Donnelley Financial Solutions, Inc. (DFIN) Q3 2017 Earnings Report, Transcript and Summary

Welcome to the Donnelley Financial Solutions' Third Quarter 2017 Results Conference Call. My name is Eric, and I will be your operator for today's call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session. [Operator Instructions] Please note this conference is being recorded. I’ll now turn the call over to Sanja Burklow. Sanja, you may begin.

Thank you, Eric. Good morning, everyone. And thank you for joining Donnelley Financial Solutions third quarter 2017 results conference call. This morning we released our earnings report, a copy of which can be found in the Investors Section of our website at dfsco.com. During this call, we'll refer to forward-looking statements that are subject to uncertainty. For a complete discussion, please refer to the cautionary statement included in our earnings release and further details in our Annual Reports and on Form 10-K and other filings with the SEC. Further, we will discuss non-GAAP financial information. We believe the presentation of non-GAAP results provides you with useful supplementary information concerning the company's ongoing operations and is an appropriate way for you to evaluate the company's performance. They are, however, provided for informational purposes only. Please refer to the press release and related footnotes for GAAP information and a reconciliation of GAAP to non-GAAP information. We are joined this morning by Dan Leib; Dave Gardella; Tom Juhase; and Kami Turner. I will now turn the call over to Dan.

Thank you, Sanja, and good morning, everyone. On today's call, I will provide an update on our third quarter performance and overview of market activity, reiterate our strategic priorities and recap the progress we've made in repositioning the company to operate as a standalone entity. Following my comments, Dave, will provide additional detail on our third quarter results and then we will open up the lines for a Q&A session. While our third quarter revenue results were below our expectations with a decline of 0.8% from last year's third quarter, our non-GAAP adjusted EBITDA grew by 9%, resulting in non-GAAP adjusted EBITDA margin improvement of 130 basis points. This profit improvement reflected the benefits of our cost reduction efforts which more than offset the incremental standalone cost and impact of the year-over-year revenue decline. The year-over-year revenue decline of 0.8% was primarily driven by a decline in our capital market transactional offering due to lower revenue related to M&A transactions and a reduction in IPO related revenue. While M&A activity was generally flat, we experienced lower revenue per transaction due to mix and complexity. This is consistent with the broader M&A market that is been skewed all year toward relatively smaller deals. IPO related revenue came in lower than expected driven by a softer market mid quarter. The decline in transactional activity was partially offset by higher capital market's compliance volume. Higher mutual funds volume and growth in our software offerings. With respect to growth in our software offerings, our Venue Data Rooms and our ActiveDisclosure compliance solution both grew more than 20%. We continue to invest in both solutions bring innovations to market that our clients expect from us. We released our newest Cloud based version of ActiveDisclosure in September. ActiveDisclosure release 3 allows multiple users to simultaneously create and edit their Word, Excel and Power Point documents which means our clients now have real time visibility to changes or edits being made to their documents by other team members. In addition, we've expanded our products via partnership. One example is our investment in eBrevia that expands the uses and functionality of Venue. eBrevia is the contract diligent tools that have been integrated into Venue which leverages artificial intelligence to help streamline the legal and due diligence processes, creating efficiencies for our clients. Within the global investment market industry, the regulatory environment continues to be dynamic both here in the US and in the EU. We've developed software built on our FundSuiteArc platform to help our clients comply with the new N-CEN and N-PORT filing requirements which we expect will be effective starting mid 2018. These requirements are part of the SEC's modernization initiatives for 940 Act Mutual Funds and ETS, aiming to enhance transparency, capturing more data elements on a more frequent basis. We were the first filer to test these nee requirements with the SEC and now have clients on-boarding to our software. In EU, the PRIIPs regulation goes live in January 2018 and we are also currently in a process of on-boarding clients needing those requirements. With respect to our operating plans going forward, I'd like to reiterate our key priorities that I discussed on our last call. We'll continue to build on the sales momentum that we've created in the areas where we've seen significant growth in our recurring revenue offerings such as our Venue Data Rooms, ActiveDisclosure compliance offering, our language solutions offering and our content management solutions within our investment markets reporting unit. We will continue to invest and make enhancement to our software-as- a- service solution. We expect such enhancement to be result of a combination of organic investment and expansion of our relationships with strategic partners. We'll continue to aggressively pursue transactional activity within global capital markets. Our client relationships as well as our reputation in the space positions us well to capture transactional revenue as market activity improves. Last, we will accomplish each of these priorities while taking a disciplined approach to managing our cost structure and deploying capital. In our first four quarters following the spin-off, we've reduced our total debt by nearly $150 million and we remain on track to end the year within our targeted leverage range of 2.25x to 2.75x. Over the past year we've taken steps to right size the cost structure, and prioritizing our investment needs and identifying new market opportunities. We are making organic investment in ActiveDisclosure, Venue, FundSuiteArc, MultiTrans, and taking a thoughtful approach to strengthen our portfolio of products and services, and bringing wide array of governance risk management and compliance-based solutions to market. These solutions will allow us to broaden our portfolio and further enhance our client relationships, which balanced with cost management and resource allocation provide opportunity to create long-term value for shareholders. I look forward to sharing more about our long-term strategy throughout 2018. Let me turn it over to Dave. Dave?

Thanks, Dan, and good morning, everyone. As Dan mentioned softness in market activity of US capital market transactions resulted in weaker than expected revenue in the quarter. However, despite a year-over-year revenue decline, we grew our non-GAAP adjusted EBITDA in the quarter by 8.8% compared to last year through cost actions we implemented late last year and throughout this year. Net sales for the third quarter were $222.6 million, a decrease of $1.8 million or 0.8% from the third quarter of 2016. After adjusting for changes in foreign exchange rates, organic sales decreased 0.9% driven by the decline in our U.S. segment, which was partially offset by organic growth of 12.8% in our international segment. The revenue decline in our U.S. segment was driven by lower capital markets transactions volume and lower healthcare print volume, partially offset by higher compliance volume, growth in our software offerings and higher mutual funds volume. Our international segment revenue growth was primarily driven by higher mutual funds volume as well as growth in our language solutions translation services. Third quarter gross margin was 36.8% or 208 basis points higher than the third quarter of 2016. This includes approximately 300 basis points of a negative impact driven by a change in the classification of IT cost to cost of sales from SG&A compared to the classifications in periods prior to the separation from R.R. Donnelley. Excluding this reclassification, the third quarter gross margin improvement of approximately 508 basis points was primarily driven by cost reductions we began to implement late last year, as well as lower outsourcing cost. Non-GAAP SG&A expense in the quarter was $59.7 million, $1.4 million higher than the third quarter of 2016. As a percentage of revenue, SG&A was 22.3% or 80 basis points higher than the third quarter of 2016. Excluding the favorable 300 basis point impact of the IT reclassification, SG&A as a percentage of revenue was approximately 380 basis points higher than the third quarter of 2016. As noted in this morning's press release, we incurred approximately $5.3 million in higher cost related to dis-synergies and ongoing costs in excess of the cost allocated to the company prior to the spin-off from RR Donnelley. Our third quarter non-GAAP adjusted EBITDA was $32.3 million, an increase of $2.6 million from the third quarter of 2016. Non-GAAP adjusted EBITDA margin in the quarter of 14.5% was 128 basis points higher than the third quarter of last year, primarily driven by our cost reduction actions which were partially offset by lower transactional volume and higher cost driven by the separation from RR Donnelley. Now I'll discuss revenue and non-GAAP adjusted EBITDA performance for each of our segments. Revenue in our U.S. segment was $186.1 million in the third quarter of 2017, a decrease of 3.2% from last year’s third quarter. Our capital markets revenue declined 4.7% primarily driven by lower transactional revenue related to M&A. The decline in transactional was only partially offset by a couple of large compliance deals we recognized in the third quarter of 2017, as well as continued growth in our Venue and ActiveDisclosure software offerings. Investment markets revenue declined 2.9% to the third quarter of last year, driven by lower healthcare print volume as well as lower content management volume, partially offset by higher mutual funds volume. Language solutions and other reported revenue growth of 8.2%, driven by higher commercial print volume. Non-GAAP adjusted EBITDA margin for the segment of 17.7% increased 286 basis points from the third quarter of 2016. The improvement in EBITDA margin was mainly driven by our cost saving actions as well as lower outsourcing cost compared to the third quarter of last year. Revenue in our international segment was $36.5 million in the third quarter of 2017, an increase of 13.7% from the third quarter of last year. On an organic basis, excluding the favorable impact of changes in foreign exchange rate, revenue in the third quarter increased 12.8% which was driven by higher volume in our mutual funds and translations services. Non-GAAP adjusted EBITDA margin for the segment of 8.2% increased 43 basis points from the third quarter of 2016. Higher mutual funds volume and the impact of cost savings actions were partially offset by a higher allocation of IT expenses. Our third quarter 2017 non-GAAP unallocated corporate expenses excluding deprecation and amortization were $3.7 million; an increase of $2.3 million from the third quarter of 2016, this increase was driven by dis-synergies related to the separation from R.R. Donnelley which were partially offset by cost saving initiatives. Free cash flow in the quarter was $65.1 million, a decline of $23.6 million from the third quarter of last year, driven by tax and interest payments in the quarter, as well as more cash used in working capital and higher capital expenditures. On October 2nd, we reprised our term loan with an outstanding balance of $200 million and reduced our interest rate by 100 basis points to LIBOR PLUS 300. We also reduced our debt in the quarter by $37.5 million and ended the quarter with $488.4 million of total debt and $32.2 million of cash. As of September 30th, our gross leverage was 3.9x compared to 3.6x at December 31, 2016, and we had net available liquidity of $293.2 million at the end of the third quarter. Since the spin-off, we have reduced our total debt by $148.1 million and remain on track to be within our targeted leverage range of 2.25x to 2.75x by the end of the year. As we enter to the last quarter of the year, let me share more detail on the updated full year 2017 guidance that was summarized in this morning's press release. Our updated guidance reflects the softer than expected environment for capital markets transaction that we experienced in the third quarter and a more conservative outlook for the fourth quarter relative to our previous expectations. We expect revenue of approximately $1 billion, representing organic growth in the range of 2% to 3%, a decrease of 150 basis points from previous guidance which I just noted reflects our third quarter performance and more conservative outlook of market activity for the remainder of the year. We expect our non-GAAP adjusted EBITDA to be approximately $170 million; $7.5 million lower than the midpoint of our previous guidance. Depreciation and amortization is expected to be approximately $43. We continue to expect interest expense of approximately $43 million. Our full year non-GAAP tax rate is expected to be in the range of 40% to 42%. We project the full year fully diluted weighted average share count to be approximately 33 million shares. And lastly, we expect capital expenditures in the range of $30 million to $35 million and free cash flow of approximately $50 million. And with that I'll turn it back to Dan.

Thank you Dave. In our first year as a standalone company we've made several changes to improve our operating efficiency and have begun the work to reposition the company for continued success. Going forward, we'll continue on this path with a focus on strengthening our core offerings, as well as investing in additional compliance based solutions to bring to market. Before we open up the lines for the Q&A session, I'd like to thank all of our employees. A month ago we celebrated our first anniversary as a standalone company, while significant progress has been made during our first year, much work remains as we close out the year and head into 2018. I appreciate your focus and dedication as we continue evolve as a company and bring new and innovative solutions to market to drive value for our clients and our shareholders. And now operator, let's open it for questions.

[Operator Instructions] And our first question comes from Charles Strauzer from CJS Securities. Please go ahead.

Hi, good morning. Dave could you maybe elaborate a little bit more on guidance and talk a little bit about the puts-and-takes what changed there. Obviously, the transactional market was a little bit soft in Q3 and what kind of you are seeing in the transactional and M&A market especially kind of in this quarter currently and maybe timing, you've seen some pickup at least in filing but maybe talk about timing of when this M&A revenue might hit as well.

Yes, thanks, Charlie. I'll have Dave will start as a couple comments and then I'll follow up after.

Yes, thanks Charlie. As we said the updated guidance is really a reflection of what we saw in our third quarter results relative to what that expectation was going into the quarter, as well as I think tampering our view of Q4 which is obviously influenced by the trend that we saw in Q3 and our preliminary view of October. When you look across the portfolio, the updated guidance is really driven by the capital markets transactional activity where we have more limited visibility. I think the rest of the portfolio is pretty consistent with previous expectations.

Yes, I just add if we drill into the transactional side, the timing difference and where we get paid and when we get paid, there is a difference in the filing activity which we've seen a pickup in or announced deals on the M&A side which we have seen a pickup. And when we are going to get paid and recognized revenue which will be more upon the pricing of an IPO and/or the documentation and completion of an M&A transaction. So as we sit here and look into Q4 in particular and as Dave mentioned, this is the list visible part of our business when we look at activity that may have been announced earlier in the year or earlier in the third quarter that's what underlies our guidance. Having said that many of these transactions can have a short cycle time which is what lead to that lack of good visibility. The balance of the business is very increasingly more predictable than the transaction side.

Excellent. And I know that one of the big priorities for use of CapEx kind of as a standalone was to kind of beef up the technology and kind of freshen that up and kind of where are you in that kind of refresh process?

Yes, Charlie its Dave. So I think you look at our CapEx guidance for the year $30 million to $35 million, much of that goes into technology and software development. I think we feel pretty good about the progress we've made this year and as we build the budget for 2018 we'd expect more that on the radar in the next 12 months or so.

Yes. And if we look at the technology offerings and these are the customer facing technology offering. They represent about 15% of our revenue and are showing nice growth and we would expect to continue to make that same level or increasing level of investment into those products that support that growth level.

And our next question comes from Michael Chow from JPM. Please go ahead.

Good morning, guys. I was just hoping to get a little bit color around the investment markets business. I understand the exposure to capital markets activity and from the capital markets side is switches but the investment markets side seems to fluctuate as well. So I am just trying to get a little bit better understanding of how you get more visibility on that segment?

Yes. Michael, this is Dave. So I'll start and I think Dan will comment as well. Yes, I think if you look at the investment market business over a longer period of time I say the trajectory of that business has been relatively flat. And it's really the combination of two factors. Roughly 60% of the revenue in that business is print related and that's been declining at about 4% per year. So the print side of it puts about 2.5% headwind on that total business. And then obviously to get back to roughly flat, the other 40% of the business has been growing at about 6% and that's to the point Dan made earlier, some of the content management and other software offerings that we are bringing as part of the FundSuiteArc platform.

Yes. I think that's over a longer cycle. If you look quarter-to-quarter any variability or at least recent variability that you would see is largely driven by large proxies that some of our customers' maybe or that we are doing for our large customers.

Yes. This is Tom. That's exactly -- it has a transactional nature to it significant proxy or special event perspectives were. And we saw that in the beginning of the year which helped drive the revenue there. And then obviously we mentioned in the prepared remarks around healthcare clients that we have less volume in that area. So that's reflected this year in that number too.

Got it, thank you, that's helpful color. And then just to follow up in the upcoming regulatory event you call out N-PORT and N-CEN and PRIIPs as well. How should we I guess how would you frame up the revenue opportunity for Donnelley? And I am just trying to understand what kind of tailwind we could potentially expect from these events?

Yes, no, thanks for that. So there has been some discussion about the timing of implementation as we look at it today we are expecting N-CEN and N-PORT to roll out mid next year. We are still going through budget process and so within our guidance for 2018 which we would give on our February call, we will certainly get into these specifics there. We've been pleased with the customer reaction to our solutions and obviously this is an incremental revenue opportunity for us. Regulation cuts both ways but in this case this regulation that requires more frequent filing and more data elements is both an opportunity within the data -- I am sorry within the filing area and then more broadly within the data area.

Yes. So I'd just add to that, it's Tom. So there is N-CEN and N-PORT, there is rule 30E-3 and then in the UK, Europe there is PRIIPs, so those are kind of on our radar screen immediately. They -- as Dan said they can cut both ways. Some of them even have to get if you will 30E-3 has been back and forth, we are prepared for it. N-CEN and N-PORT, we got good roll up but it takes SEC and some other regulatory bodies to get them enacted and they tend to move around. So it's the predictability of the revenue in of it self is and we have to wait for that to happen. But those are on the radar screen, those in particular.

Understood. And then just one quick which I mean just to confirm would N -PORT be the largest opportunity for Donnelley of the [4-5] you mentioned.

Yes. The N-PORT and N-CEN is definitely an incremental opportunity for us. And we are lining up the customers and the accounts now for that opportunity. The others are less predictable and in fact 33 could work against us in some ways with print related revenue. But again that's not really been ratified so but you are right N-CEN and N-PORT is definitely the incremental opportunity in the upcoming year.

And our next question comes from David Ridley-Lane from Bank of America Merrill Lynch. Please go ahead.

Sure. So I guess you had previously expected fourth quarter margins to be above third quarter given the lacking of the public company cost and dis-synergies from the spend. But the revised guidance seems to imply the fourth quarter margins will be lower than the third quarter, just trying to get some more details on that.

Yes, David. Thanks for the question. I think when you look at the revised guidance right and again the mix of business were in particular revised view on the capital markets transactional work and the margin associated with that. I think is what carrying through the implied guide for Q4.

And so I guess that raises the question are you expecting US capital markets revenue to be down in the fourth quarter?

We haven't got that specific but I think if we look at the trend that we've seen this year and certainly what we saw in Q3 that's probably -- certainly what we've seen from a trend perspective and I think again Q4 I think is reflective of what we saw in Q3, as well as I said earlier kind of the early view, preliminary view of October result.

And then how much of this $20 million run rate cost savings will be recognized here in 2017?

Yes. So it's pretty close to all of it. And when you think about the timing of when we took those actions a lot were at the tail end of 2016 and very early 2017. And so I think you should think about as -- essentially pretty close to all of those cost savings rolling through in the 2017 results. Sorry just to go back on your earlier question, from a trend perspective and capital markets right I think we've seen growth in ActiveDisclosure, growth in Venue really what we are talking about here is the transactional work which again with lower visibility and kind of the disproportionate margins relative to our average I think is what you -- that the math kind of behind the Q4 impact.

Yes, and it really becomes the call on the market and the timing within the market and we feel pretty good from our position within holding -- with regard to holding share and performance within the market but it's tough to predictable both the overall margin environment and then also the timing of when some of the deals will come out.

And our next question comes from Bill Mastoris from Robert W. Baird. Please go ahead.

Thank you. Some of my questions have already been answered but Dave if you could remind us on your revolving credit facility? You had an availability reduction, is that on a leverage grid, could you remind us why that was reduced from the $300 million?

Yes. Based on the maximum leverage covenant.

And we have no further questions at this time.

Okay. Thank you very much, Eric. And thank you for joining us for the call. And we'll talk to you in February if you don't see us sooner at a conference. Thank you.