I often like to undertake sector reviews to find investment ideas. My last forays were into online dating, which uncovered Spark Networks (LOV) now up 50% since I wrote a Top Idea here, and consumer subprime finance which led to my Curo Holdings (CURO) article found here. This time I am working my way through the compliance sector and will be sharing some observations along the way starting with Donnelley Financial Solutions (DFIN) in this article. As usual I apply my initial screening criteria of strong tailwinds, attractive valuation, skilled and aligned management and key risks.
Source: Company May 2018 Investor Presentation
Donnelley Financial Solutions was spun out of R. R. Donnelley & Sons (RRD) in October 2016. As shown in the slide above, its main operating segments are Capital Markets and Investment Markets where it holds leading positions in the US and Internationally. It sold its Language Solutions business in July 2018. Investment Markets is aimed at financial institutions and insurance companies assisting them with compliance related matters through its FundSuiteArc cloud-based software products. Its Capital Markets activities include:
Transaction Solutions: M&A and IPO document management systems and cloud-based Venue Virtual Data Room. Most recently it acquired eBrevia in December 2018 to offer clients advanced machine learning software that extracts key information from documents.
Compliance Solutions: preparing Exchange Act filings that are compatible with SEC’s EDGAR system. Main SaaS offering is its ActiveDisclosure platform and it made a strategic investment in AuditBoard to give clients access to their SOXHUB service.
EDGAR Online - Data and Analytics: EDGARPro enables investors, analysts, lawyers, auditors and corporate executives to access detailed company information
Are there strong tailwinds?
From a macro perspective neither capital market activity nor compliance are in themselves areas of rapid growth. However, within these markets tailwinds benefit those who are most adept at technological innovation. As one of the dominant players in most of its markets, Donnelley Financial looks like it has been in defensive mode for much of its independent existence. It readily acknowledges that the global risk and compliance industry is highly competitive and technology innovation has lowered barriers to entry most severely in its mutual fund, variable annuity and public company compliance solutions sectors. Technology advancements have allowed clients to manage more of the financial disclosure process themselves. In May 2018, Donnelley Financial revealed their new business plan that centers on transitioning its business to a software and technology focused company.
Source: Company May 2018 Investor Presentation
As shown in the slide above, in reality the transition effort has been unfolding for over a decade through a three pronged strategy of developing software in-house, entering into strategic partnerships and through acquisitions. Donnelley Financial takes a very cautious approach to acquisitions often preferring to enter into strategic partnerships before acquiring the company years later. As shown above, this has been the case for Prospectus Central, EDGAR Online and most recently its December 2018 acquisition of eBrevia. Its internally developed software platforms, ActiveDisclosure, FundSuiteArc and Venue Virtual Data Room, continue to form the backbone of its SaaS offering aimed at reducing cyclicality through recurring subscription revenue and increasing retention. Is Donnelley Financial benefiting from strong tailwinds? I would say no. Rather it is focused on managing change in order to protect its current position.
Valuation - is this an asymmetric trade?
Source: Company 2018 10K
The net effect of the transition efforts to-date has been muted. As the 5 year headline operating income financials above indicate, Donnelley Financial has been a zero growth proposition for too long. Its 2018 net sales fell primarily due to the sale of its Language Solutions business in July 2018. SaaS net sales are growing up 19.3% (slightly above its 4 year CAGR of 17%) in Q4 2018 vs Q4 2017 representing 22.0% of Q4 2018 net sales. But SaaS is still too small to move the total sales dial upwards. Donnelley Financial is guiding towards 2019 net sales of USD930 million, a further fall from 2018 levels, and its 2022E target of USD1,070 million assumes almost negligible growth.
2018 net earnings of USD73.6 million benefited from a one-off gain of USD38.6 million on an after tax basis from the Language Solutions sale. Unsurprisingly, Donnelley Financial is trading on very under-demanding historic multiples of 0.9x EV/revenue, 5.7x EV/adjusted EBITDA and a PE ratio of about 14.8x (excluding one-off sale gain). Long-term debt has fallen over USD200 million since 2016. About USD145 million came from two non-recurring sources, a separation-related payment from R. R. Donnelley for USD68 million in 2017 and the sale of Language Solutions raised USD77.5 million in 2018. To conclude this section, I don’t see this as an asymmetric trade.
Does it have skilled management whose interests are aligned with shareholders?
Daniel Leib has been CEO since Donnelley Financial’s spin-off and was formerly R.R. Donnelley’s CFO. According to the last Schedule 14A filing he has a beneficial ownership of 221,611 shares equating to a less than 1% holding. Altogether directors and executive officers have a 1.58% interest equating to USD8 million. This is a very minor exposure. The CEO’s target pay cash vs. equity mix is 34%:66%. For 2017, CEO Leib received total compensation of USD5.9 million. Over 2017, Donnelley Financial's share price fell 15% and a further 20% since then to current levels. Since the spin-off its share price has only headed in one direction and that is down. Clearly CEO and shareholder interests are not aligned and it is questionable whether the CEO, coming from R.R. Donnelley, has the technology background to drive real change.
What are the key risks?
Cyclical nature of the business: deriving a large part of its revenues from capital market activity exposes Donnelley Financial to cyclical risks. For example, the Q4 2018 market volatility had an adverse impact on transactional activity with global IPO volumes falling and no high yield debt deals completed in December 2018.
Technology disruption: Donnelley Financial enjoyed the trappings of market leadership in slow moving markets for many years. Though technology is forcing change, Donnelley Financial does not seem to be at the forefront of the innovation curve. Its efforts to transition to a technology focus are yet to produce sustained growth. There is a real risk more technologically savvy competitors will take market share.
Leverage: though Donnelley Financial has been paying down its long-term debt at a steady pace it remains vulnerable to downside risk particularly in a recessionary environment.
Donnelley Financial often screens well given its low valuation multiples. But having taken a closer look at this company it fails to make a compelling investment in my view. It is struggling to capture the benefits that technology is bringing to its target markets. Its revenues have flatlined for years and for a low growth business its valuation is reasonable. Its CEO has been richly compensated since the spin-off while shareholders are down over 30%. It remains overly exposed to the cyclical capital markets and has sufficient debt to cause concern in a recessionary environment. In my view its main hope of turning the corner is accelerated technology innovation and a more aggressive acquisition strategy.
Disclaimer: Opinions expressed herein by the author are not an investment recommendation and are not meant to be relied upon in investment decisions. The author is not acting in an investment advisor capacity. This is not an investment research report. The author's opinions expressed herein address only select aspects of potential investment in securities of the companies mentioned and cannot be a substitute for comprehensive investment analysis. Any analysis presented herein is illustrative in nature, limited in scope, based on an incomplete set of information, and has limitations to its accuracy. The author recommends that potential and existing investors conduct thorough investment research of their own, including detailed review of the companies' SEC filings, and consult a qualified investment advisor. The information upon which this material is based was obtained from sources believed to be reliable, but has not been independently verified. Therefore, the author cannot guarantee its accuracy. Any opinions or estimates constitute the author's best judgment as of the date of publication, and are subject to change without notice.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.