Donnelley Financial Solutions, Inc. (DFIN) Q3 2020 Earnings Report, Transcript and Summary

Ladies and gentlemen, thank you for standing by, and welcome to the Donnelley Financial Solutions Third Quarter Earnings Conference Call. [Operator Instructions] I would now like to hand the conference over to your speaker today, Justin Ritchie, Senior Vice President, Investor Relation. Thank you. Please go ahead, sir.

Thank you. Good morning, everyone, and thank you for joining the Donnelley Financial Solutions Third Quarter 2020 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 dfinsolutions.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 statements included in our earnings release and further details in our annual report on Form 10-K, quarterly report on Form 10-Q and other filings with the SEC. Further, we will discuss non-GAAP financial information. We believe the presentation of non-GAAP financial information 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 earnings release and related tables for GAAP financial information and reconciliations of GAAP to non-GAAP financial information. I'm joined this morning by Dan Leib, Dave Gardella, Kami Turner and Tom Juhase. I'll now turn the call over to Dan.

Thank you, Justin, and good morning, everyone. From all of us at DFIN, we hope that you and your families are staying safe and healthy. I'm very pleased with the company's performance for the quarter, which included both a return to more normalized levels of growth in software sales and a significant increase in transactional activity, driven by a robust IPO market. The influx of higher-margin tech-enabled services and software solutions net sales, our proactive pruning of low-margin print work, along with the significant impact of our ongoing cost control efforts, resulted in third quarter non-GAAP adjusted EBITDA margin of 22.7%, an improvement of 680 basis points from last year's third quarter. Total sales were up nearly 7% from last year's third quarter as the pickup in IPO activity that began in June accelerated in the third quarter, boosting sales across our transactional offerings globally. Strong capital markets transactional market activity and robust market share performance resulted in overall transactional sales growth this quarter, the first quarter of year-over-year growth since the third quarter of 2018. Software Solutions sales totaled $51.1 million, marking an all-time quarterly record for DFIN. The sales growth in software solutions of 10% was more in line with our historical growth rate, led by the recurring compliance products, primarily FundSuiteArc and ActiveDisclosure, growing a combined 12.7%. In addition, our data room product, Venue, achieved an all-time high for quarterly sales and grew by 8% year-over-year, its highest growth quarter since the fourth quarter of 2018. This growth was largely driven by an increase in announced M&A deal activities starting late in the quarter, combined with a strong IPO environment. The additional steps we took earlier this year to optimize our operations, including streamlining our organizational structure and real estate footprint, are reflected in our third quarter performance and contributed to the 53% increase in adjusted EBITDA from the third quarter of 2019. Our increased profitability, combined with lower interest expense from our consistent deleveraging, led to a significant increase of $0.50 per share in third quarter non-GAAP net earnings. These results, in conjunction with diligent management of working capital, led to free cash flow of $67.6 million in the quarter, $15.4 million higher than the third quarter of 2019. At quarter end, our net debt was lower than last year by $81 million, resulting in net leverage of 1.5x, a full turn lower than the third quarter of 2019. We are now well below our targeted leverage range, providing considerable financial flexibility and liquidity in the current and ever-changing economic environment. The execution of our strategy is delivering positive results. We have delivered year-over-year expansion in EBITDA margins for 5 consecutive quarters, demonstrating not only the positive impact of aggressive cost management but also the continued improvement in our business mix. Over these 5 quarters, our sales have decreased by $31 million. Non-GAAP adjusted EBITDA has increased by $34 million. EBITDA margin has expanded by 440 basis points, and free cash flow has increased by $74 million. Moreover, the $31 million decrease in sales is the combination of a $54 million decrease in print-related sales, partially offset by $14 million of growth in our software solution sales and $9 million of growth in our tech-enabled services sale. The trends in our results reinforce the value of our 44 in '24 strategy. Specifically, targeting 44% of our sales from software solutions by the year 2024, driven by increases in our software solutions and tech-enabled services sales and decreases in print sales, driving margin expansion and continued strong cash generation. Before I share a few additional updates, I would like to turn the call over to Dave to provide more detail on our third quarter financial results and our outlook for the fourth quarter. Dave?

Thank you, Dan, and good morning, everyone. As Dan mentioned, we delivered very strong third quarter results, including significant year-over-year increases in non-GAAP adjusted EBITDA, non-GAAP adjusted earnings per share, operating cash flow and free cash flow. We maintained strong market share in our transactional filing business and grew our software solution sales, all while continuing to focus on driving operational efficiencies. These efforts resulted in a 680 basis point improvement in our third quarter non-GAAP adjusted EBITDA margin compared to the third quarter of 2019, further extending the trend we established in the second half of 2019 and further demonstrating the strength of our business. On a consolidated basis, net sales for the third quarter of 2020 were $209.5 million, an increase of $13.6 million or 6.9% from the third quarter of 2019. Software solution sales in the third quarter increased by $4.5 million or 9.7% compared to the third quarter of 2019, primarily due to increased fund activity and product adoption within FundSuiteArc, an acceleration of room activity in Venue as well as solid subscription growth in ActiveDisclosure and price increases in our other compliance software offerings. Tech-enabled services sales increased by $20.6 million or 24.6%, primarily due to increased capital market transactional and compliance activity. Print and distribution revenue decreased by $11.5 million or 17.6%, primarily due to lower demand for printed materials with investment markets, including less commercial printing where we have proactively exited certain low margin contracts, rightsizing our production footprint in advance of the anticipated reduction in print demand related to the regulatory changes from Rule 30e-3 and 498A. Third quarter non-GAAP gross margin was 46.4% or 830 basis points higher than the third quarter of 2019, primarily driven by favorable business mix featuring higher-margin tech-enabled services and software solution sales, combined with lower overall print volume and the impact of ongoing cost control initiatives, partially offset by an increase in incentive compensation expense associated with the strength of our financial performance. Non-GAAP SG&A expense in the quarter was $49.7 million, $6.2 million higher than the third quarter of 2019. As a percentage of sales, non-GAAP SG&A was 23.7%, an increase of approximately 150 basis points from the third quarter of 2019. The increase in non-GAAP SG&A is primarily due to the increase in sales, changes in the business mix, higher incentive compensation and benefits-related costs, partially offset by the impacts of ongoing cost control initiatives. Our third quarter non-GAAP adjusted EBITDA was $47.6 million, an increase of $16.5 million or 53.1% from the third quarter of 2019. Our third quarter non-GAAP adjusted EBITDA margin was 22.7%, an increase of 680 basis points from the third quarter of 2019, again, primarily driven by the impact of ongoing cost control initiatives, operating leverage on higher sales and a more favorable sales mix, partially offset by increases in incentive compensation and employee benefits expense. Turning now to our segment results. Net sales in our Capital Markets Software Solutions segment were $34.1 million in the third quarter of 2020, an increase of 8.3% from the third quarter of 2019, primarily due to increased venue data room activity, continued growth in ActiveDisclosure subscriptions as well as price increases in our other compliance software solutions. Venue sales increased 8% from the third quarter of 2019, driven by an improving M&A environment late in the quarter while ActiveDisclosure also had a solid quarter. Non-GAAP adjusted EBITDA margin for the segment was 25.2%, an increase of over 520 basis points from the third quarter of 2019. The increase in non-GAAP adjusted EBITDA margin was primarily due to the operating leverage benefits on the increased sales as well as the impact of operating efficiencies, partially offset by higher incentive compensation expense. Net sales in our Capital Markets, Compliance and Communications Management segment were $96.1 million in the third quarter of 2020, an increase of 16.9% from the third quarter of 2019, primarily due to increased capital market transactional and traditional compliance activity. As Dan mentioned earlier, this quarter was the first time we've seen year-over-year growth in transactional sales since the third quarter of 2018. This growth was largely driven by the pickup in IPO activity that we saw starting in June, which accelerated in the third quarter with IPO market pricings nearly tripling from the third quarter of 2019 with DFIN gaining additional market share. M&A filings remained slow in the third quarter as the pickup in announced deals we saw in September has not yet resulted in the corresponding increase in M&A filing. Debt-related transactional activity remains solid, albeit not as robust as it was earlier this year and also provided a sales lift in the quarter. Traditional compliance sales were up in the quarter, primarily due to increased 8-K activity related to the new Fast Act mandate that went into effect for accelerated filers in the third quarter. Non-GAAP adjusted EBITDA margin for the segment was 44.8%, an increase of 1,750 basis points from the third quarter of 2019. The increase in non-GAAP adjusted EBITDA margin was primarily due to the influx of high-margin transactional sales, along with the impact of ongoing cost control initiatives, partially offset by higher incentive compensation expense. As I mentioned earlier in my remarks, the third quarter was a very strong IPO quarter, and DFIN continued to lead the transactions filing market, maintaining strong market share, especially in large and complex transaction. The quarter was also significant with respect to SPACs, or Special Purpose Acquisition Companies, which made up a large share of the total number of IPOs. We were prepared for the shift as we started to direct more attention to SPACs in 2019 when we recognize an increasing number of large and high-quality SPACs coming to market. Our increased focus on this segment has paid off, with DFIN filing a company's best number of SPACs in the third quarter, representing a significant market share increase in the space with many of these filings, leveraging our software disclosure product, ActiveDisclosure. Net sales in our Investment Companies Software Solutions segment were $17.0 million in the third quarter of 2020, an increase of 12.6% from the third quarter of 2019 due in part to increased activity from existing clients adding new funds to the platform. We also saw a strong demand in our new ArcDigital offering, which provided a sales lift to the segment just 1 quarter after its release. Non-GAAP adjusted EBITDA margin for the segment was 25.9%, an increase of nearly 1,700 basis points from the third quarter of 2019. The large increase in non-GAAP adjusted EBITDA margin was primarily due to the operating leverage on the increase in sales as well as the impact of operating efficiencies, including cost savings related to our ArcRegulatory solution in Europe, where we moved from an outsourced to an in-house solution. Net sales in our Investment Companies Compliance and Communications Management segment were $62.3 million in the third quarter of 2020, a decrease of 7.2% from the third quarter of 2019, primarily due to lower commercial printing sales related to contracts we are exiting in connection with the rightsizing of our manufacturing platform as well as lower mutual fund compliance and transactional print volume. Non-GAAP adjusted EBITDA margin for the segment was 3.2%, a decrease of 200 basis points from the third quarter of 2019. The decrease in non-GAAP adjusted EBITDA margin was primarily due to lower overall print volume and higher incentive compensation expense related to the strength of the consolidated financial performance of the company, partially offset by the impact of ongoing cost control initiatives. In addition, our proactive exit from certain low-margin print contracts, while still in the process of rightsizing our print platform, causes a near-term negative operating leverage impact as the planned fixed cost reductions are not scheduled to be completed until early 2021. Our third quarter 2020 non-GAAP unallocated corporate expenses were $10.5 million, an increase of $8.0 million from the third quarter of last year. The increase in unallocated corporate cost was primarily due to increased incentive compensation and higher benefits-related costs, partially offset by the impact of ongoing cost control initiatives. Free cash flow in the quarter was $67.6 million, an improvement of $15.4 million from the third quarter of last year, primarily due to higher adjusted EBITDA and lower cash interest. We continue to focus on working capital management. And our efforts resulted in an improvement to DSO of approximately 1 day from last year's third quarter. We ended the quarter with $291.9 million of total debt and $251 million of non-GAAP net debt, including $61.5 million drawn on our revolver. And from a liquidity perspective, we had full access to our $300 million revolver as well as $40.9 million of cash on hand. As of September 30, 2020, our non-GAAP net leverage ratio was 1.5x, down a full turn from the third quarter last year. We repurchased approximately 444,000 shares of common stock during the quarter for $5.1 million at an average price of $11.54 per share. Year-to-date, we've repurchased just over 1 million shares of common stock for $8.9 million at an average price of $8.43 per share and have approximately $16.1 million remaining on our $25 million stock repurchase authorization. As it relates to the fourth quarter, transactional activity in capital markets remained robust throughout October. However, given recent market volatility, geopolitical uncertainty and the ongoing pandemic and the unknown impact of all of these items on the global economic landscape, visibility in this area of the business remains limited. In addition, as I noted earlier, we continue to exit low-margin print contracts in preparation for the upcoming regulatory changes that will impact print demand beginning in 2021. Given these factors, we are taking a conservative approach to our fourth quarter outlook, expecting sales to be in the range of $170 million to $180 million, down approximately 5% to 10% and from the fourth quarter of 2019, roughly half due to a decrease in print revenue related to low-margin customer printing contracts that we proactively exited, with the remaining portion related to the anticipated impact of the macroeconomic landscape on our capital markets transactional and Venue offerings. For size contacts, transactional activity and Venue generated approximately $83 million or 43% of our total sales in the fourth quarter of 2019. Regarding profitability, we expect our fourth quarter non-GAAP adjusted EBITDA margin to be in the range of 13% to 15%, slightly higher than last year's fourth quarter at the midpoint. I'll now pass it back to Dan. Dan?

Thanks, Dave. I'd like to highlight a few items, and then we'll open it up for Q&A. Regarding the upcoming regulatory change that will reduce demand for print in 2021, we are well prepared. We continue to expect a reduction in print-related net sales of approximately $130 million to $140 million in 2021 and a reduction in non-GAAP adjusted EBITDA of approximately $5 million to $10 million related to the regulatory change. We are on plan and, in some cases, ahead of plan as it relates to delivering the cost savings associated with rightsizing our platform. And I remain confident in our ability to meet or exceed the plan. In addition, I'm excited about the pace of development of and demand for our software solutions. As we mentioned in our earnings release, we signed the largest ever software solutions customer contract in the company's history. This multiyear, multimillion-dollar contract further deepens a key investment company's client relationship and represents an expansion of their end investor financial reporting capabilities on a global basis, leveraging our ArcReporting solution. We also saw a significant demand from our investment companies clients for our recently released ArcDigital solution, as clients look to DFIN to help transition their document composition and distribution workflows to a post 30e-3 environment, where distribution of printed documents will be significantly diminished. The Venue team recently announced a first-of-its-kind data privacy assessment tool for our virtual data room offering. Venue continues to transform how companies meet their data privacy obligations by scanning data room content to find personally identifiable information. After automatically identifying and visualizing potential exposure, Venue now empowers professionals to instantly redact sensitive data. Our clients are thrilled about the ways this tool makes their job significantly easier and allows them to get ahead of near constant regulatory changes. Elsewhere, the FDIC announced recently that it has selected 14 technology companies to compete in the next phase of the agency's rapid prototyping competition, a tech sprint designed to develop an innovative new approach to financial reporting, particularly for community banks. Among the other market leaders, DFIN was awarded an initial contract to develop a prototype addressing the business problem. In the next stage, we will demonstrate a prototype for this high-profile partnership that will transform the FDIC's financial reporting. This is an exciting opportunity for us to demonstrate our extensive domain and technological expertise against some of the other premier financial technology providers, leveraging both our leading AI tool, eBrevia, and our Venue virtual data room. In closing, we are excited about our third quarter financial results, along with the various sales and operational wins that produce them. We have worked over the last 4 years to build a great company and are well on our way to achieving the objectives we committed to as part of our 44 in '24 strategy. Lastly, I want to thank the DFIN employees around the world who have been working tirelessly to maintain our operations and ensure our clients continue to receive the highest quality service without disruption. Stay safe and healthy. Operator, we're ready for questions.

[Operator Instructions] Your first question comes from Pete Heckmann of Davidson.

I appreciate the comments on the outlook. Certainly, it looked like October's IPO activity was really strong. Can you talk about any particular comparisons that you might have with the last year in terms of large projects in either capital markets or the investment side?

Yes. Pete, nothing specific as it relates to large transactions that we might have had last year. I think when we look at the outlook for the fourth quarter, as you commented, October IPO market was very strong. I think when you look at just some of the uncertainty across the economic landscape, whether it be related to the election, the uncertainty around the results at this point, et cetera, we typically see a slowdown around the election period. And so we're just taking a cautious approach to Q4. And then on top of it, in addition to the expectation of a little softer transactional market, more of the low-margin print work that we're exiting, we saw that happen in Q3. More comes out in Q4. And so that's what's really behind the guidance with the expectation that, from a software perspective, we'll continue to see growth.

Right. Right. Okay. That makes sense. And then just in terms of -- I can't remember -- I may have missed it if you mentioned it, but some of the work on enhanced disclosures in the investment world that the SEC is looking at, how do you see DFIN playing a part in that? And are you proactively trying to shape the discussion of how these enhanced disclosures could be -- enhanced investor disclosures could be designed?

Yes. So it's a great question. So when we think about 33 and 498A, which are in process now going effective in 2021 and what sits behind the large reduction in print and a software opportunity that's in front of us in 2 of our products within the Arc Suite, it does allow us to solve clients' digital content management and distribution needs, and those sales efforts are proceeding well. We would view the new proposal on investor experience, that enhanced disclosure, similarly that it offers opportunity for us to further deepen relationships via our software products.

Your next question comes from Charlie Strauzer of CGS Securities.

Just a couple of things. First, if you could drill into the margin expansion year-over-year in the quarter a little deeper, maybe look at this in terms of how much of that was really transactional-related versus software or other. Just give us a better sense of how much of that margin kind of expense related that was expenses coming out of the equation versus just pure pickup and mix, that kind of thing.

Yes. So Charlie, I'll start, and then if Dan wants to jump in. I think when you look at the biggest year-over-year delta from an earnings perspective was the cost takeout. And I should reiterate that the vast majority of that cost takeout is permanent. We're obviously benefiting a little bit from a travel and entertainment perspective given the virus. But the cost takeout numbers are significant and mostly permanent. That obviously does get offset a little bit by some of the incent comp, and we also have a 401(k) plan that's also performance based. And just given the tremendous performance, that expense is up for the year. And as it relates to transactional, most of that obviously came through the equity side in the form of IPOs. I think revenue there was up probably $11 million, and that revenue typically comes through at a very high incremental margin. And so that's probably in the $8 million to $9 million range of increased profitability, which then gives you some sense that, back to my earlier comment, that the cost savings in the quarter is larger than that.

Yes. So you can leverage that nicely. And then obviously, has done a good job of taking the cost out, not only through the pandemic but prior to that, but how much more costs are kind of yet to come? Or do you think you've identified or taken out what you need to kind of to put you in a good place?

Yes. So just to add on to a bit of Dave's comment as well and it addresses this question, the -- if you look on the software side and the efficiencies that we've gained, we would expect to see strong incremental margins from software sales growth. But you look at the margin, and we're driving it, as Dave mentioned in his comments, from operating efficiencies within the software, we've replaced some -- a partner relationship with our own software capabilities. And that's led to very good flow-through on sales -- profit flow-through on sales. In regard to the -- your last question, we -- the biggest thing we have in front of us from a demand perspective on the negative side is the 30e-3 and the print side, which we've been aggressively managing toward, feel very good about our plan there. We do have some actions that will be coincident with the regulation going into effect that we've been managing towards throughout this year. And then we'll continue to stay very disciplined on the cost side as we always do. And as we see growth in software, it's great to see the flow-through coming through at a much higher level, given the efficiency efforts that we've we put in place. And it's really just getting much higher velocity off of our investment in development dollars.

That's great. And then just one last one for me, if I could. Software solutions, you said you signed a large deal in history. Just kind of looking at new sales, has the pandemic helped you guys at all in terms of driving people from in-house to outsourcing? Are you seeing kind of a pickup more on inbound sales calls related to that?

Yes. So it's interesting. So the contracts that you referenced, that will have bigger -- has a little bit of an impact in this year, but really, full year impact starting in 2021. And it's our -- given the business unit it's in, it's a 3- to 5-year type of contract. We did see at the height of the pandemic, some negative impact on software sales growth. Part of that relative to Venue was the M&A environment that we've seen now improve in September from an announced deal perspective. And then even on our recurring compliance product, we did see at the height of the pandemic slower willingness of clients to move or go deeper on some of the product lines. That's largely past us now. And so to your point, now that you start to see where the discussions take place on ways of -- to use your term, outsourcing or increasing the amount that we can help our clients digitize their business and move forward with our software solutions.

Your next question comes from Raj Sharma of B. Riley.

I wanted to understand a little bit about the -- so on the transactional side are you seeing any difference or change in the pricing per transaction? Or in the revenues that you get for the transaction, has that changed at all? And then just wanted to drill a little bit into the fourth quarter that you are projecting or that you're guiding. Is the transactional revenues there? Are they -- are you assuming a flat? Or are you assuming a down versus this quarter? And then I have a follow-on question about the print.

Yes. Right. So sure. So when -- regarding your question on transactions, I think when you look at the fourth quarter and what's baked into the outlook here, yes, we are expecting transactions to be down from the third quarter of this year. And again, I think when you look at the total decline, like I said, it's -- part of it is driven by the low-margin print work that we're exiting as well as this decline in transactional, again, with growth -- a little bit of growth on the software side.

Got it.

Yes. And Raj, just to add on to Dave's point, on the -- your question on pricing, we're really not seeing a change on a unit pricing basis. I think it's much much more. There is a mix impact, so depending upon what's in the hopper or the Q. But on a unit pricing basis, not seeing an impact. And we've adjusted. We were the first one out with the virtual IPO process. We talked about that a bit on our last call, and that's just been a great example of how we've adapted in the environment. We're seeing some demand to get back in person, but still the vast majority of interest is to continue doing things virtually.

Right. And then on the decline in print, is that similar in Q4 that you had a decline in Q3?

That actually probably accelerates a little bit more in Q4 relative to what we saw in Q3.

And how does that split between the compliance side of the business and on the transaction side? I would assume most of that is in the compliance side.

No. So most of it will show up in the global investment companies business where we have commercial printing rolling up there.

Your next question comes from Jake Williams of Wells Fargo.

I just wanted to focus on that large contract -- software contract with an investment company, particularly on the revenue drivers. Are there any annual price escalators on the next 3 to 5 years? Or is that kind of a flat subscription?

Yes. We wouldn't get into particulars on a contract, but we're very comfortable with the pricing on it. And I think more importantly, what it does for our client adds tremendous value as the systems do from an efficiency and cost perspective. And so we're comfortable with the price that we've been able to achieve.

Okay. Is there any volume component to that revenue model there? Or is it more kind of a pure subscription model?

No. There are volume components. So as we've talked in the past about in this part of the business, there is a price per fund and then the number of funds that are loaded. And there's implementation as well.

Got it. And it sounds like there was probably no revenue contribution from that contract in 3Q, maybe a little bit in 4Q, but most of the impact will show in 2021?

Correct.

Jake, let me just clarify there. So that contract was with an existing customer. So it's not a net new. Some of the growth aspects of it will be net new for us in terms of the mix and the impact on revenue. But that -- we're doing work for that client today.

There are no further questions at this time. I turn the call back over to the presenter.

Okay. Thank you. And we'll look forward to speaking with you at -- in February following the fourth quarter and in the interim. Thank you.

Ladies and gentlemen, this concludes today's conference call. Thank you for participating. You may now disconnect.