Description

Donnelly Financial Solutions, Inc. (DFIN) is the leading financial risk and compliance software company providing solutions to public and private companies, mutual funds, and other regulated investment firms. The company was last written up by SwissBear in 2020 and I highly recommend reading that excellent report. The company is at an interesting inflection point today having transitioned the legacy print business to their proprietary software platforms amid a downturn in transactional activity. As transactional activity (IPOs and M&A) picks up and new regulations are implemented, DFIN stands to benefit meaningfully.

The stock currently trades at $61 per share and has 30 million shares outstanding for a market cap of $1.8 billion. The balance sheet is excellent with net debt of $100 million for a Total Enterprise Value of $1.9 billion.  I think the company can earn $4.50 - $5.00 per share in ’25 with software revenue representing ~45% of sales. Furthermore, recurring revenue will represent ~80% of revenues. Valuing the company at 16-18x inclusive of the capital generated this year puts my target at $80 - $100 per share.

My investment thesis is as follows:

1.      The market underestimates the transition to software revenues and the recurring nature of those revenues.

2.      The last two years have been among the worst for transactions – namely IPOs and M&A in recent history. That business appears to be returning with a solid 1Q of      which DFIN has done the majority of transactions.

3.      The excellent balance sheet will allow for attractive capital returns.

What do they do?

The company is broken down into two segments based on the end customer – Capital Markets and Investment Companies.

Capital Markets: This segment was 68% of sales and EBITDA and is the leading provider of solutions to public and private companies subject to SEC reporting requirements. Simply put any document that is filed with the SEC – whether a 10K, proxy, IPO document, or merger document utilizes their software to ensure file and ensure compliance with regulations. DFIN has the largest market share and is known for its consulting and advisory assistance. The main software platforms built by DFIN and used by corporates are ActiveDislosure – a SAAS-based product purpose-built for financial reporting and used to manage SEC filings and Venue – a virtual data room used to securely organize, manage, and distribute confidential information.  

Investment Companies: This segment assists mutual funds, alternative investment, and insurance companies with regulatory filings such as monthly and annual statements, proxy advisory disclosures, and more. The software platform is called ArcSuite and is broken down into ArcReporting – document reporting, ArcPro – cloud-based workflow tools, ArcRegulatory – EMEA PRIIPS and MiFID II reporting, and ArcDigital – customized and audit-traceable reporting for SEC Rule 30e-3 and 498A.

The following chart taken from their investor presentation provides a nice overview:

Investment Thesis:

1.      The Company Has Transformed to a Sofware/Recurring Revenue Model

               The company was spun off in 2016 with a lot of leverage (>4x) a small base of software (14%) and recurring revenue (31%). Today the company has transformed through a mix of diligent R&D investment and disciplined cost management to a mix of 37% software revenue/75% recurring revenue. I believe this is underappreciated by the market as evidenced by only four sell-side analysts covering the company and an earnings multiple below those of peers (Broadridge trades at 26x forward P/E and Workiva >100x). Importantly, the transition to a software-based business is ongoing with targets to get to 60% software/80% recurring revenue by 2028. This growth is due to a combination of increased adoption by corporates and investment companies, increased regulations requiring more compliance (including rules requiring tailored shareholder reporting – see investment thesis 2, and ESG compliance), and a larger serviceable market. This slide captures the outlook:

2.      The Return of Transactions and Opportunity from New Regulations

As DFIN transitioned customers to utilize their proprietary software platforms in the last two years, they have also faced a large headwind from reduced transactional activity – namely few IPOs and M&A. In 2022 and 2023, using data from Jay Ritter at UF Warrington, the market only saw 38 and 54 IPOs, the lowest two-year total since 2008 and 2009. This compares to an average of 208 companies per year that came public between 1980 and 2003 and 148 in the previous 10 years ending in 2001. Transactions matter for DFIN and the company has averaged $290 million in transactional revenue per year. However, the headwind in the last two years resulted in transactional revenue dropping to $246 million (2022) and $202 million (2023).

In the 1Q of 2024, we have already seen IPOs increase with companies like BrightSpring, Amer Sports, Reddit, and Astera Labs coming public. I calculated 15 IPOs year-to-date with DFIN representing 11 of the issuers. Importantly, once an issuer chooses DFIN to assist with the IPO, they often continue to use their software for additional filings creating a virtuous earnings stream.

A normal transaction year would result in $90 million of incremental revenues, of which I believe a 40%-50% drop-through is likely.

In addition to increased transactional activity in 2024, there are additional regulatory requirements that investment companies will be required to implement. The most significant is the Tailored Shareholder Report which becomes effective this July. The rule impacts 12,000 funds and 32,000 share classes and requires a two to three-page document outlining a fund’s performance and fees, along with a brief narrative in plain English. It mandates that the information be tagged using iXBRL. As CEO Dan Leib said on the fourth quarter call:

“DFIN was first to market with an alpha release of our Tailored Shareholder Reports software solution in October of last year. Since then, we've been working diligently on product enhancements to enable clients to complete TSR workflows at scale. With Tailored Shareholder Reports being a financial report, DFIN is ideally positioned to leverage our ArcReporting offering, the leading financial closed solution for investment companies, and our deep expertise in the areas of iXBRL tagging and compliance filing to create an end-to-end compliance solution for Tailored Shareholder Reports. Importantly, our ArcReporting product offers clients the ability to execute financial calculations, report creation at the fund and share class level, iXBRL tagging, reviewing, and filing, all through a single solution.”

TSR is expected to add $20-$25 million annually in revenue. In 2024, the business will be marginally profitable as it invests in service and consulting. However, beginning next year I believe margins should approach 50 percent.   

3.      Capital Allocation and Valuation

The company has done a masterful job in reducing expenses and elevating margins over the last several years. This has been done through reduced headcount (Forty percent fewer employees since 2018), optimized real estate footprint, 100% variable print costs through outsourcing, and everyday cost focus which has improved gross margins from 37% to 58% since 2016. The company is asset-light and spends $60 million per year on cap, and $12 million in interest expense.

My base case for 2025 includes transactional revenues normalizing at a 40%-50% drop through the investment in tailored shareholder reports needed to get customers up and running is complete and the base business grows 5%-10%. This results in a target for net income/free cash flow per share of $4.57 - $5.19. As the company has a clean balance sheet, a highly recurring revenue model, and requires moderate capital investment, I believe a multiple of 16x-18x is appropriate. This results in a target price inclusive of cash generated this year of $80 – $100 per share.

Appendix:

DFIN Investor Presentation: https://s24.q4cdn.com/818789537/files/doc_earnings/2023/q4/presentation/DFIN-Investor-Presentation-Q4-2023.pdf

IPO Historical Data: https://site.warrington.ufl.edu/ritter/files/IPO-Statistics.pdf

Catalyst

Increased regulation requiring companies and investment funds to comply through additional filings.

Normalization of transaction activity.

Capital allocation given excess free cash flow.