|Shares Out. (in M):||32||P/E||0||0|
|Market Cap (in $M):||715||P/FCF||10||0|
|Net Debt (in $M):||600||EBIT||146||0|
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Donnelley Financial Solutions, Inc. (“DFIN”): Long Idea
Financial services and communication company that was recently spun off
Return on tangible capital is ~50%
Return on invested capital, including goodwill, is ~20%
Asset light business
CapEx is less than 3% of revenue
8.3x EBITDA minus CapEx
10% FCFE valuation
Why Does This Opportunity Exist?
Recent spin off (~ 1 month old).
Fairly complicated pro forma financials and pro forma adjustments.
Retail investors who held all shares that they received as part of spin off have experienced reduced dividends and likely to view the transaction as a under-cover dividend cut.
Low transactional activity in 1Q 2016 which make LTM financials look poor compared to 2014 and 2015 financials.
Volatile markets in October 2016 which does not help a spin off.
R.R. Donnelley & Sons Company (“RRD”) recently spun off its publishing and retail-centric print service and office products company LSC Communications (“LSC) and financial communicants and data series companies Donnelley Financial Solutions, Inc. (“DFIN”). DFIN is a subject of this report. RRD has retained 19.25% stake in DFIN and LSC. RRD will dispose of its DFIN stake within the twelve month period following the distribution.
Before the spin off, DFS was a part the financial reporting unit of Strategic Services segment of RRD.
Capital Structure at a Glance
This is DFIN capital structure at a glance.
History of DFIN
DFIN in its current shape and form is a result of several acquisitions completed by RRD over the years: DFIN was built through the combination of RR Donnelley's financial print business, Bowne (acquired), and EDGAR Online (acquired).
Since 2009 RRD completed four relevant acquisitions:
Prospectus Central, LLC (an e-delivery company)
Bowne (financial communications and filing company – both print and online)
EDGAR Online (which specializes in EDGAR and XBRL filings with the SEC) and
MultiCorpora (a translations and language solutions company)
DFIN also made strategic (i.e., minority) investments in:
Peloton Documents (a media and interactive communications provider) and
Mediant (a provider of electronic and printed shareholder communications),
Reasons for Spin Off
The spin off information statement lists all typical reasons for a spin off (almost a laundry list). So we will mention only one here (and we should take with a grain of salt):
“allows investors to separately value each business based on their unique investment identities, including the merits, performance and future prospects of their respective businesses. The Separation will also provide investors with three distinct and targeted investment opportunities”
Again, this reason is not that uncommon either. What is more interesting is how the management viewed the valuation of DFIN before the spin off transaction.
On 2Q 2015 RRD management said:
“you look at [DFIN] and you think about what some of their trading comps might be. I think some of those comps are trading at 2 plus times where we trade today as 1 entity.”
While we would not necessarily push that far, it is interesting to see what RRD management thought (rightly or wrongly) about value of DFIN.
Business Description; Business Segments; Reporting Units; Revenue Mix
What DFIN Does: a High Level Overview
DFIN is a financial communications services company. What does it mean? DFIN provides services to its clients in the financial space (very broadly defined) related to disseminating information and making public / regulatory filings.
Examples of DFIN clients may include:
A private company going through an IPO which needs to make lots of filings with the SEC.
A public company that needs to make regular SEC filings (e.g., 10Q, 10K, etc.).
An investment fund that needs to make filings with the SEC and provide certain financial information to its clients.
As digitalization and “structured data” started invading the space of regulatory filings, DFIN embraced it as well and its product and service offerings expanded to include digital products / services.
In DFIN’s own words:
“we serve capital market and investment market clients by delivering products and services to help create, manage and deliver accurate and timely financial communications to investors and regulators. We also provide virtual data rooms to facilitate the deal management requirements of capital markets and mergers and acquisitions transactions, we provide data and analytics services that help professionals uncover intelligence from disclosure contained within public filings made with the United States Securities and Exchange Commission, and we provide language solutions through which we can translate documents and create content in up to 140 different languages for our clients.”
This was a high level view but now let’s delve into more details.
DFIN: Two Business Segments and Three Reporting Units
DFIN has two business segments: U.S. (~85% of revenue) and International (~15% of revenue).
U.S. Business Segment has three reporting units:
global capital markets (GCM) (~50% of total revenue)
global investment markets (GIM) (~32% of total revenue)
language solution (~14% of total revenue).
International Business Segment has not reporting units though we suspect that it has similar revenue streams (though global capital markets equivalent would have a higher portion of revenue than in the U.S).
DFIN: Revenue Breakdown by Segment and Reporting Unit
Below we provide a table that summarizes revenue breakdown by segment and unit.
U.S. Segment: Global Capital Markets Unit (GCM)
GCM clients consist mainly of domestic and international companies that are subject to the filing and reporting requirements of the Securities Act of 1933 (The Securities Act) and the Securities Exchange Act of 1934 (The Exchange Act).
GCM: Revenue Mix
GCM revenue mix consists of transactional revenue and compliance revenue.
GCM transactional revenue depends upon M&A, IPO, debt financing and other similar transactions. The products / services provided are related to various regulatory (mostly SEC) filings and deal management solutions. This is what DFIN says about those products and services: “We also support public and private companies throughout the mergers and acquisitions transaction process and in public and private capital markets transactions with deal management solutions focused on aiding transactional efficiency from inception to completion.”
GCM transactional revenue accounted for ~52% of GCM revenue in 2015 and 25.6% of total DFIN revenue.
GCM compliance revenue is more steady and almost recurring. An example would be quarterly filings. GCM compliance revenue is not dependent upon transaction activity.
GCM compliance revenue accounted for ~48% of GCM revenue in 2015 and ~23.7% of total revenue.
U.S. Segment: Global Investment Management Unit (GIM)
GIM clients are United States based mutual funds, hedge and alternative investment funds, insurance companies and overseas investment structures for collective investments that have to follow U.S. laws and regulations and thus make various financial and regulatory filings.
GIM Revenue Mix
GIM revenue has very little correlation with the M&A and IPO and other transactional activity, and most of GIM revenue is compliance in nature which means that compliance revenue is (almost) recurring.
For example, in 2015 ~96% of GIM net sales or ~31% of total revenue were compliance in nature, while the remaining 4% of our GIM net sales or 1.3% of total revenue were transactional in nature.
GIM: Client Mix
Based on 2015 revenue mix, ~60% of GIM revenue were derived from clients in the mutual funds industry and 40% were derived from clients in the healthcare and insurance industries.
Other Client Information
GIM’s clients currently include clients in the U.S., Canada, Ireland, the United Kingdom, Luxembourg, India and Australia.
Interestingly, according to DFIN, the average relationship with GIM clients exceeds 12 years.
U.S. Segment: Language Solutions Unit
Language Solutions Unit is the smallest and accounts for ~4.2% of total revenue.
In DFIN’s own words:
“language solutions offerings support domestic and international businesses in a variety of industries by helping them adapt their business content into different languages for specific countries, markets and regions through a complete suite of language products and services. We provide our language solutions offerings to clients operating in a variety of industries, with our language solutions 2015 net sales derived from clients in the financial, corporate, life sciences and legal industries, among others.”
While International Segment has no reporting units, DFIN has disclosed a few things about its International Segment.
International Segment: Breakdown by Geography
In 2015, operations in Europe, Asia, Canada and Latin America accounted for ~48%, 33%, 17% and 1% of international segment net sales, respectively.
It means that Europe, Asia, Canada and Latin America accounted for ~6.8%, 4.7%, 2.4%, and 0.1% of total revenue in 2015, respectively.
International Segment: Revenue Mix
DFIN’s international business is primarily focused on working with international capital markets clients on capital markets offerings and regulatory compliance related activities into or within the United States.
In addition, the International segment provides services to international investment market clients to allow them to comply with applicable SEC regulations, as well as language solutions to international clients.
DFIN: Revenue Breakdown – Services vs. Products
DFIN derives revenue from selling both services and products. Products refer primarily to physically printed communication / filings, etc. For example, mutual funds must send certain information to its clients in paper format.
Services vs. Products: Revenue
Below we provide a breakdown between revenue from services and revenue from products.
Not surprisingly, product revenue is declining. What we do not know is how much of this decline is driven by volume and how much is driven by price.
Services vs. Products: Gross Profit
The gross profit profile of services and products is different. Below we provide relevant information.
Services vs. Products: EBITDA and Operating Income
What we do not know, however, is what percentage of SG&A is attributable to Services and what percentage of SG&A is attributable to Products.
We did not attend a roadshow that DFIN did before the spin off. However, as far as we know, management tried to emphasize that margins on printed products are close to zero. When we look at the gross margin of ~29%, we are a bit puzzled by how that margin completely disappears when you get to operating income. However, it is possible.
Source of Sustainable Competitive Advantage
DFIN has very impressive ROIC. When looking at ROIC excluding goodwill and using 2015 financial performance, ROIC is ~50%. When we include goodwill in our invested capital calculations, ROIC goes down to ~20% which is very impressive.
This high ROIC begs a question: what is a sustainable completive advantage?
Admittedly, it is quite difficult to pinpoint the competitive advantage that DFIN has. We tend to think that the source of competitive advantage comes from scale and switching costs.
DFIN has an envious scale. We can attempt to measure scale by using penetration of DFIN’s services into large U.S. corporations. According to DFIN, it is serving 422 of the S&P 500 companies (84.40% penetration) and 745 of the Fortune 1,000 companies (74.5% penetration). Admittedly, we do know exactly “how penetrated” these clients – meaning how many services and products each of them buys from DFIN.
We tend to think that there are some switching costs (though we do not want to overestimate them). While moving from compliance services provider to another is definitely doable, the nuisance and inconvenience involved are substantial and inertia is strong. Fear of the unknown (what if a new provider is worse?) is large. The best parallel we can think of is how many hedge fund managers would like to shift to another admin or another audit / tax firm unless they absolutely must do that.
It is worth reminding that the average age of a GIM client exceeds 12 years. This provides circumstantial evidence that switching costs exist.
Small Costs Relative to Risk Taken Through Transition
In the grand scheme of things, costs incurred by large and mid-size U.S. corporations and funds are fairly small relative to their total SG&A. Saving a little bit of money may not worth the risk and mindshare of relearning the minutia of doing SEC filings.
Business Model: Other Components
In this section we will cover various elements of DFIN’s business model that are relevant for understanding this company.
Volatility of Performance
One of end markets that DFIN serves (M&A and capital markets transactions) is inherently volatile. Thus, operating and financial performance of DFIN would be volatile as well. For example, 1Q 2016 with few capital markets transactions was significantly weaker than 1Q 2015.
Let’s try to quantify this inherent volatility. When measured as per cent of total revenue, U.S. GCM transactional revenue accounts for 25.6%, U.S. GIM transactional revenue accounts for 1.3%, and most of 14.2% of International revenue (let’s say 75% * 14.2% = ~10.65%) is transactional in nature as well.
Putting it all together, ~37.6% of total revenue is transactional in nature and thus will inevitably fluctuate.
There is a small mitigating factor that the Company mentions though we do not want to overestimate it:
“We mitigate some of that risk by offering services in higher demand during a down market, like document management tools for the bankruptcy/restructuring process”
Recurring Revenue Is Substantial Part of the Business
The flip side of the revenue mix is that ~58.2% of revenue are compliance driven and mostly recurring.
We are not quite sure what the breakdown of Language Solutions revenue is but it is fairly small part of revenue (~4.2%). If we were to guess, we would say that most them of are recurring in nature for this reason. According to the Information Statement, in 2015 ~62% of revenue were recurring in nature. If we add 58.2% that we calculated above and 4.2% of revenue from Language Solutions, we would get to ~62.4% which is very close to DFIN’s 62%.
Customer Acquisition and Lifetime Value of Customers
While DFIN does not talk (think?) about its clients in terms of life time value, it is probably worthwhile to bring it up. We do not have lots of data to address this comprehensively though which means that our discussion will be high level.
When a company is going public, it is likely to rely on its bankers and lawyers to choose DFIN or its competitors to do all necessary filings, use data room services, etc. If DFIN is chosen, chances are high that this recently IPOed company will use DFIN’s services for its periodic filings. Finally, if such company does an M&A transaction, DFIN has a very good chance of being engaged again.
DFIN’s capability to provide various products and services and one stop shopping to its clients is likely to be another contributor to its success.
Fixed vs. Variable Costs
DFIN seems to praise itself for a highly variable cost structure. Let’s look more into this.
For example, in the spin off statement DFIN wrote:
“Since 2010, we have managed our cost structure to be highly variable in nature…by outsourcing and management efforts”
“Cost components such as outsourced purchases of composition services, printing, and language solution translators, certain direct materials such as paper, ink and packaging materials, and certain portions of transportation costs are entirely variable…”
There is also an informative slide in the DFIN presentation where it gives quantitative measures. DFIN breaks down all costs into four groups:
100% variable costs
75% - 100% variable costs
50% - 75% variable costs
Less than 50% variable costs
We did some back solving and present our findings below.
So using our mid-point assumptions (except for less than 50% variable costs where we assumed 100% fixed costs), about ~81.4% of the cost base is variable and less than 19% is fixed.
Again it is difficult to decode, how much of that is driven by print where we would expect to see more variable costs than in the services business.
Customer concentration does not present significant concerns as no customer accounted for 10% or more of revenue in 2013 – 2015.
DFIN’s competitors are different depending on the reporting segment.
GCM: Competitors and DFIN’s Market Position
DFIN breaks down GCM competitors into three categories.
full service financial communications providers, such as Merrill Corporation, Toppan Vite, Summit Financial, RDG Filings and Vintage Filings
technology solution providers focused on financial communications, including a number of small to midsized companies providing governance, risk and compliance solutions like Certent, Trintech and Workiva, companies focused on the virtual data room space, the largest of which is IntraLinks
general technology providers, which include a number of large companies that offer point solutions that are usually part of a larger enterprise solution set, including IBM Cognos, SAP and Oracle and, in the virtual data room space, Dropbox and Box.com
Despite multiple competitors, DFIN seems to be the largest player. Here are some relevant data points:
GCM provides services to 379 of the S&P 500 companies
GCM provides 685 of the Fortune 1,000 companies
IPO segment / product share in 2015
DFIN – 56%
Merrill – 25%
Vintage – 6%
Top 20 deals in 2015
DFIN – 75%
Merrill – 15%
Vintage – 5%
DFIN breaks down GIM competitors into three categories.
full service traditional providers, including Command Financial, Merrill Corporation, Toppan Vite, Millennium and DG3
small niche technology providers providing technology products and content management platforms to serve the early parts of the communication process or providing filing or document hosting tools and services for the distribution part of the communication process, including Confluence, Kneip, Data Communique and Workiva
local and regional print providers that bid against us for printing, mailing and fulfillment services, including VG Reed, Wurst, Mcardle, Marek Group, FGS, Universal Wilde, Fitzgerald Marketing and Allied Printing
Despite multiple competitors, DFIN seems to be the largest player. Here are some relevant data points:
DFIN – 37% of SEC filings.
Next largest provider – 6%
Mutual funds 2016 YTD:
DFIN provided 41% of Edgar filings
Merrill came in 2nd at 6%
Self-filers at 22%
Long-standing GIM relationships
7% revenue CAGR since 2011
6% revenue CAGR since 2011
11% revenue CAGR since 2011
Tailwinds and Headwinds
DFIN is facing some tailwinds and headwinds. Let’s address them.
We actually see only one major tailwind.
Long DFIN = Long Increasing Regulations
By taking a long position in DFIN, one is also “long” increasing regulatory burden. We think that it is a good position to be in.
The number of headwinds seems to be higher.
Long DFIN = Long Active Managers
By being long DFIN, one is also long active managers. Given the increasing inflows into passive investment vehicles, it is a headwind.
Long DFIN = Long Printed Communications
As we discussed, DFIN’s derives a significant portion of its revenue from printed products. Decreasing revenue from printed products is almost granted (according to DFIN which estimates the rate of decline of ~4% - 5% per year).
There is a threat that the share of self-filers can increase.
Pro Forma Financials and Spin Off Adjustments
Now we will work with necessary adjustments and pro forma financials to arrive to DFIN’s “normalized” cash flow / earnings.
Pro forma financials include $0.9M and $2.2M of separation expenses in 2015 and 1H 2016 respectively.
We will need to add them when we work with “normalized” earnings.
It is worth noting that DFIN was expecting to incur additional $1.4M of separation costs before the spin off that were not reflected in its 1H 2016 financials.
Standalone Company Costs
Historically, certain corporate and overhead costs incurred for RRD were allocated to DFIN. Now DFIN will need to spend its “own” money and incur standalone company costs.
This is what the spin off statements says:
“The costs to operate our business as an independent public entity are expected to exceed the historical allocations, including corporate and administrative charges from RRD of approximately $6.8 million for the six months ended June 30, 2016 reflected in the accompanying condensed combined financial statements and $13.5 million for the year ended December 31, 2015.”
The spin off statement and the presentation state further that
“The preliminary estimates for these net incremental expenses range between approximately $11.0 million and $16.0 million on an annual basis going forward. The pro forma impact of such incremental costs has not been reflected herein as many of the costs expected to comprise this increase are not factually supportable at this time. Actual expenses could vary from this range estimate and such variations could be material.”
On top of this, DFIN has transition services agreements with RRD and LDSK under which it would pay $3.3M annualized for 12 to 16 months. Please note that we view this charge as one-off and not incorporating it in our calculations of DFIN’s normalized earnings power.
Adjustments Due To Commercial Agreements
DFIN also disclosed that
“DFS expects to receive a material benefit to SG&A on a go-forward basis ($10.8mm based on 2015A volume) due to revised pricing on the remaining logistics relationship with R.R. Donnelley”
We assume that this benefit is dependent on volume of printed products which is declining. Hence, we will haircut from $10.8M to $9M to be conservative.
Another peculiar feature of the spin off transaction is a note that DFIN received from RRD of ~$68M that should be paid by April 1, 2017.
Note L to the pro forma financials says it all:
“(L) Reflects cash to be transferred to RRD in order to arrive at the agreed upon cash needed for working capital purposes pursuant to the Separation and Distribution Agreement. The Separation and Distribution Agreement also includes a provision for RRD to make a future cash payment to Donnelley Financial no later than six months following the Separation. Based on current assumptions, a receivable of $68.0 million has been included in the pro forma adjustments related to this amount.”
The more complex adjustments are pension related.
First, note (H) to the Pro Forman Financials says:
“(H) Effective as of the Distribution Date, RRD expects to transfer certain defined benefit pension plan net liabilities associated with Donnelley Financial’s active, retired and certain other employees. The net benefit obligations we will assume will result in recording estimated net benefit plan liabilities of $64.7 million (consisting of a total benefit plan liability of $336.7 million, net of plan assets having fair market value of $272.0 million), accumulated other comprehensive losses, net of tax, of $71.3 million, and $25.9 million of related deferred tax assets. Our estimates may change as we approach the Distribution Date and continue to refine our estimates of the net liability transfers as of that date. The actual assumed net benefit plan obligations and incremental income could change significantly from our estimates.”
So it appears that the net DBO deficit is ~$64.7M. DFIN is also getting some DTAs of $25.9M.
However, the presentation deck says that “as of April 30, 2016 underfunded obligation of $72M”.
Presumably, ~$64.7 is more recent and, therefore, more accurate number but we should keep in mind that DFIN may end up with ~$72M deficit.
Adjusted Enterprise Value
Now we can calculate Adjusted Enterprise Value.
Normalized EBITDA and FCF
Let’s start with making adjustments that we discussed to Adjusted EBITDA as provided by the company.
In 2013 – 2015 CapEx was less than 3% of revenue.
We will model $30M going forward which we think is conservative.
Cash Interest Expense
As part of the spin off, DFIN will have ~$650M of debt and undrawn RCF of $300M.
Thus, the cash interest expense (including RCF fee) would be about ~$45M.
Figuring out cash taxes is probably the most imprecise part of arriving to FCFE.
Income Tax Provision
Below we provide relevant information about the income tax provision and breakdown between current income tax expense and deferred income tax expense.
However, DFIN has some NOLs (though they are not huge buy any means). DFIN had domestic and foreign NOLs deferred tax assets and other tax carryforwards of
$16.4M and $3.0M, at December 31, 2015
$18.6 million and $3.7 million, at December 31, 2014,
of which $4.0 million expires between 2016 and 2025.
What is very peculiar here is that despite being highly profitable the decrease in NOLs from 2014 to 2015 was ~$2.2M for Federal and ~$0.7M for foreign.
Even more interestingly, DFIN provided a valuation allowance as “it is more likely than not that the deferred tax assets will not be fully realized”. The valuation allowances were:
As of December 31, 2015, and 2014, valuation allowances of $4.9 million and $5.3 million, respectively, were recorded.
GAAP Income Tax Expense ad Cash Taxes
With the caveat that cash taxes are likely to be lower than GAAP income tax expense, we will try to calculate GAAP income tax expense and use it as a proxy for cash taxes.
Below are our calculations.
DFIN disclosed that it expects ~$3M of pension contributions in 2016. We do not know whether it is a great proxy going forward but given lack of information we will use it.
FCFE: Putting It All Together
Putting it all together we arrive to ~$70.6M of FCFE.
Current EV/EBITDA Valuation
On EV/EBITDA valuation, DFIN trades at ~7x.
Current EV/(EBITDA minus CapEx / Intangibles) Valuation
On EV/(EBITDA minus CapEx / Intangibles) DFIN trades at ~8.3x.
Current FCFE Valuation
DFIN trades at almost 10% FCFE.