Description

Overview

If you were expecting a write-up on a printing business, we’re sorry to disappoint.

One might look at Donnelley Financial’s (DFIN) pre-spin history as a part of namesake RR Donnelley (RRD), its 40% revenue exposure to printing, and its classification as a “financial printer” and easily come to that conclusion.  We instead note that print only contributes ~10% to EBITDA, while the other 90% comes from value-added services and software for which DFIN is generally viewed as a market leader.  In fact, we think DFIN should be viewed and valued as a business services and software company, and considering all of DFIN’s board members have either an operating or investing background in one of these two fields, we suspect the company would agree.

DFIN has historically been the 800 lb. gorilla in the “financial printing” space.  We believe the shares are cheap because DFIN is viewed as a serial share loser in a declining print-facing industry, a perception that isn’t helped by the company’s confusing segment disclosure.  Our diligence suggests DFIN is the entrenched leader in its market, with one of its key segments experiencing a strong recovery from a cyclically weak 2016 at 50%+ incremental EBITDA margins.  At 8x LTM EBITDA, DFIN is arguably trading 2+ turns below comps on depressed earnings.  Assuming what we think is a conservative base case, we think there’s 50-60% upside to where shares trade today, supported by steady cash flow and a large cash payment from pre-spin parent RRD not reflected on the 3/31 balance sheet.  If the hockey stick recovery in high-margin IPO volumes continues (up 80% YTD), the upside can be even greater.

DFIN’s Services

For additional background on DFIN, please refer to Ares’ write-up on October 30, 2016

DFIN’s services fall into two broad buckets.  First, DFIN sets itself apart in the management of the large and complex filings required for M&A and IPO transactions, where the company perennially commands over 65% total market share.  For anyone who’s had to take a company public or sell a company as an investment banker or private equity investor, you might recall late nights “at the printer” to get documents in order.  In all likelihood you may have spent those late nights in a Donnelley conference room.  While the model here has changed over the years, DFIN’s value proposition has not – quarterbacking the document, making sure it’s fully SEC-compliant, and acting as gatekeeper to what could be well over a dozen various parties that have their hands on the document.

DFIN also provides document management services for other regulatory filings, the rules for which are numerous and ever changing.  For SEC filings, documents also need to be “EDGAR-ized”, or converted to a format that can be posted to the SEC.  In 2009, the SEC added more complexity by phasing a requirement to XBRL-tag financial data, enabling easier access to third-party data services.  Since errors as minor as messing up a signature page result in having to file an amendment or potentially pay fines, companies outsource it to providers like DFIN.  As we’ll discuss later, this dynamic has changed considerably for recurring filings, such as 10Ks and 10Qs, with the advent of SaaS provider Workiva.

While DFIN provides revenue and gross profit data by Non-Paper (Services) and Paper (Products) segments, we find it much more helpful to think about the business by major service offerings, which we summarize below:

Global Capital Markets: Transactional

This service primarily involves managing the documentation, filing, printing, and document distribution surrounding IPO, M&A, equity and debt offerings, both in the US and internationally.  DFIN is the gold standard here, regularly capturing 70%+ of the largest, most profitable transactions.  We’ve spoken with several of DFIN’s largest competitors, who lament that DFIN is often awarded deals uncontested.  As the Chief Accounting Officer of a major publicly-traded Silicon Valley company told us, when it came time for their IPO, “Donnelley [was] the place to go, there’s no other real option we’d consider.”

We made over 20 calls to various finance executives, competitors, transaction lawyers, and investment bankers, and a couple of consistent themes emerged for why DFIN has maintained its dominant position in this service.  First, the cost of the service is small relative to both the potential cost of error as well as the value of the transaction overall.  Second, the actual decision maker is most often the lawyer or banker on the deal, not the company, and it’s usually just not worth it for them to risk getting egg on their face by going with a smaller player to save their client a few bucks.  These are typically very large and complex documents, and you don’t want to find yourself explaining to your client why DFIN wasn’t managing the process when a transaction gets delayed because of a filing error or an error is discovered during litigation.  As one M&A lawyer told us, no one gets fired for choosing Donnelley.

Margins for this service are outsized – according to management, incremental EBITDA margins of 50-60% versus the company average of 17-18%.  So while 60% of DFIN’s revenues come from “recurring” compliance-related work, the cyclical nature of transaction activity means earnings can be fairly volatile and it’s important to consider where transaction activity is heading when modeling earnings growth.

Global Capital Markets: Compliance

This involves service and software used for the preparation, editing, EDGAR-ization, and XBRL-tagging of all recurring regulatory filings made by publicly traded companies, including 10Ks, 10Qs, and 8Ks.  DFIN charges companies by the edit to ensure numbers tie, signatures are in the right place, page references match, etc.  DFIN also provides software that “EDGAR-izes” and XBRL-tags the document so that it can be submitted to the SEC.

This is fairly commoditized work because these documents don’t change all that much from iteration to iteration.  One might even say it’s little more than glorified word processing, and that wouldn’t be inaccurate, but the process was onerous enough and the costs of error high enough that companies outsourced it to folks like DFIN, who used to command over half of this market.

“Used to” because in 2010, an upstart company called Workiva entered and completely changed this market overnight, going from a standing start to over 35% market share.  We’ll delve into more detail on how Workiva changed this market, DFIN’s response, and why we think DFIN’s share has stabilized.

Margins for this work are understandably lower than transaction work – management has told us something closer to company average, although we think they’re probably slightly lower.  That said, this work is recurring and provides a reliable source of earnings to offset some of the cyclicality in the transaction business.

Global Investment Markets

These services are similar to those DFIN provides for its clients in Capital Markets Compliance work, namely the preparation, management, and filing of various recurring regulatory documents and disclosures, however the clients here are mutual funds, insurance companies, and healthcare companies.  That said, the competitive dynamics are quite different.  Unlike with K/Q work, DFIN has been able to maintain its leading market share (35%+ vs. the 2nd largest at 6%) despite competitive threats from Workiva (who has topped out at <5% market share, according to our data as well as company disclosure).  Long-term contracts help (3 years on average), but based on our call-work, the real reason is that, similar to transaction work, it’s the attorneys that generally make the vendor decision.  Combined with the fact that these filings tend to be more complex than K/Q’s, funds are more reluctant to in-source the filing work via a DIY software solution like Workiva.  In fact, DFIN has stated that their retention rate exceeds 95% on all customers who generate more than $500k in annual revenue.

Other Services

Venue Virtual Data Room – we haven’t spent substantial time researching DFIN’s virtual data room service, Venue, due to its relatively minor contribution to the overall business (~5% of total revenues).  Venue ranks a distant third to market leader Intralinks (recently acquired by Synchronoss) and #2 Merrill Datasite.  However, this business is growing fast (20% in 2016 and almost 40% in Q1 2017) and at high margins.  In fact, we understand that Venue enjoys typical software gross margins of ~80%, and that as this business scales, incremental EBITDA margins will be substantially higher than company average.  While it may not be a needle-mover today, we expect it will matter much more in the next few years.

One item to note: we believe Venue is benefiting from some collateral fallout that Intralinks may be experiencing due to management turnover and accounting issues at Synchronoss (see icebreaker25’s write up of SNCR and discussion for more background there).  In fact, when discussing the acceleration in growth last quarter, DFIN CEO Dan Leib stated that the 38% growth in Venue “… represented, in our estimation, some share coming over to us.”  In a follow-up conversation, Leib told us that they are getting a large number of inbound inquiries from Intralinks salespeople looking to move.  Venue may see outsized growth over the next year if share continues to shift, none of which we’re modeling.

Language Solutions – DFIN employs over 5,000 local linguists to support translation, interpretation, and proof-reading services across 140 different languages.  This business represents <5% of total revenue and, as the lowest margin revenue stream of the business, a negligible contribution to earnings.

So why’s the stock cheap?

Overblown worries about exposure to Print.

It’s hard to fault the market when in its own filings, DFIN provides relatively unhelpful segment information that highlights its 40% revenue exposure to print (management has told us this is required by the SEC).  However, we understand that EBITDA margins on print revenues are roughly ~5%, which would imply that Print revenues contribute only 10-12% to EBITDA.  And despite the well-known secular headwinds to print, we expect this EBITDA to remain fairly stable.

Print revenues reside primarily across two of DFIN’s services: Investment Markets and Capital Markets Transactions.  Within Investment Markets, one would suspect that with electronic delivery of prospectuses and reports, print would be a negligible piece of this business.  In fact, we estimate that print represents roughly 60% of Investment Markets revenue as, according to one DFIN competitor we spoke with, less than 30% of fund shareholders opt in for electronic distribution.  That percentage will obviously increase over time, but in response, DFIN has increasingly outsourced its printing capacity, allowing the company to maintain EBITDA in this segment despite revenue declines.  Absent a dramatic acceleration in these declines, we believe DFIN can continue to manage to stable EBITDA here.

Within Capital Market Transactions, print revenues are primarily related to M&A.  In 2007, Notice and Access rules implemented by the SEC allowed companies to either post filings to their website or email them to shareholders rather than deliver paper copies.  This obviously decimated the need for printed copies of most SEC filings, with one major exception: those related to M&A.  This means that a company undergoing an M&A transaction is still required to distribute physical copies of all transaction documentation to every stockholder of record.  While the expansion of notice and access to M&A would certainly be a risk, our callwork suggests that no such momentum exists and we expect Print’s contribution to DFIN’s M&A business to remain steady.

Overall, Print is a minor contributor to the overall business and we feel comfortable that even this piece will generally hold steady over time.

Perceived existential threat from Workiva

The actual business model under which DFIN operates is a bit antiquated.  When you send your document to DFIN, you not only abdicate control, but you also end up paying DFIN for every edit you then want to make to your own document.

The business was ripe for disruption: enter Workiva.  Workiva introduced itself to the market in 2010 with a compelling value proposition – a SaaS-based collaboration software platform built from the ground up that allowed companies to own the document through the entire filing process.  And best of all, it allowed finance teams to EDGAR-ize, XBRL-tag, and upload to the SEC with a push of a button.  DFIN saw its >50% market share in compliance-related filings collapse.  The chart below illustrates this, though we note that data pre-2013 are not complete as the XBRL requirement was phased in over several years beginning in 2009 (and this data only captures XBRL-tagged filings).  That said, data for the last 3 years are complete and the trend is accurate:

Source: XBRLCloud

In response, DFIN rolled out its own SaaS-based solution in 2013 called ActiveDisclosure, which now accounts for about half of the 10K and 10Q filings that DFIN’s customers make.  We think this rapid adoption reflects the success of the platform and is the reason that DFIN’s share of these compliance filings has stabilized over the last 3 years (Workiva has continued to take share at the expense of others).  In addition, ActiveDisclosure enjoys high software margins and continued migration should be accretive to overall margins over time.  In short, we believe the big declines in this business are over.

But what about DFIN’s share in higher-margin IPO and M&A work?  Why couldn’t Workiva similarly run away with the market there?  Whereas it makes sense for a company to adopt a DIY solution to update regularly recurring documents like a 10K or 10Q, the one-off nature and process complexity of transaction filings are simply not conducive to a solution like Workiva.  In addition, DFIN’s value proposition in a transaction isn’t limited to the document itself, but also in managing all the various parties that have their hands in it.  Industry experts have told us that Workiva simply isn’t built to replicate what DFIN can do in a meaningful way.

Second, and perhaps more importantly, in order for Workiva to plausibly challenge DFIN’s position, the software would require broad adoption by all the various transaction service providers that would need to access the document, including lawyers, accountants, bankers, etc.  Then you’d need to get all these parties, and most importantly the client, comfortable that quality and version control will be maintained despite expanding document access to everyone involved in the transaction.  The inertia here is simply too substantial, which our callwork with various players in the ecosystem confirms.  Given these considerations and the simple cost-to-value proposition of the work, we believe DFIN’s position in the transaction space is virtually unassailable.  Workiva would appear to agree – follow Workiva’s earnings transcripts and it’s clear that Workiva is turning its attention much more to non-SEC applications for its software:

WK Q4’16 Earnings Call: “Increased subscription revenue, or non-SEC use cases from existing customers, continues to be the primary driver of our add-on revenue retention rate.”

WK Q3’16 Earnings Call: “We've shown how we had evolved from a single SEC solution in 2010 to now expecting that non-SEC use cases will generate about half of our subscription bookings for the full year of 2016.”

We think that Workiva has plucked the low-hanging fruit in the SEC arena and that this risk is now largely behind DFIN.

Why do we like the stock here?

IPO and M&A work recovering off a cyclically low 2016

2016 was a bad year for investment bankers.  The number of US IPOs was down nearly 40% to a total of 105 IPOs, the lowest level since 2009, and down over 60% since 2014.  The number and value of global M&A transactions over $1Bn announced in 2016 was down 17% and 34%, respectively:

    Source: Renaissance Capital      Source: CapitalIQ

Because transaction work lacks visibility, DFIN management, during its first ever post-spinoff earnings call in February, decided to be prudent and assume a 2017 transaction environment flat to 2016 when providing its initial 2017 guidance.

Since then, we’ve seen a nearly 80% year-over-year increase in the number of IPOs priced while the number of global M&A deals is up 10%.  Based on our data, we believe DFIN’s growth in both is even greater, and we saw the impact of this recovery in DFIN’s Q1 results – an 11% increase in revenue and a 37% increase in EBITDA.  This reflects the earnings impact we expect to see should high-margin transaction activity continue to recover.

While management raised guidance following Q1 results, we continue to believe it’s overly conservative as it assumes a relatively stable transaction environment for the balance of the year, even as the data thus far indicates continued growth.  DFIN has cautioned that Q2 faces some difficult comps due to an abnormally high number of large M&A deals last Q2 in the midst of an overall weak 2016, so we don’t expect the type of growth we saw in Q1, but we do believe 2017 guidance is more than achievable, with material upside if transaction activity trends continue.

Attractive Free Cash Flow Generation

We wouldn’t rely solely on a recovery in the deal environment to justify owning the sto ck and find DFIN’s ability to generate an attractive level of free cash flow equally as compelling.  Based on carve-out financials, DFIN historically generated $80mm-$100mm of FCF annually, while 2017 guidance calls for $50-60mm of FCF, reflecting a lower level of deal activity underlying management guidance vs. prior years and higher standalone costs (note, even in 2016 DFIN generated over $85mm in FCF).  This guidance still implies a respectable 7-8% FCF yield, but given $10-15mm of one-time cash restructuring costs included in these numbers, we think true ongoing FCF is something closer to $70-75mm.  Of course, the upside is materially higher if transaction volumes do continue to trend as they have been.  A cash sweep provision in the company’s debt agreements requires DFIN to prioritize FCF toward debt reduction.  Factoring in a cash payment of $68mm paid by RRD to DFIN on 4/3 as part of its spin-off agreement (note: this is not reflected in DFIN’s 3/31 balance sheet), we believe the company will be able to lower their current 3.8x leverage ratio to just below the upper end of their target range of 2.25x-2.75x by year-end.

Cost cuts should help drive a big second half

The company has done a good job of disclosing the various puts and takes on incremental costs and expected cost savings associated with its spin-off from RRD.  The incremental costs include $14.3mm of expenses that RRD underallocated to DFIN when presenting carve-out financials and $15.5mm of additional standalone costs for a total of nearly $30mm in incremental expenses.  Offsetting this are $20mm of cost initiatives (primarily headcount reductions) already taken and $7mm of savings realized from the re-pricing of a logistics agreement with RRD (DFIN was previously paying above-market rates) for a total of $27mm in offsetting benefits.

While DFIN has already incurred over half of the incremental expenses, the company has realized virtually none of the offsetting cost benefits, which will be weighted more heavily to the second half of this year (mostly in Q4).  While we recognize that cost savings can be fuzzy and generally hesitate to ascribe too much credit to these programs, it appears these savings are much more tangible, and management’s confidence in achieving these targets seems to improve with each conversation we’ve had with them.

Other items

RRD Secondary Overhang Behind the Company – as part of the spin, RRD retained nearly 20% of DFIN shares with the requirement that they dispose of the shares within one year.  Understandably, this was a major overhang on the shares that kept a lid on the stock (shares actually closed down after DFIN’s Q1 beat-and-raise).  RRD finally sold their shares on 6/13 via a secondary offering priced at $21.25, about a 2% discount to prior close.  With the secondary now behind the company, we hope the focus will remain solely on DFIN’s improving fundamentals.

Additional Sellside Coverage – Until recently, DFIN was covered by a single analyst out of CJS Securities.  As of June 19, it was also picked up by Citi, who led the secondary (Initiated with a Hold rating).  We expect expanded coverage from other sellside shops, especially now that the secondary is behind the company.

Summary Financials and Valuation

Our 2017 base case EBITDA of $180mm is at the high end of the company’s $175-$180mm guidance range.  We assume 5% EBITDA growth in 2018 driven by low-single-digit top-line growth and slightly higher margins.  2017 FCF of $53mm, at the low-end of company guidance, gets DFIN’s leverage levels below the upper end of its target range of 2.25x-2.75x by the end of the year.  Again, this doesn’t assume much upside from transaction activity recovery (7% EBITDA yoy growth for the remainder of the year vs. the 35%+ seen in Q1).

There are no perfect comps for DFIN, but we list a number of companies in the analysis below that overlap with DFIN’s businesses in one way or another.

One thing to note: Lionbridge (LIOX) is a great comp for what is arguably DFIN’s worst and lowest margin business, Language Solutions.  LIOX was taken private by private equity firm HIG Capital earlier this year.  For the analysis above, we used what we believe is the unaffected share price for LIOX in order to come to valuation, but we note that ultimately HIG purchased LIOX for over 8.5x trailing EBITDA.  Again, given that Language Solutions is DFIN’s least valuable business, we think the LIOX comp provides a good datapoint to suggest our 8.5x target multiple for all of DFIN is probably conservative.

Risks

• Downturn in transaction activity – we’ve spent the write-up talking about an upturn in transaction activity, but clearly a downturn would be equally as impactful on the downside.  Looking through RRD segment disclosure going back to 2008/2009, its “Financial Print” revenues were down 6% in 2008 and 9% in 2009.  Given the high margin nature of the work, the earnings declines were surely much greater.  While this is something we’re monitoring closely as part of our diligence, this remains the largest single risk in this stock in the near-term. 

• Workiva risk/further technology disruption – Workiva has recently won a few IPOs, including Cloudera and Hamilton Lane.  We understand these were one-off and relationship-driven and we’re comfortable after our diligence that Workiva has a long way to go before they matter in this part of the business.  However, we’re mindful that if Workiva continues to win work in the transaction space, it gives them valuable case studies to pitch to new clients.  And given that they’re already being used by most companies for compliance work, Workiva already has a foot in the door.

• Expansion of Notice & Access to M&A – based on our calls, this doesn’t appear to be on anyone’s radar, but something to watch for.  Given print’s minor contribution to EBITDA, we think this is more of a headline risk than a fundamental one.

Catalyst

• Earnings beats/raises as transaction activity recovers
• Additional sell-side coverage