw up (non-compliant with the particular court) could be meaningful. Customers are also sticky as switching costs are high (not worth the risk unless you are a very unhappy customer). Given the strong competitive position and cash generative nature of the business, Counsel Press could be appealing to a long-term financial buyer should management decide to shop it around. If not I am happy to own it.

Valuation

For 2013, they’re guiding ~100m for the segment, so I use that and run rate EBITDA margin from H1.  For 2014, I am assuming 100m for DR and the current 15m for CP. Management said they believe DR will do 100m in the near future (but not necessarily this year) and continue to grow DD from there. I’m assuming DR gets to 100m in 2014 and basically matures form there, a conservative assumption given the secular tailwinds that are highly likely to continue past next year (and that industry analysts are expecting the market to grow a mid-teens CAGR for at least the next 5 years). I also adjust for maturity/normalization of the cost structure to account for growth investments. I think 31% EBITDA margins is a conservative assumption for maturity. I assume GMs stay about the same at 56%, I feel this is conservative as future business will have a bigger mix of higher margin technology services. Based on my run-rate H1 margin assumption, they will spend ~29m on SG&A this year. That level could easily support 100m of sales at DR and the same 15m at CP (they think it could support meaningfully more that that, allot of guys on the payroll they hired in anticipation of future growth), this would be around 25% of sales. 25 + 44 = 69, 100-69 = 31.

*Margins in 2012 were depressed as a result of integration costs form acquisition of ACT, and a generally disappointing H1 related to lumpy business/timing)

So for normalized/mature 2014 we get 35.7m in EBITDA, less 3m mcx, less taxes (35% of EBT which includes amortization of 6m) of 9.3m = FCF of 23.4m. Assuming 2% terminal growth and a discount rate of 10%, we get ~292m. Discounting that back a year to the present brings us to 265m. Then finally we net out minority interest (9.9% of DR, ~8.6% of the segment) and the value to DM shareholders is ~242m. Since they will generate significant cash in the next year, I could credibly add it to my valuation but I’ll leave it out for conservatism.

I don’t actually think that this segment’s 2014 financials will look anything like this. Most likely they will continue growing and investing for growth for many years before they ultimately get to mature margins and revs (management thinks DR will do 150m at 35% EBITDA margins a few more years out). They are very unlikely to generate 35m EBITDA next year but they will likely do more than that in the not so distant future. I am fast forwarding maturity a bit so it might seem like my estimates are aggressive, but I’m being conservative in my estimate of the EBITDA number they will actually do at maturity. This is just a very rough proxy to estimate the earnings power of the segment if they were to mature in the near term.

Just as a sanity check their closest public comp, Epiq, trades ~7½ x projected EBITDA and 25% of their business is made up of the lower growth, cyclically challenged bankruptcy segment. Management has been very vocal in their belief that the E-discovery segment would trade at a much high multiple of EBITDA in isolation.

Mortgage Default Processing Services - NDeX

NDeX assists law firms in processing foreclosure, bankruptcy, eviction, litigation and other case files related to residential mortgage defaults. They process, host and manage the case file and assist with non-legal process steps, ensuring that each case meets the stringent regulatory requirements of its respective state. The advantages of using NDeX (instead of in-house or other law firm back offices which make up the lion’s share of the competition) are scale/flexibility and expertise/technology. NDeX also has important proprietary case management software that took a great level of know-how and experience to develop and is very well regarded because of it’s proven reliability, which gives their clients credibility with the banks/servicers.

Dolan bought into this business in the late 2000s hoping to cash in on the giant glut of underwater, and soon to be underwater, homes and resulting foreclosures. They paid over 240m for the business all in and believed that foreclosures would remain elevated until 2018. For the first few years they made a ton of money, things were going well and they looked quite smart. What ended up happening is that it got so bad that regulators began stepping in with extreme measures that made it very difficult/risky to foreclose on delinquent mortgages. Since then the NDeX acquisition has been looking less and less smart. Over the last three years the combination of increasingly stringent regulatory pressure and the housing recovery have destroyed NDeX profitability. Gross margins got slammed as price increases could not match increased costs of processing, and operating margins were hit even harder as fixed costs were spread over many fewer files, each of which was generating less gross profit. This Led to a business that went from doing more than 50m in EBITDA three years ago to burning too much cash for DM to comfortably hold onto it in it’s original form. Even though the competitive position of the business was still intact.

In the Q1 release, management laid out plans to restructure NDeX in order to “isolate the highest value things they can offer clients”, which included plans to sell the processing operations and license the technology infrastructure (datacenters) plus software.  On July 9 2013 Dolan announced that it sold the processing operations of its NDeX South business to the law firm affiliates of that business and has reached an agreement to sell its IN business to its Indiana law firm affiliate. Total considerations from the deal are $17.5m to be paid over the next three years by the law firm buyers (Barrett and Felwell). The only full units that remain are Minnesota and Michigan. Unless there is some sort of miracle turnaround in the next month, management is very likely going to sell these as well, so let’s assume they get 2.5m (very conservative in my view considering they likely have more than that in NWC).

The agreements included provisions that allow the NDeX south buyers to use the software w/out having to pay additional fees for at least the next few years. But the agreements also let DM out of the contracts that restricted them licensing to competitors. In addition to competitors in existing states, DM is planning on modifying the software to market in new states. Management believes that they will do 2-5m in EBITDA in the newly restructured unit but that is will take a few years to ramp up. Lets assume they can do 3m in 2 years, apply a 7x multiple (fair considering this will be higher quality, higher growth license fees) and you get 21m. Discount that to present at 10% and you get 17.4m. Take the 20m of proceeds from sale and take it down to 16 because of the credit risk and you get 33.4m for the segment.

As far as the environment is concerned, I do not pretend to be smart enough to time these things so I wont. One could craft a good argument that the extreme regulatory action is merely stalling inevitable foreclosures or that this housing recovery is some sort of head fake driven by speculation and PE guys. Perhaps. Perhaps not. One thing I am smart enough to know is that the need to process foreclosures in a timely and compliant manor is not disappearing. AND in the long run foreclosures will go up and down, but trend up as household formation drives growth in total mortgages outstanding.

Business Information

DM owns a bucket of very targeted local business journals and court papers, serving legal, real estate, financial and government sectors. The segment generates ~44% of its revs from public notices (mainly through court and commercial papers), and the balance is split between display/classified ads and subscription revs. They provide very tailored information that is not available in mainstream outlets.  They are usually the only content producer serving their markets, partly because the size of the market is not usually big enough to support two profitable players; and partly because they have barriers to entry in: 1) very sticky captive customer base, the aggregate subscriber retention rate for the segment is 82%; 2) startup costs associated with generating content and selling ads are very hard to justify if the competitor owns the market and has a high level of customer loyalty. Obviously traditional print is under real secular pressure but most of DM’s publications have been transitioning to online mediums. If you look at aggregate retention rates for the segment, they’ve gone from 76% 5 years ago to 82% today. I believe allot of the secular hit has already been taken and what remains is the higher quality publications (more targeted) and the stickier customers who need the info and cant get it elsewhere.

Public notices are notices that governments and private sector entities are required to post, concerning certain legal events and legislative action. DM is approved to publish public notices in 18 (out of 19) of their markets. It is a good business with major barriers to entry emanating from the extensive qualification requirements that favor DM’s incumbent geographic monopolies. However ~75% of their public notice revenues come from foreclosure related notices, which are obviously under cyclical pressure as discussed in the last segment. Public notice retention rate is over 90%.

DM also has (had) a legislative reporting business that competes in a bigger more competitive market of DC people (congressman, lobbyists, consultants etc…). They bought their way into this business a few years back and it has been a disappointing investment. Last quarter DM announced it’s intention to dispose of this business and seek alternatives for DataStream and LISA.

LISA’s website seems to have gone offline entirely, so I am assuming its worthless. DataStream was bought ~30 months ago for 15m. I am assuming they can get 7m now.  Looking at the rest of the business, TTM EBITDA is around 10.8m after netting out DS and LISA.  I think these are high quality businesses in the aggregate and probably deserve a meaningfully higher EBITDA multiple, but lets put it at 6 (conservative considering EBITDA is cyclically depressed by lower foreclosure notices and has an amplified effect from operating leverage) that’s still $65m. Add back DS and you get a value of ~$72m for the segment. 

The major risk to this business is that legislators reduce the public notice requirements or qualifications to publish them. I think this risk is partially mitigated by the diversity of state governments that effect this segment; but it is, admittedly, difficult to handicap.

Corporate

Unallocated corporate should be ~7m in the next year once the effects of the cost cuts show and the drag of severance is gone. Assuming 35% tax rate the after tax expense to shareholders is ~4.6m. Figure it will grow at a 2% clip and discount it at 10% and you get (57.5m).

DM owns 35% of DLNP (Detroit Legal News Publishing) a conglomerate of court and commercial papers, so it’s equity method accounting and they currently carry it at 8m. Considering they have gotten ~3.2m in cash distributions in TTM, I feel comfortable taking that at face value. Distributions are pretty consistently in excess of NI, which has pushed down the carrying value. There is not good enough info to deduce the exact source of the disparity between distributions and net income, but it probably has to do with amortization (which is obviously non-cash and in many cases non-economic) and liquidating assets.

All in they paid over 240m for NDeX. Assuming that they sell MI and MN for 2.5m and they value the continuing operation at 20m, that is a 200m loss. At 35% you have a 70m tax asset. We don’t have precise information yet because NDeX south happened in Q3 and MI and MN have not happened at all yet, but just conservative ball parking it let’s say it’s worth 40m.

I’m not wild about management (their whole dig is leverage and acquisitions, not exactly a value investor’s dream partner) but they are certainly not a deal breaker.   CEO (Jim Dolan) has been there for 20 years and is fairly well incentivized; he owns over 6% of the common or 3x average pay over the last three years at current depressed trading value (a few years ago it was ~20x his average pay). He got destroyed on NDeX because he underestimated the regulatory factors but he has done a decent job rolling up and managing a collection of good businesses over two decades. Additionally, the good thing about the debt is that it keeps him disciplined, at least until he rights the ship. If the big worry is that he overpays for acquisitions (NDeX) than it is no worry at all because his covenant doesn’t give him the room. And to his credit he’s been very focused on deleveraging and has been making good on his promises.

Capital Structure

The common is at the bottom of a fairly aggressive (but improving) capital structure. At the top there is a senior secured term loan with an MRQ outstanding balance of 115m. The amended credit agreement says DM will use the proceeds from the NDeX divestiture to pay some of this down so we should see that, in addition to FCF, bringing down the debt in Q3. Then they have a revolving credit facility that has 27m (MRQ) drawn. So we have 142m in total debt. These obligations have the same creditors, terms and maturity. Here are the highlights:

-Syndicate of banks, Wells, U.S National, a few others

-Due on December 6, 2015

-Floating rate based on risk-free plus a credit spread between 50 and 400bps depending on the debt to TTM adj. EBITDA ratio.

-Fixed charge coverage ratio of at least 1.2x.

-Debt cannot exceed 4.5x adj. pro-forma TTM EBITDA.

In the Q4 release management guided to 30-35m EBITDA for the year, excluding NDeX, and they are well on target to get there. However the parts of NDeX that they still own (MI and MN) did worse than they expected and they have not yet pushed them into discontinued ops so they do expect they might breach their covenant in Q3 and are currently negotiating an amendment to get more room. I am not as concerned as the market seems to be considering that DM breached their covenant on several occasions over the last few years, and each time the creditors granted them waivers. The creditors are very unlikely to foreclose on account of another breach considering the actual core businesses are within the covenant, and DM will generate more than enough cash to pay them. Given that DM has been very aggressively paying down debt and restructuring, and has been consistently making good on their goals to do so, I expect the creditors to continue to be reasonable.

In late January 2013 DM sold 700k 8.5% cumulative preferred shares for $23 to pay down part of the term loan. Face is $25 and there are no dividends in arrears. That’s a $17.5m claim.

SOTP

242 (Litigation)

33.4 (NDeX)

72 (BI)        +

8 (DLNP)

40 (Tax Asset)

(57.5) (Corporate)

_____________

$338m firm value (Cash balance is small enough that none of it is really “excess”, so I treat total debt as net debt)

338 – 142 – 17.5 = $178.5m equity value / 30.9 million diluted shares = ~$5.77 ~190% upside from the recent trading price of $2.

Downside

I have played around with the numbers and, barring any unexpected severe negative shocks; it is honestly difficult to construct a case where you are overpaying at the current trading price. Sure I could pick a believable number below the current price and back into it to build a bear case, but why bother? So I went with another approach. There is great downside protection built in because the stock is already so cheep, however given the leveraged nature of the equity, operating leverage, and customer concentration, it is within the realm of possibility that something terrible happens and the common gets totally wiped out.

So for my bear case I assume total Armageddon. DR commits a massive, unprecedented, horrific blunder, they lose all credibility, everyone fires them and the business falls apart. The governments of most states reduce public notice requirements and the business Information segment suffers too. EBITDA turns negative, creditors foreclose on the assets and the common goes to zero, ZILCH!

Conclusion

Dolan is a group of high quality assets that we have the chance to buy it at a steep discount to any reasonable estimate of intrinsic value for reasons that are both temporary and currently being resolved. Operating under the assumption that the upside is the fairly conservative scenario I laid out, and the downside is the very draconian scenario necessary to get to zero, we can draw an interesting conclusion. If the stock is worth nothing in a disaster and $5.77 otherwise, at $2 Mr. Market is telling you that there is a 65% chance that DM will get destroyed. At these implied odds, this is a risk that I am happy to underwrite!