The company breaks out their lines of business into three segments, mostly by customer type:
- Global Capital Markets: Clients consist of primarily publicly traded companies that are subject to the Securities Act of 1933 and the Securities Exchange Act of 1934 who need to make periodic regulatory and investor filings along with transactional filings when M&A, IPOs, bankruptcies or other large corporate actions happen. About half of the revenue from this segment is recurring in nature, the other half is transactional and depends heavily on deal making activity in the financial markets. Donnelley Financial did business with 422 S&P 500 firms in 2015 via this segment.
- Global Investment Markets: Clients consist of mutual funds, hedge funds, insurance companies that use Donnelley Financial's products to create reports, prospectuses, fact sheets and other marketing materials. Almost all of this segment is recurring in nature, although it may face broader secular headwinds as active management strategies continue to face challenges outperforming and the resulting outflows.
- Language Solutions: DFIN's smallest segment provides translation services that adapt business content into different languages for specific countries. This segment could be where future acquisitions are made as the market is highly fragmented.
RR Donnelley didn't run what is now DFIN as a separate business vertical prior to the spinoff making it difficult to see historical numbers or business trends. Besides reading the Form 10-12, it might be helpful to go back and review Bowne & Co (BNE) which RR Donnelley bought back in 2010 for ~$460MM, significantly beefing up their financial communications business. For cyclicality context, Bowne's revenue dropped about 20% from 2007's peak to 2009's trough.
Why do the spinoffs?
RR Donnelley split up into three companies which itself could create some market uncertainty (seems to have today at least) as investors digest the prospects for each separate business. Donnelley Financial appears to be the best business of the three, but to complicate matters RRD CEO Thomas Quinlan jumped to what looks like the 'garbage barge' retail printing business (LSC Communications) and the remaining RRD will be maintaining a 19.25% interest in both spin-offs for up to a year which could result in exchange offers for fans of those transactions.
But overall, the spinoffs seem to be designed to separate the headwind facing business, LSC Communications, from the parent that has moved to a more value add business model. Secondarily highlighting the high margin, low capital intensive financial communications business (DFIN) from the parent, which should lead to DFIN trading at a higher valuation. Most of the legacy pensions, PP&E, and other old-economy like cash drags will be either going to LSC Communications or staying with RR Donnelley.
Management
Daniel Leib, the old CFO of RRD, is now the CEO of DFIN. He's been the CFO of RRD for many years and before that was their internal M&A and strategy lead. I generally like when CFO's take over the head job, especially of a company like DFIN that is expected to generate a lot of free cash which management will need to allocate and DFIN's entire business model is based around financial statements and regulatory disclosures, Daniel Leib as a former CFO should be intimately aware of these challenges from a client prospective. The board will be led by Chairman Richard Crandell, 77, he like the rest of the board don't appear to have much of a printing industry background, more technology and software, lending more credit to the strategy of shifting the company to software products.
Valuation
Donnelley Financial will be substantially asset-light, they outsource much of the physical printing during peak times around proxy season, and have minimal capital expenditures ($20-30MM) as they shift their business to more software and cloud offerings.
New IPOs and deal making activity was a little muted during the first half of the year, particularly the first quarter, pushing down DFIN's numbers year over year. I'm going to use a rough $200MM EBITDA number, below the current run rate to account for both some peak market activity risk and the inherent carve out risk of using proforma Form 10-12 numbers. DFIN has approximately $600MM in net debt and 32.4 million shares outstanding (which includes the stake retained by RRD), at $24.50 per share, DFIN is trading at 7x EBITDA for a mostly recurring revenue stream, with strong margins and minimal cap ex requirements. Seems too cheap to me.
Disclosure: I own shares of DFIN
$200 mm of Adj. EBITDA seems very generous. LTM is $193 mm (see table), which ignores the $14 mm of expected incremental PF costs outlined in the Form 10. This takes LTM to $179 mm.
ReplyDeleteFair criticism on the expense allocation, I breezed by that a little too quickly, but a run rate of $179MM would contradict some with their statements that this is a low 20s-high teens EBITDA margin business and deal activity was pretty slow to start the year in a lot of areas. But even at $179MM, it trades for under 8x after falling more yesterday afternoon, what's the right multiple for this business? Maybe it is 8x given we're near all time highs and this has some leverage? Could be right.
DeleteI hear you on deal activity, but remember that 42% of this business is still paper-based. It seems like a potential value trap.
DeleteIn speaking with a few others, sounds like management has been saying in their roadshow that the paper side is basically run at zero margin and mostly just facilitates other complimentary business at this point. They do have two plants that they own, but the rest is outsourced, sounds like they've at least tried to prepare for the day where mutual fund annual reports being sent by snail mail isn't the default.
DeleteWhat is the market cap of DFIN?
ReplyDeleteAt $23 and 32.4 million shares, the market cap is $745MM.
DeleteThe closest comps trade at 11-12x FY17 and FY18 EBITDA. Not to say that there is a great comp out there, but with DFIN apparently shifting even more towards the digital side of things, you could argue that 7x seems like too large of a discount given 20-21% margins and manageable leverage.
ReplyDeleteWhat do you think are the closest comps? I thought about more what I'd pay for a business with similar characteristics, didn't really have a comp set in mind, maybe that's what you're getting at too? My thinking was I'd buy it for 7x, and be interested in selling it at 9-10x, maybe that's too low, but we'll cross that bridge if we get there. Thanks for the comment.
DeleteNo pure comp out there. Closest in my opinion would Computershare (higher margin, higher leverage) and Broadridge (lower margin, lower leverage). Both trade around 11-12x consensus.
DeleteSome similarities to Issuer Direct (ISDR) as well, right?
DeleteI didn't realize ISDR was public, thanks, looks cheap too so maybe not the best comp if you're a DFIN bull, but could be an acquisition target?
DeleteM&A transaction would likely be the exit strategy for an ISDR investor. I haven't looked too closely yet, but this DFIN spinoff really piqued my interest in the space. DFIN likely has some competitive advantages given how it serves so many S&P 500 companies, and the top mutual fund houses. ISDR looks like it might have lower margins depending on how you treat the product development expenses(not yet sure if they both make the same capitalizing vs expensing decisions). I wonder which company is more prepared for a massive shift towards structured data in regulatory filings? I suspect DFIN, but I'm not sure. On the other hand, it would be interesting if ISDR could give some of that cash back to shareholders... Thanks for the great post. Its awesome when a spinoff reveals the high margin capital lite part of a business.
ReplyDeleteAlso interesting that they said on road show that the paper side of business was basically zero margin. I have been trying to figure out the difference between margins for deadtree vs. online. If the paper part is indeed zero margin, that means that a higher margin part of the biz is effectively growing to eclipse the low/no margin part. Decent longer term setup.
ReplyDeleteThank you for the idea. I looked at its financials and it does look cheap. However, I have the following concerns. Can you please share with me your thoughts on these?
ReplyDelete1. Business seems to be in terminal decline. All yoy metrics decline except one item--- SG&A.
2. Impairment charges every year. That seems bad, as they can always tell people that excluding this one time impairment charge, our adjusted earnings is xxx.
3. With reasonable leverage, why is the note priced so high? 8.250% Senior Notes due 2024
Donnelley Financial also priced its $350 million senior secured term loan B facility under its new credit agreement, under which Donnelley Financial will borrow at 4.00% over LIBOR, subject to a LIBOR floor of 1.00%.
4. Page F-6. Accrued liabilities and other always a cash drain on operating cash flow every year. That seems unusual for a business in decline.
I don't view this as a business in decline. The printing side of the business certainly is at a low-to-mid single digit pace per year, but as others have mentioned, this business is very low margin and masking the healthy side of the business, the software/data services which generates more than half the revenue (and likely a vast majority of the profit). The revenue declined year-over-year because of the slowdown in transaction during the first half of 2016, seems like a long time ago now but not a lot got done in the M&A, debt, or securitization markets during the first quarter. Free cash flow should be ~$90MM, they have a lot of optionality there to invest and offset the declining print side of the business.
DeleteThe impairment charges in recent years don't seem out of line to me, pretty minor? I'd also be careful reading too much into carve-out financials going back much farther than a year or two as this wasn't run as a standalone business unit at RRD, but was instead created by pulling out different aspects of several of RRD's reporting segments.
The note is priced a little high, but not terribly so, I think people are a little scared of the leverage at 3+x and you have the term loan above the note in the capital structure. The term loan at LIBOR + 4.00% looks more in line to me.
Thanks.
MDC, how do you get to ~$90M of FCF? My math is different and I am curious what I am missing.
ReplyDeleteEBITDA of $190 minus CapEx of ~$28M - $30M minus $42.6 of cash interest minus cash taxes of $40 - $50 (their tax expense on I/S in 2015 seems a bit high to me). With these numbers I am ending up with $70M to $80M maximum.
I think that 8.25% Notes are actually quite bad as they will be taking a significant chunk of cash flow. If priced at 200 bps lower, it would result in $6M in cash interest savings. With the market cap of ~$810, it is 0.75% difference in FCFE yield which is not insignificant.
My math, feel free to criticize:
ReplyDeleteEBITDA: $200MM
D&A: $41MM
Interest: $42MM (this will likely come down as they'll receive $68MM from RRD early in 2017 that they could use to delever)
Pre-Tax Earnings: $117MM
Taxes @ 35% rate: $41MM
Net Income: $76MM
Add Back D&A and Subtract Capex: $41MM - $29MM
FCF: $88MM
I'm trying to come up with more of a run-rate number, I view 1H 2016 as below the run rate, others can come up with their own view. And given management's 2.25-2.75x leverage target and the $68MM RRD receivable, it looks like interest expense should come down, maybe they can refinance the note down the road as they delever.
Carve-out financials are tough. Thanks for the comment.
Thank you for a prompt response. DFIN can definitely use the $68M RRD receivable to pay down debt. However, I think if they choose to go "pay down debt" route, they would use the cash to pay the bank debt rather than going to the market and buying back bonds.
ReplyDeleteRe: refy of the Notes. I have not read the indenture (I have not seen it yet) so I am purely speculating here. I think that Notes would have a 2 year or more "no refy" protection. Pure speculation.
I don't believe in doing relative values. Your benchmark may be not valued correctly. That is how RE is valued and because it is, we got 2007-09 when all houses were valued grossly high.
ReplyDeleteI prefer to look at yields and then compare my alternatives.
DFIN has a 58% ROIC on replaceable assets. It has ~200M EBIT. With EV = 1325 there is a EBIT yield of 15% which is very attractive compared to 2% 10 year bonds, even if they go up to 6%.
DFIN was distributing ~70M back to its parent every year. Now it gets to retain and employ it. Some will go to debt reduction.
I thought it was a bargain at $22 and backed up the truck, apparently a little soon.
Thanks Jim, I concur and added a little more today.
DeleteI was going through some of your recent ideas (now that we closed the chapter on VRS..) and thought this one looks interesting on cash flow yield. Here's something I don't understand. If paper/print is a declining business with zero margin, why do they not exit it? Wouldn't that improve the company's overall growth profile and warrant a re-rating of its valuation? I'm just thinking aloud..
ReplyDeleteGood point, I think zero margin isn't the right way to think about it. We don't know the true margin because management doesn't break out their reporting that way (good question on why?), but they represent it as a low margin. I believe the important thing about the printing exposure is its variable cost, they utilize something like 35 printing facilities during the peak season (annual reports, proxy season) but only own 2 of these, the rest are outsourced (most likely to RRD).
DeleteI cant decide if the stock is going south due to (expected) selling by holders of RRD or because this is yet an other "garbage barge" spin executed to separate a terminal business...
ReplyDeleteThey filed their 10-Q yesterday, while sales are flattening out in their capital markets business, they were still down year over year. Operating margins also came down which throws some of the variable cost theme into question and being long DFIN is also being long active mutual funds which is arguably a terminal business. There's still some spinoff noise in there, and some shareholders puking, I don't think it's the garbage barge, this was intended to be the good business, just ran into some headwinds that weren't present when the spin idea was contemplated/announced. If you look at the combined RRD/DFIN/LKSD it's been a disaster, maybe there's some opportunity in there somewhere?
DeleteWill have to take a fresh look which wont be hard for me since I never looked at these before. It is quite remarkable, however, that the three stocks are sliding in such a ridiculously strong market.
ReplyDeleteAs always, continue to follow this blog closely and learn something with every post. Would be curious if you have any thoughts on the Q3 performance at GRBK? Many thanks.
ReplyDeleteThanks.
DeleteYes, I thought the GRBK results were good, it's sort of turned into a sleepy company at this point and may take a while before we really see the stock price move significantly higher again. They have an interview posted on their website that discusses Nashville as a potential new market for them, they do seem set on doing an acquisition to grow into their capital structure, hopefully they don't screw that up (unlikely given the ownership). Also, looking back on the recent NOL shell era, this one might turn out to be the best use of NOLs, profitable every quarter, no real need to continually go out and make additional acquisitions to pull the tax asset forward other than their normal course of business land buys. I have some reservations of giving up 50% of the profit at the homebuilder level, seems like a bad deal for GRBK, but does insulate them a tiny bit in a downturn. I added a bit last year and haven't done anything with my position since, imagine owning this one for a while longer.
Very intelligent conversation. I spent a lot of time thinking about this one. I too thought it was very cheap and bought around 20. I liked the economics of software side of the business, the history of margin improvement, and at 7x EBITDA with high ROA, it seemed like a steal. The quarterly scared me though. At some point, they have to grow the revenue. I sold at the same price I got in at. I'll still be following the earnings though. A dividend or increase in revenues would be a real catalyst.
ReplyDelete