Description

Summary and Investment Thesis:

Heads I win, Tails I win more

Donnelley Financial (NYSE: DFIN) is a Chicago-based global risk and compliance solutions company in the final innings of a multiyear turnaround from a transactional revenue print business toward a recurring revenue product mix of Digital and Software Solutions. This transition has been accompanied by non-core asset sales and other prudent business decisions, which have drastically reduced debt and boosted Software-as-a-Service “SaaS” investments. Over the next few quarters, the company will embark on a transformative reduction in print volume, which will instantaneously free up large amounts of working capital and ‘kitchen sink’ the sales decline while accelerating margin expansion. As we approach that inflection point, I believe the current stock valuation of 4x LTM EBITDA will move closer to 10x LTM EBITDA as investors embrace the simpler FinTech SaaS narrative. If the company fails to deliver, I think shareholders will begin to lose patience and push for change. Heads I win at $20, Tails I win more at $44. 

Introduction

DFIN provides regulatory filing solutions, software solutions and print and distribution solutions to public and private companies as well as mutual funds and other regulated investment firms. Its dominant market share, broad platform of complimentary offerings and strong brand recognition make it a one-stop-shop for its client base, which includes some of the biggest and best companies in the world. 

• Market leader in SEC compliance transactions and shareholder communications: 10Ks, 10Qs, prospectus offerings and mutual fund documents

• Multiple avenues to leverage business moat through rapid adoption of risk and compliance software, driven by the continued digitization of SEC filing requirements 

• Large base of recurring revenues combined with highly profitable capital markets transactional business

• Capital light business model (Capex 2-3% of sales) with improving revenue mix leads to strong cash flow characteristics

Recent Events

The company recently reported Q1 2020 Earnings, which were in-line with analyst estimates despite a large pullback in March due to the Covid-19 pandemic. In the press release and analyst conference call, management outlined its capital requirements through 2024. The team went through a detailed roadmap of how the company would take EBITDA margins from 15% to 20% by the end of 2024 through its growth in SaaS and digitization of filing solutions, which is much higher margin than print. More importantly, the company was able to repurchase a sizable portion of its high cost publicly traded debt and buy back $3mm of stock. These actions show the strength in management’s conviction in the underlying business, as well as its strong free cash flow characteristics. 

The US IPO market is slowly recovering after the lull from the onset of Covid-19. People have adjusted to their new working environments and embraced new ways to do business. One of DFIN's IPO clients, SelectQuote, completed the first all-virtual IPO for the NYSE, and DFIN provided the technology, regulatory expertise, and hands-on customer service to successfully bring the company to the public markets. This all-virtual IPO was years in the making and shows how far DFIN has come in transforming itself. 

As we move into June 2020 and the market opens up with the largest deal of the year, Warner Music, I expect plenty of positive news flow from the company. More importantly, Covid-19 has accelerated a lot of the company’s software and digital offerings like the all-virtual SelectQuote IPO. As such, DFIN has done a remarkable job in leveraging its market leadership and helping its clients succeed in the ‘new normal’. To reinforce this companywide transition, the employee motto at DFIN is ’44 in 24’ or 44% SaaS/Digital in 2024. I’ve taken it a step further with my $44 price target. 

Conclusion

Outside of valuation and 'simplification of narrative', DFIN did something remarkable in Q1. In the midst of economic turmoil, the company used its credit revolver (4% rate) and repurchased $66MM of its $300MM 8.25% debt at 95. This debt isn't callable until October 2021, and had been trading pre-Covid at 107. In addition, the company bought back $3MM worth of stock at $6.19 (authorized $25MM in February). All of this was done in March, and I suspect the company was aggressive in April and May. Activist Investor Jeff Jacobowitz of Simcoe Capital is on the board and owns roughly 10% of the company at higher prices. Jeff has a long history of successful SaaS exits. 

DFIN was spun off from RRD in 2016 to eventually sell to a company like Broadridge. At that time, DFIN was predominantly a compliance-oriented print business with a growing portfolio of digital and SaaS offerings. The company grew recurring revenues from 8% in 2013 to 21% as of March 31, 2020. By 2024, management expects Recurring Revenue SaaS business to be 44% of total revenues. In comparison, SaaS makes up over 60% of Broadridge sales with legacy print somewhere between 35-40%. It also trades at 20x EBITDA.

The company recently announced a $130mm reduction in print sales volume in accordance with Rule 30 (e) 3, which removes the mandated mailing of printed documents for certain industries. This anticipated sales drop would take place in the first six months of 2021, freeing up a lot of working capital and removing a major stock overhang. I believe that investors will start buying the stock prior to this inflection point, as the company will start to look much more like a FinTech SaaS company. Moreover, I believe it would make more sense for a potential acquirer to merge with DFIN prior to this inflection point. Without a merger, we think DFIN could get closer to $44 over the next few years, which represents 10x our 2024 EBITDA estimate. If DFIN surprises to the upside, $44 could prove conservative. In comparison, Broadridge trades at 20x, which would imply a $100 share price for DFIN. 

Company Description

Donnelley Financial (NYSE: DFIN) is a Chicago-based global risk and compliance solutions company. DFIN provides regulatory filing solutions, software solutions and print and distribution solutions to public and private companies, and to mutual funds and other regulated investment firms. The company operates through four business segments: Capital Markets – Software Solutions (14.5% of 2019 revenues), Capital Markets – Compliance & Communications Management (44.5%), Investment Companies – Software Solutions (7.2%), and Investment Companies – Compliance & Communications Management (33.8%). DFIN, which has 2,900 employees, operates in 62 locations in 13 countries. The company was formed as a stand-alone public company following its spin-off from R.R. Donnelley & Sons) in October 2016. 

Company History

Donnelley Financial was created as part of RR Donnelley, a diversified publishing and printing company that was founded in Chicago in 1864. RR Donnelley entered into the market for the production of financial reporting communications in 1936, and committed to build the business focused on the financial communications vertical in the 1980’s. 


Over the past decade, RR Donnelley acquired four companies to expand the breadth of their solutions in the areas of financial reporting and compliance communications, which are now part of Donnelley Financial. The largest deal was Bowne & Company, acquired in November of 2010 for $465M, which more than doubled revenue in the financial communications niche. 


Bowne was a leading financial printer, focused on collaborative transactional solutions for companies accessing the capital markets with operations in North America, Latin America, Europe, and Asia. The collaboration centers provided by Bowne in key global markets have increasingly led to clients engaging the company for their cloud-based virtual data room solution, Venue. 


Another notable deal, EDGAR Online, was completed in August of 2012 for $72M to supplement the company’s capabilities in disclosure and reporting for US listed corporate issuers and investment managers filing financial data reports with the SEC. EDGAR Online brought key data tagging capabilities to meet developing SEC mandates (like XBRL). The most recent acquisition, MultiCorpora, was completed in 2014, and brought language translation technology capabilities. 


Beginning in 2007, RR Donnelley began developing technology solutions in the areas of virtual data rooms (Venue), content management (FundSuiteArc), and regulatory disclosure workflow (ActiveDisclosure). By 2010, the operations that became Donnelley Financial were generating roughly 7% of revenue from software solutions. Through continued investment, each of the aforementioned solutions has become a Top 3 player in market share. 

The company has also made minority investments in several companies where management has identified capabilities that they view as valuable for their strategic growth plans. While not specifically disclosed, I believe the investments have generally been in the $1M-$5M range for equity ownership in the 10%-20% range. Four of the investments have been structured to provide Donnelley Financial with the right of first refusal (in certain circumstances) to acquire the remaining ownership of the companies.

Spin-Off Details: In 2015, RR Donnelley’s board committed to a plan to split into three publicly traded companies to help each company more closely focus on their distinct strategic growth plans with independent access to the capital markets. The Donnelley Financial portion included the operations related to servicing the financial reporting, compliance, and collaboration needs of corporate issuers and investment management companies (as well as investment banks, law firms, and private capital funds). 

On October 1, 2016, 81% of Donnelley Financial was spun-off in a tax-free distribution to RR Donnelley shareholders. A similar percentage of sister company LSC Communications (LKSD) was also spun-off at the same time to create the third new independent company. LSC Communications was comprised of the operations focused on publishing, retail-centric print services, and office products. RR Donnelley initially retained a 19% interest in each spin-off, but these were divested through public offerings in 2017. 

Balance Sheet Discipline

At the end of 2016, Donnelley Financial had $551M in net debt, which consisted of $36M in cash, and total debt of $587M, representing gross leverage at 3.7x adjusted EBITDA. In 2017, their first full year as an independent company, management reduced total debt by $129M and brought the leverage ratio down to 2.7x ($406M in net debt). In 2018, net debt fell to $315M and then to $280M in 2019 representing 2.04x adjusted EBITDA. This disciplined approach to reducing leverage was accomplished through FCF, operational efficiencies and non-core asset sales, which have been upward of $120mm.  As of March 31, 2020 DFIN had net leverage ratio of 2.3x, higher due to the seasonal print inventory build. Management targets net leverage ratio in the range of 2.25x to 2.75x. Bank covenants allow leverage up to 3.75x LTM EBITDA.  

Capital Structure

As of March 31, 2020 DFIN had liquidity of $201.7mm including $7.7mm in cash and $194mm available under its $300mm revolving credit facility which has a maturity date of December 18, 2023. The company, as of the end of 1Q20, had a net leverage ratio of 2.3x, which was down from 2.9x at the end of 1Q19, and 3.5x at the time of its spin-off in 2016, as its ample free cash flow enabled deleveraging. Management targets a net leverage ratio in the range of 2.25x to 2.75x. 

Stock Repurchases

On February 4, 2020, the Board authorized a stock repurchase program, under which the Company is authorized to repurchase up to $25.0 million of its outstanding common stock through December 31, 2021.

During the first quarter of 2020 (all in March), the Company repurchased 615,896 shares in open market transactions for $3.8 million at an average price of $6.19 per share. As of March 31, 2020, the remaining authorized amount under the current authorization was approximately $21.2 million. In addition, the Company purchased and retired $66.5 million (notional amount) of the Notes at an average price of 95.25 and recognized a pre-tax gain on the extinguishment of debt of $2.3 million, which was net of unamortized debt issuance costs, and is recorded within interest expense, net in the Unaudited Condensed Consolidated Statements of Operations.

DFIN shares volume was 8,209,200 in March, which equates to a little fewer than 10% of total volume. In Q2 2020, DFIN share volume was approximately 19,913,900. Using the same metric, I estimate that DFIN repurchased anywhere from 1,500,000 to 1,900,000 shares in the quarter at attractive prices. In April, DFIN shares traded below $5 for 7 trading days and under $6 for an additional 11 trading days (18 days total). 

Competition

DFIN with its FundSuiteArc offerings competes with Confluence, Workiva, ToppanMerrill, Appatura, Kneip, Kurtosys and FilePoint. The company’s Venue business competes with SS&C Technologies, Intralinks and Merrill’s DatasiteOne, while its eBrevia business competes with Seal Software, Kira, Luminance and RAVN. DFIN’s ActiveDisclosure business competes with Workiva, Certent, and Toppan Merrill’s Bridge.

Why is DFIN a good business? 

DFIN’s client list in 2019 included more than 350 of the companies in the S&P 500 and more than 750 companies in the Fortune 1000. The company’s blue-chip client base includes such firms as Microsoft, Oracle, Upwork, Salesforce, TD Ameritrade, Home Depot, Spotify, American Airlines General Motors, Dropbox, and Bank of America. DFIN also works with 80% of the top 50 global fund complexes.    

The legacy DFIN business has immense brand recognition and is the dominant provider of Securities and Exchange Commission “SEC” Transactional Filing and SEC Compliance Filing. Historically, DFIN has been the go-to provider of print and tech-enabled services for SEC filings. Large companies rely on DFIN to get the job done correctly and typically don’t shop around to other providers to save a few dollars. As print services have declined, DFIN has been able to capture the digital portion of these offerings due to its strong brand and best-in-class services. This transition is the primary reason for lower revenues and higher margin story. The same thing is happening in the investment management markets. 

DFIN versus BR

Broadridge Financial Solutions was spun out of ADP in 2008 and faced a similar turnaround situation. Like DFIN, Broadridge had a lot of its business tied into publicly traded companies and activist proxy contests. As it relates to Proxy Solicitations, Broadridge is far and away the dominant provider controlling over 80% of the market and has been known to command a ‘kings ransom’ to provide its services. While an extremely profitable business, it has low growth, and is cyclical in nature. To address these issues earlier in the decade, Broadridge used its massive hoard of Free Cash Flow and started purchasing complementary software solutions to drive growth and stabilize revenue. In addition, it started buying back shares and paying a dividend. 

I believe DFIN is forging a similar path. The biggest difference is that Broadridge has a decade head start. This head start, in addition to its larger size, is a driving force in the disproportionate valuation difference between the two companies. This valuation gap is the primary reason I think Broadridge needs DFIN more than DFIN needs Broadridge. More importantly, DFIN is near the finish line of its 5-year turnaround plan. At any price below $30, an acquisition of DFIN by Broadridge would be extremely accretive. The two companies truly are a match made in heaven due to their complementary business lines and minimal direct competition. 

Rule 30e-3

In May 2015, the Securities and Exchange Commission proposed Rule 30e-3 under the Investment Company Act, which would permit investment fund providers (mutual funds and ETFs) to make periodic reports (such as annual reports and interims) available on the fund company’s website instead of mailing printed copies of these reports. In effect, the default choice for investors would flip from paper reports to electronic delivery/access.

While the proposed rule saw strong support from the fund industry, given the potential to reduce investor communication expense, investor advocates argued some investors could be dis-enfranchised by the change and that this could result in fewer investors reviewing the reports and related disclosures as well as less participation in voting on issues raised in periodic fund proxies. In August 2016, the SEC Chairperson decided to drop the plan due to this opposition, but most industry observers expected that it would be revisited.

In December 2017, the SEC’s Investor Advisory Committee recommended a slight modification to the SEC’s proposed rule 30e-3 with a “Summary Disclosure Document” or an “enhanced notice” approach for the Internet availability of annual and semiannual mutual fund reports. The Summary Disclosure Document would provide investors key fund information in a one or two page printed notice while providing the location of more detailed information available on fund company websites (or by request). 

On June 4, 2018, the SEC voted to approve the rule with few changes, but investment funds cannot take actions to comply with the new rule before January 1, 2021. The SEC also released a report and opened a comment period on ideas on improving fund disclosure. At that time, DFIN management estimated Rule 30e-3 would result in the loss of $70M in related Product revenue and $12M in adjusted EBITDA (after associated cost reductions) for the full first year (based on current volume levels). During the Q1 2020 conference call, management revised that number upward to $130mm in sales and $10MM-$15MM in EBITDA. I believe management used the occasion to include other business that didn’t meet their profitability threshold. Broadridge has taken a similar approach. 

Shareholder Activism

Since spinning out of R.R. Donnelley, the company has been hampered by requests to put itself up for sale. There have been numerous calls for an outright sale. Starting in 2017, Jeff Jacobowitz started building a position in the company. By February of 2019, Simcoe had a position of roughly 7.9% and Jeff Jacobowitz was added to the Board of Directors. In conjunction with the announcement, Simcoe agreed to vote all of its shares in favor of each of the Company’s nominees at the 2019 and 2020 annual meeting of stockholders. Jeff is a value investor with a focus on undervalued Software companies, including numerous successful activist campaigns. Since early 2019, Simcoe has added to its position and now owns roughly 10% of the company at higher prices. I estimate his cost basis to be around $12. 

For the 2020 Annual Meeting of Shareholders and Proxy Statement there was a proposal from individual investor, Sam Yake to sell the company outright. During the “Virtual Only” annual meeting, Mr. Yake was allowed to speak for five minutes. The proposal only received 300,000 votes. Per the standstill agreement, Simcoe voted against the proposal. I believe that the 2021 annual meeting will see more fireworks, particularly if the stock price doesn’t improve or management fails to execute on some if its initiatives. Moreover, Simcoe will be allowed to vote independently. Abbreviated text of investor proposal is below. 

Samuel Yake, who has provided certification indicating that, as of December 31, 2019, he was the beneficial owner of 16,288 shares of the Company’s common stock and that he intends to maintain such ownership through the date of the 2020 Annual Meeting, expects to introduce and support that the stockholders of Donnelley Financial Solutions, Inc. hereby request the Board of Directors to arrange for the prompt sale of Donnelley Financial Solutions, Inc. to the highest bidder.

The purpose of this proposal is to allow Donnelley Financial shareholders to send a message to the Board of Directors that they support the prompt sale of the Company to the highest bidder. This proposal is not binding on the Board of Directors of Donnelley Financial; however, if the proposal receives substantial support from the shareholders, the Board may choose to carry out the request set forth in the resolution.

Sam believes that the very poor performance of Donnelley Financial’s stock since it became a public company in 2016 should cause the shareholders and the Board to examine whether remaining independent continues to make economic sense. I believe that the time has come for the shareholders to realize the fair value of their investment in Donnelley Financial.

Insider and Notable Stock Ownership

Shares Outstanding: 34,500,000

Management:  ~500,000

Board of Directors (BoD) ex Simcoe: - ~275,000

Simcoe Capital, BoD: 3,309,508

BlackRock: 5,396,721 (16%)

American Century: 3,364,456 (10%)

Vanguard: 2,203,634 (6.5%)

Note: Long-time 5% shareholder Fidelity offloaded its position in March of 2020 upon the exit of its Portfolio Manager

Valuation

I believe DFIN deserves an EBITDA valuation of well over 10x EBITDA due to its recurring revenue business model as well as its dominant market position. At 10x 2024 EBITDA of $160MM, I get to $44 per share using 35mm shares outstanding and $25MM in net debt, which is conservative given the current share buyback and management commentary on leverage. Starting in 2022, DFIN should begin to show revenue growth and have rapidly expanding margins. In 2024, I believe DFIN will do around $800MM in sales at 20% EBITDA margins. With most of the heavy turnaround completed, an acquisition of DFIN by a larger company is likely in the near term. If anyone other that Broadridge makes a bid, fireworks could follow.    

Catalyst

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Catalysts

• Q2 2020 Earnings: Potential upside to guidance and update on debt and share buyback

• Company guided to $220MM to $230MM in sales for Q2 which included a pullback due to Covid-19 

• IPO market has accelerated in May and June which included business from SelectQuote Insurance (first ever Virtual Only IPO) and WarnerMedia, the largest IPO of 2020 

• $2.4MM of stock was purchased in March per the Q1 earnings, I expect them to announce a large number for Q2, particularly due to the stock weakness in April, which saw prices drop below $5

• Q1 2021 and Q2 2021 Inflection point will unlock working capital and remove a major overhang (print decline) in the shares

• Debt refinance: 8.5% Publicly Traded debt is callable in 2021 and company should refinance at a much lower rate

• Potential Merger with Larger FinTech Company which would immediately unlock shareholder value and be highly accretive to strategic acquirers