Donnelley Financial (DFIN) has seen declining revenues since its spinoff and investors have written it off as a dying print business. It is easy to overlook its incredible brand strength in certain business segments along with the successful transitioning of a growing share of its revenue to SaaS with this overhang. For a few key reasons discussed in this article, we believe their fundamentals are now poised to improve and there is 100% upside for investors from current levels.
DFIN spun off from RR Donnelley in 2016. The company provides services and Regtech to public companies and investment companies (Mutual funds, ETFs, hedge funds, variable annuities) that must ensure compliance with the SEC. They have four business segments:
1. Capital Markets Compliance & Communication (CMCC)
2. Capital Markets - Software Solutions (CMSS)
3. Investments Markets Compliance & Communication (IMCC)
4. Investment Markets - Software Solutions (IMSS)
Capital Markets Compliance & Communications CMCC - This segment encompasses all non-SaaS revenue that is linked to meeting public companies' SEC driven compliance needs. We think it is helpful to further categorize this segment into two separate buckets: 1.) transactional filings like IPOs, M&A, Issuances, 8-Ks, debt offerings etc. 2.) regularized filings such as 10-Ks and 10-Qs.
DFIN's market share of the overall transactional filings market is dominant, durable and verifiable. According to our own work random sampling over 20,000 transactional filings their share is estimated at greater than 50%. This is a quantification of the value embedded in their long-standing brand. The phrase, "no investment banker or lawyer gets fired by choosing Donnelley" is still a common utterance. Watch a competitor speak to the competitive advantage of Donnelley in this video from minute 33:00 to minute 35:00.
Transactional filings are supported in part by CMCC's service arm and printing arm. Although CMCC's transactional service arm has staying power, the low margin printing component, which makes up roughly 40% of CMCC's revenue, is in secular decline (see chart below). Revenue from the second bucket (regularized filings) is derived from companies that outsource or partner with Donnelley to meet their SEC regularized filings needs. CMCC's revenue that is linked to regularized filings is also in secular decline as companies transition to filing using software packages. The good news here is that Donnelley has developed "ActiveDisclosure", a SaaS solution that enables its customers to transition from the traditional hand-holding approach to self-service.
Capital Markets Software Solutions CMSS - Revenue from this segment is linked to Software as a Service that help public companies meet their SEC compliance needs. CMSS is composed of two SaaS offerings, Venue Virtual Data Room (supports transactional filings) and ActiveDisclosure (supports regularized filings). Venue revenue correlates with DFIN's market share of IPO deals. CMSS's second flagship SaaS product is ActiveDisclosure with revenue at a steady 40mm. DFIN has spent aggressively in this space to catch up with new rival Workiva.
Investment Markets Compliance & Communications - This is non-SaaS revenue that is linked to helping facilitate investment companies file with the SEC and present shareholder information to investors. Although Donnelley's brand is not quite as unassailable as it is on the transactional side of capital markets, they do enjoy a 40+% market share of fund filings (source: DFIN investor relations). Fund filings are supported by IMCC's service arm and print arm. In 2019, Due to regulation 30e-3 that give funds the option to default to electronic filing for shareholder reports, this segment's revenue will be reduced by 140-150mm translating to about 10-15mm EBITDA hit. The same pressures that Donnelley is experiencing on the CMSS side are felt here although the revenue reduction from print is brought forward with rule 30e-3. Although these reductions in revenue screen poorly, ultimately the more they shed of low margin print revenue, the better investors can evaluate their healthy assets.
Investments Markets Compliance & Communication IMSS - This isDonnelley's "FundSuiteArc" software offering, that allows fund companies to store and manage compliance and regulatory information. This segment has seen revenue growth as of Q1 2020 and will continue to be bolstered by steady CAPEX. Just like CMSS, you will see a natural flow of revenue from non-SaaS segments into SaaS segments.
Why it's trading at a low multiple
The downward trendline of their revenue and stock price since their spinoff in 2016 sends prospective investors running for the hills. Their revenue has been in decline since the spin for several reasons - print based revenue continues to shrink, divestiture of non-strategic revenue producing assets and loss of share on the capital market compliance side. There are some mitigating factors to be considered. First is that shedding low margin print based revenue is a good thing as the company will no longer be painted with the "printing" brush. The second is that the loss of share on 10-Qs and 10-Ks has galvanized the company to shifting to a SaaS based business. All driven by sound capital allocation decisions and executive pay both being tied to SaaS growth and cash flow goals.
The company is misunderstood. Some still think of this as a pseudo print business that is basically a dinosaur getting outcompeted left and right. This could not be further from the truth and the print-based revenue is almost going away in its entirety after 2021. Additionally, the market seems to be hung up on revenue growth when this is really a story about beneficial changes in revenue mix that cash flow oriented investors will enjoy.
The revenue received from public company transactional filings is about 30% of consolidated revenues. Additionally, the reason the transactional side is more important than its revenue weighing suggests is that this gives them initial client engagement and allows them to offer the client more services. There is no getting around some cyclicality to their business. However, as more business shifts to SaaS, revenue will become more recurring. The mitigating factor here is that revenues are not as cyclical as people believe as the Investment Markets segment along with ActiveDisclosure are not dependent on the transactional environment.
From about 2010 to 2016, competitor Workiva was able to snag ~50% market share away from Donnelley in compliance filings. Workiva created a solution for collaborative cloud-based software that makes the regularized filings of 10Ks a Qs more efficient. As a result of being outcompeted in this arena, Donnelly has invested heavily (30-40mm annually) in their SaaS offerings, the lion's share going toward a software solution called ActiveDisclosure that has recently bucked the trend. Revenue from Active disclosure in Q1 2020 was $31,200,000 vs $30,500,000 of Q1 of the previous year. The decline in revenue due to loss of market share has not only recently abated but is showing strong signs of reversing.
Although some investors might associate market share loss in one segment to the entire business this is simply not the case. Their market share in the IPO and M&A market is underappreciated and remains durable and dominant. The effect of this is that they own the initial engagement with the customer allowing them an advantage when it comes to providing them with other solutions. The conversation around solutions for regularized filings is considerably easier if they are totally dependent on you to IPO.
Other competitors have tried to enter this space to no avail. It isn't as easy as just setting up a software solution and displacing/disrupting the old model. There are a plethora of lawyers, accountants, investment bankers and regulators that all need to be quarterbacked to launch a successful IPO. Maybe one of the few areas where experience is a plus and cannot be disrupted by software and relationships still matter. This is evidence by the fact that Workiva has tried to grab share in this segment but failed. Their share is in the low single digits. As they grow their SaaS revenue, operating leverage will increase given incremental margins from SaaS segments are high (incremental margins in the 30%+ range).
The cyclicality to their business model is not as severe as people believe. M&A and IPOs make up roughly 30% and 40% on the transactional side and are typically are not too correlated. There is generally not a dearth of both during an extended period. Additionally, with the shift to SaaS, the revenue will become more recurring.
The company unveiled new business segment reporting in Q1 2020 (the new segments were used in this article) with the intention of providing investors with a clear picture of growth vs non growth assets. This way investors will be less likely to paint all assets of the company with the "print" paint brush. As a result, investors will be able to clearly see the growth in the SaaS business and have a higher likelihood of properly assessing the assets of the company.
Transactional volume on both the M&A and IPO sides has been lackluster in the past 12 months according to earnings reports. Given rates are near zero and there has been a huge injection of liquidity from central banks to unfreeze capital markets, this should set the stage for increased IPO and M&A activity. This would be a significant boost to their business.
The biggest and most meaningful catalyst is the continued improvement of their SaaS business. If SaaS revenue continues to grow, potential investors will no longer be able to disregard growth assets of the business.
Risk and Forward-Looking Considerations
DFIN's biggest risk is that their SaaS revenue stops growing. Their SaaS revenue has been growing roughly 5% yoy and our thesis is predicated on the continuation of this growth. Investors should regularly check filings to ensure evidence of growth or if growth dips down for a quarter, management should have clear explanations to confirm the competitiveness of their SaaS solutions.
Another risk is that the IPO market freezes for a couple years due to coronavirus concerns. IPOs have numbered thus far about 50% of normal levels. The number of IPOs and M&A activity is useful to keep track of going forward for investors.
We used a DCF model that discounts future years FCFF and nets out debt to arrive at a valuation for DFIN. We estimate FCFF as (EBITDA - maintenance capex)* (1-tax rate). We use a normalized and adjusted EBITDA to take into account cyclicality along with one off charges. We also use a Monte Carlo that uses a uniform distribution for long term assumptions (past three to five years).
Our assumptions are that CMCC & IMCC segments will continue declining in revenue 3% annually while IMCC reduces revenue by an additional 150mm starting 2021 due to rule 30e-3. All data around revenue trendline and rule 30e-3 are found in Donnelley's 10Qs and Ks. The company grows SaaS segments by 5% over the next 4 years before normalizing to a long-term growth rate of 2-3%. Capex remains in the 30-40mm range and declines to 3% of revenue in year 4. Margins trend up to a blended 20% target in year 4 and tax rate remains 21%. WACC is roughly 12% which is high in today's low rate environment given the cyclical nature of certain business segments. After netting out the 380mm of net debt and pension liability, this leaves a market cap intrinsic value of 600mm, more than a 100% upside from today's price.
Looking at DFIN's stock price drop over the past few years from $29/share to $8/share today, it is hard to be optimistic about the future for DFIN. However, lucky for DFIN (or us), stock prices have no memory. DFIN still has a defensible brand and has stabilized market share in its most competitive segment. We believe that as the market realizes this and sees DFIN becoming a higher margin business due to its SaaS transition, DFIN should see significant price appreciation. This is one of our of highest conviction ideas at the moment.
State of IPO market
The amount of companies coming public towards the second half of 2020 has been a bit insane to say the least. According to SEC regulatory filings, Q3 2020 has seen 81 IPOs (ex SPACs) making it the busiest Q3 by deal count since 2000. Average IPO first-day pop has been 37%. The actions from government organizations to shut down economies have devastated industries such as hotel and leisure but have been a boon to sectors such as Healthcare and Tech. As society pushes for a vaccine, more people than ever are now working from home evidenced by screen time on our favorite devices up almost 60% since the pandemic began. Throw in trillions of dollars in liquidity injected in our capital markets system and you get a volcanic surge in demand for these companies. Tech and Healthcare companies have rushed for the exit as they make up over 50% of deal count this year. Many heads of private companies are unsure if this craze will continue and the FOMO is palpable. We have all experienced this to some degree, for the first time ever we are starting to get stock tips from Uber drivers. There is no denying there is something in the air.
SPACs - From zero to hero.
SPACs used to get no respect, they raised small amounts of money and performance post-merger left a lot to be desired. In 2014, SPACs started to get a bit of traction with 12 SPACs raising 1.8B. Fast forward to Q3 2020 and a jaw dropping 83 SPACs have come to market raising a total 30.6 billion. In addition, the size of SPACs continues to rise with Ackman’s largest ever SPAC raise of 4B. Why now the deluge? Well, a few reasons. Firstly, SPACs are now leveraging the star power of hedge fund personalities and reputations of asset managers to raise capital. Names like Chamath, Ackman, Apollo headline all-star casts helping to raise gobs of capital with the promise to give potential issuers a path to come to market quickly and cash in on the recent craze. What would you be thinking if you were the founder of a private company and witnessed Snowflake IPO at 170 times TTM revenue? Cue the frenetic napkin math. A benefit to private companies that decide to IPO the SPAC route is forgoing the extensive due diligence involved in the standard IPO process. In fact, the SPAC sponsors seem not to care even if the company is pre-revenue! Early stage companies that have went the SPAC route this year like Nikola and Fisker serve as good examples. The market is saying, “here is a pool of cash and no worries about proving your concept.” There is no doubt scarcity value within certain sectors and SPACs are a byproduct of this appetite explosion. Not surprisingly then, the SPAC momentum increases because it is increasing. SPACs pending acquisitions averages a 29.4% return and a median return of 9.9%. Sounds like a risk-free trade, all you have to do is buy the units and sell the news.
SPACs are not a replacement for the typical IPO process but a nice complement that increases the range of potential private companies that are considering going public. It offers something different. Guaranteed capital and a quick way to get to market without having to go through too much scrutiny. This comes at a cost of dilution to shareholders of the SPAC and the issuer. As you can guess, this can be quite a costly route for investors and companies. SPAC sponsors that eventually end up taking 20% of the merged entity without providing any ongoing value can be a hard pill to swallow for some.
DFIN's share of the SPAC market is consistent with their broader IPO market share. SPACs also continue to rise in terms of complexity and size which means more coordinating with counter parties and increased dealings with regulatory agencies. All good news for DFIN. It is hard to be optimistic about SPAC staying power given post-acquisition performance is consistently negative for the group. This being said, DFIN will enjoy a bump from the current environment.
Direct Listings - The new kid on the block
Sounds like an IPO killer, right? Why pay those pesky underwriting fees, when you can let open access, supply and demand take care of everything? It is easy to picture VCs backslapping and yelling, “turns out we never needed those banker dudes to begin with, haha!” Well, not so fast. There is merit to Direct Listings, as any of you that follow Bill Gurley will no doubt have heard a million times before. To understand this, it is first best to start with dispelling the stunning misperceptions surrounding Direct Listings. The media gets it wrong in interpretation, impact, motivation and pretty much everything else. Here is an example of an article that gets it exactly wrong. The mistake they are making is assuming certain similarities exist with standard IPOs. They are confusing the reference price with the offer price in the primary market. It is not. For a standard IPO, this is the price set through Dutch auctions during the book building process. Primary market transactions are indeed happening at this price. The reference price is more or less meaningless in the sense that it is meant to serve as some sort of ethereal valuation rather than an indication of transactional activity. The price of Palantir, for example down on its debut this year, not up. Its first trade was at $10 a share and it finished at $9.5 dollars a share. Direct listings are a completely different animal in that investment banks are no longer underwriters but financial advisors. There is no book building and there is no primary market. The issuer receives zero funds from any buyers and on day one of trading, the float is effectively equal to the shares outstanding because there is no lockup. Any insider can dispose of their shares if they please. This gives us all we need to understand the intent of a Direct Listings. The sole motivation is not, as the media thinks, to avoid paying investment banking fees. Direct Listings are also expensive. Listen to the Slack CEO talk about the costs. The primary intent is for insiders to not be diluted and locked up. As of the time of this writing, Direct Listings can only facilitate a secondary market. Initial offerings have to be approved and the exchanges are trying to push this through SEC review right now. I suspect the SEC will eventually pass this sometime next year but investor protection remains an issue. Underwriters are on the hook for public disclosures when a company goes public the traditional route. Without the underwriter acting as a watchdog, I suspect the SEC will attempt to add certain regulations to the Direct Listing process to assume a similar level of investor protection with IPOs.
The ability to conduct a direct listing has been an option for quite some time, so why now? In short, certain companies have been around long enough, have extensive VC support and generate enough cash where they don’t need the money. Also, they do not need a bank to sell them. Companies like Spotify, Slack & Asana have institutional investors tripping over themselves to get a piece. Why go on a roadshow when everyone wants to see you? Unfortunately, the vast majority of private companies, do not enjoy such an advantaged position. As it stands, only four of companies have completed a Direct Listing in the last few years. The inability to conduct a capital raise being the primary deterrent currently from conducting a Direct Listing but there is more than that. Contrary to what some might believe, investment banks do in fact add value by putting company founders in front of their clients. They effectively have a distribution arm that is valuable to founders and worth paying for. Especially when the company realizes they will have to pay for financial advisors anyway to help with the market making, regulation and analyst support. The traditional IPO process is not of much value to a few select unicorns and for those, Direct Listings are a better alternative. Bill Gurley’s refutation to this is that someone will build a platform so all investors can jump on and see the latest investor day presentation and interest can be drummed up that way-- no need for a bank to sell anything. I think this misses the point that for wider Direct Listings to be a success, you need broad institutional participation which would simply not happen for smaller & less well-known companies. Selling and relationships still matter when it comes to raising money and investment banks acting as intermediaries in this capacity are here to stay.
Now, how does this affect DFIN? Although it is hard to the exact haircut, DFIN does make less revenue on Direct Listings. If Direct Listings begin to enjoy a much wider scale it would lower their revenue profile. No road shows means less coordination with lawyers, bankers and less meeting in general. All this translates to less revenue but it is important to keep in mind that this isn’t all bad news for DFIN. They still generate revenue coordinating filings and the door is still open to sell compliance software for recurring filings. The way companies come to market will continue to evolve along with investor appetites. We continue to monitor the motivation behind these different avenues and structural changes that might exist that give way to markets evolving. Ultimately, the changes that we are seeing are positive for markets and DFIN remains well positioned to take advantage of the environment.