Donnelley Financial (DFIN)
Headwinds to Tailwind Make for a Compelling Setup
Date – 1/6/25
Ticker: DFIN
Stock Price - $60.42
Market Cap - $1.81B
Business Overview
Capital Markets – Provides services to private and public companies, helping clients prepare necessary registration forms. Their technology platform and personal expertise expedite and correctly file all required materials. Beyond the initial IPO, SPAC, and de-SPAC, Donnelley (DFIN) provides ongoing assistance during M&A transactions, debt offerings, and other transactions (Q3 24TTM transactional revenue totaled $206m or 26% of sales). Outside of these transactional/infrequent events, DFIN provides clients with compliance solutions compatible with SEC EDGAR, 8-K, 10-Q, 10-K, and proxy fillings. Utilizing DFIN's platform, clients can reduce the probability of submitting incorrect or incomplete documents to regulatory agencies, which can be costly and time-consuming. DFIN is one of the only (if not the only) companies providing end-to-end filing needs. From private to public and ongoing filing requirements thereafter. Most competitors offer segments of the process, whereas DFIN is one of the only companies with compliance/transaction solutions throughout a business's life cycle. Q3 2024TTM Capital markets revenue of $548m represented 68%.
Investment Company – Donnelley provides solutions to investment companies, primarily mutual funds, alternative investments, and insurance companies required to file ongoing regulatory documents. The Arc Suite platform allows clients to manage their financial and regulatory compliance needs via a workflow tool designed to simplify, automate, and accelerate filings while catching errors before submitting these files to the SEC. Arc Suite allows firms to input quarterly or monthly data, which will self-fill other line items in documents that require the same information. For an Investment company, this might include month-end AUM or fee changes. For public companies, filling out quarterly financials will populate the 8-K, 10-Q, 10-K, and any prospectus relying on that data. Investment company revenue accounted for 32% of TTM revenue.
Thesis
1. Donnelley's transition to a more recurring/reoccurring business decreases business seasonality and cyclicality. Software Solutions (100% recurring/reoccurring) represents $322m of TTM revenue and carries high incremental margins. Margins in this segment increased an estimated ~370bps in 2024, on top of a 340bps expansion in 2023. Long-term management guidance for this segment is mid-teens growth, which makes the stock very cheap if achieved. Even if they come in slightly below guidance, the stock's current valuation indicates little confidence in achieving this target.
2. Donnelley's other, more profitable but lumpy business is its transactional business, tied to M&A, IPOs, and other corporate actions. The charts below detail US IPOs and M&A transactions. Tech-enabled revenue skews towards this lumpier profile (52% of 2023 revenue was transactional). On a TTM basis, ~25% of revenue came from transactional or event-driven activity. While the percentage of revenue may not grow due to software growth, the overall dollar amount will as activity normalizes.
3. History of taking share – In addition to Tech-Enabled solutions, Venue, a certified data room platform that allows clients to share confidential information in real-time throughout the transaction lifecycle, is tied to event-driven activity. Venue revenue is included in Capital Markets software solutions. Despite declining transactions, Venue has performed exceptionally, taking share from the competition. In 2023-2024e, Venue revenue grew 10.5% and an estimated 28% in a down market. Historically, DFIN has spent ~5% of sales on CAPEX. Going forward, this is increasing to 7% as they look to accelerate software growth. As the leader in SEC Filing Agent for Funds & Corporations, Content Management (Arc Suite), #2 in Compliance Filing Software (ActiveDisclosure), and #3 in Virtual Data Room Software (Venue). Donnelley's accelerating growth in their high margin and recurring/reoccurring business is welcome. In the near term, earnings overstate FCF as they invest incremental capital into software development (CAPEX > D&A).
4. Easy comps with a less restrictive administration (Lina Khan will be replaced) and increased financial disclosures related to annualized recurring revenue (ARR) and gross and net retention (GRR/NRR) give investors insight into key business drivers. In Q4 2023, DFIN closed the sale of Ebrevia (software), which has been a slight headwind to top-line growth of 1-2% per quarter. With the lapping of this ending in 2025, comps are easier. 2nd throughout 2023-2024, customers using DFIN's Section 16 services were under a software + transactional contract. These customers fully transitioned to a software license under the ActiveDisclosure business. Because of this, management noted that churn would be higher than usual. Recently, management began disclosing gross and net retention levels within their ActiveDisclosure business. Both have improved sequentially throughout 2024. From Q1-Q3, GRR was 89%, 91%, and 93%, while NRR was 90%, 93%, and 95%, respectively. Retention should normalize at a higher level as we move further from the transaction to a subscription contract change. As a key KPI, demonstrating high GRR & NRR increases investor confidence in the durability of the business.
5. In October 2022, the U.S. Securities and Exchange Commission (SEC) adopted the Tailored Shareholder Reports(TSR) rule, mandating mutual funds and exchange-traded funds (ETFs) to provide concise and visually engaging annual and semi-annual reports to shareholders. This initiative aims to enhance transparency and ensure investors receive transparent and pertinent information about their investments. DFIN has reported additional software revenue from its Tailored Shareholder Report solution within the Arc Suite. They anticipate achieving $11 million to $12 million of incremental recurring software revenue on a full-year basis from this offering. Half of this revenue will be realized in 2024 (Q3/Q4), with the full amount (which I expect to increase as other funds switch to the premier TSR platform) realized in 2025 and beyond. DFIN released its first TSR offering in October 2023, giving them first-to-market advantages.
Management Incentives Aligned With Business KPI's
Management's bonus and long-term incentives align with the key business drivers. Annual cash bonuses comprise Adjusted EBITDA and Software Solution net sales growth. Performance Stock Units (PSUs) are based on Software Solution net sales and Adjusted EBITDA margin. Restricted Stock Units (RSUs) are based on the stock price. As software solution net sales comprise a larger portion of revenue, margin expansion will occur. Embedded in this metric is GRR. If they provide value-added services to clients, and clients therefore stay with DFIN, GRR & NRR will continue improving, thus making software revenue growth "easier." Dan Leib, CEO, owns 1.5% of the company, while the remaining executives own less than 1%.
Recent negative developments and a potential reason for the languishing stock price despite an improving outlook, Director Jeffrey Jacobowitz owned 7.7% of DFIN (2.278m shares) as of the 2024 proxy filing in April 2024. Since then, Jeffrey has reduced his position to ~860k shares after his recent sale of 234,000 shares on 11/6, bringing his ownership stake from 7.7% to ~2.9%. In addition, on November 19th, he stepped down from his position on the board. Given these actions, I expect him to fully exit his position, likely by the end of Q1 2025. This added selling pressure will likely cap the near-term upside, though it allows management to repurchase shares at an attractive price. YTD, they've repurchased 700k shares and an additional ~250k shares in October. Q1 & Q2 are seasonally the weakest cash flow periods, limiting buybacks, while Q3 & Q4 represent the best cash flow quarters.
Risks
- Software growth and capex reinvestment fail to deliver an adequate ROI.
- Jeffrey Jacobowitz knows something outside investors do not.
- M&A and IPO volumes remain sluggish, and my optimism surrounding improving tech-enabled revenue growth results in lower EPS.
Valuation
Upside optionality stems from management hitting their software sales targets. My software sales growth is well below management targets. Second, increasing capital market activity drives Venue and tech-enabled revenue higher than anticipated. Both can occur simultaneously, driving significant revenue and EPS revisions and leading to a higher multiple. My 3-year bull case is $7+ in EPS, and a 20x multiple gets you to a $140+ stock.
Catalysts
- Share overhang from Jacobowitz sell-down ends
- M&A and IPO activity increases as a more lenient administration steps in
- Earnings revision cycle as the business outperforms expectations