R.R. Donnelley and Sons Co. Q3 2009 Earnings Conference Call

| About: R.R. Donnelley (RRD)

R.R. Donnelley and Sons Co. (NASDAQ:RRD)

Q3 2009 Earnings Call

November 04, 2009 10:00 a.m. ET


Dave Gardella - VP, IR

Tom Quinlan - President and CEO

Miles McHugh - SVP and CFO


Charlie Strauzer - CJS Securities

Craig Hubert

Eugene Fox - Cardinal Capital Management

Edward Atorino - Benchmark


Good morning. My name is Teresa, and I will be your conference operator today. At this time, I would like to welcome everyone on the R.R. Donnelley third quarter 2009 results conference call. All lines have been placed on mute to prevent any background noise. After the speakers remarks there will be a question-and-answer session. (Operator Instructions). Thank you. Mr. Gardella, you may begin your conference call.

Dave Gardella

Thank you Teresa. Good morning and thank you for joining us for R.R. Donnelley's third quarter 2009 results conference call. Earlier this morning, we released our earnings report, a copy of which can be found in the Investor Section of our website at rrdonnelley.com.

During this call, we'll refer to forward-looking statements that are subject to uncertainty. For complete discussion, please refer to the cautionary statement included in our earnings release and further detailed in our Annual Report on Form 10-K and other filings with the SEC.

Further, we will discuss non-GAAP and pro forma financial information. We believe that presentation of non-GAAP and pro forma results provide you with useful supplementary information concerning the company's ongoing operations, and are 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've also posted to our website in the investor section, a description as well as reconciliations of non-GAAP measures to which we will refer on this call.

We are joined this morning by Tom Quinlan, Miles McHugh and Drew Coxhead. I will now turn the call over to Tom.

Tom Quinlan

Thank you, Dave and good morning everyone. I do not think that any year has begun with more uncertainty than this one. As 2009 kicked off, we recognized that it would be almost impossible to try to predict the specific impact that the global economic slowdown would have on our customers and on our industry overall.

In the face of so many uncertain variables we told you that we would push through by focusing intently on that which is under our control and by positioning the company to take full advantage of opportunities that emerge as conditions improve.

Our Q3 results reflect the value of this approach. In August, we told you that we expected a returns of the historical pattern of sequential revenue growth in Q3. And that revenue declines would moderate on a year-over-year basis. And as we expected, that has been the case.

Please let me make it clear that we are not satisfied with merely slowing the rate of decline. As a worldwide provider of integrated marketing and communication solutions, we have a more than $280 billion global opportunity in front of us in a few minutes, I'll talk about some of the actions we have put in place throughout 2009 to position us to win more of that business. Though we are still experiencing softer demand we posted non-GAAP earnings per diluted share from continuing operations up $0.54.

Miles will talk about some non-recurring items and other factors that impacted EPS, but our efforts to win a diverse mix of business and to relentlessly control cost continue to bear fruit.

I will address three areas that reflect our disciplined approach to managing in this uncertain environment before Miles takes you though the quarter in detail. After his discussion, I'll return for a couple of quick comments. And then we'll open it up for questions.

The first area I'll touch on has to do with the steps that we have taken to maintain our financial strength and flexibility which has been the lynch pin of our response to the unprecedented conditions that began to emerge in 2007. Through the first three quarters cash from continuing operations was $1.1 billion up over 400 million or almost 60% as compared with the same period last year.

We remained confidently on target for the year to generate free cash flow, which is cash from continuing operations less capital expenditures in excess of $1 billion. R.R. Donnelley continues to reduce debt, while investing in the business and maintaining our dividend. We took advantage of improved credit markets to use our strong cash flow to convert some longer term debt into shorter term borrowings that we can pay down this year.

In August the bond offering a $350 million that matures in seven years and the tender for $640 million of debt that previously matured in 2010 and 2012, enables us to continue reducing our debt and provided us with a favorable future repayment schedule that doesn't see a significant maturity until 2014.

We believe that our solid financial position gives us a competitive advantage, as it allows us to better serve our customers by investing in productivity and growth initiatives, including the deployment of new proprietary technology.

The second topic, I'll talk to is the component of our overall strategy that is continuing to position R.R. Donnelley to complement and expand the interconnectivity between our conventional capabilities and our emerging global platform of digital resources.

The speed with which emerging media is making the impact continues to accelerate. It took Radio 38 years to reach an audience of 50 million people, television took 13 years, the internet, four years, iPod, three years and it took facebook just two years. We aren't sure out of which garage the next media revolution will emerge, so we are watching that space carefully and making targeted investments where we feel that the technologies will ultimately be attractive to our global customer base.

Digital communications underlie the acceleration I just mentioned. We continue to expand and enhance our global digital infrastructure. This year we increased the world's largest digital printing fleet to more than 1000 units in over 60 facilities worldwide. More importantly, despite challenging economic conditions, we have introduced a steady stream of innovations this year.

Our own innovation pipeline allowed us to announce that R.R. Donnelley has developed an imaging technology breakthrough which combines the full variability of inkjet imaging with the speed, quality flexibility and economics of offset materials. We'll be deploying these units which we regard as game changing beginning in 2010. Remember that this came on the heels of our 2008 development of the industry's first 1200 DPI High Speed Four Color inkjet web press. Organizations that may be more conventionally associated with digital technology have taken notice.

During the quarter we announced that R.R. Donnelley and Hewlett-Packard have finalized plans to create a technology alliance to collaborate on developing digital printing solutions for Inkjet based presses.

In addition, we have complemented this alliance with an exclusive agreement with Muller Martini to create the first high speed inline Inkjet printing and book binding system.

As we have announced, we will take delivery of the first six integrated systems in the US with deployment occurring in 2010 and 2011. This technology will truly deliver the potential for game changing advantages for our customers and for our cost scheduling production and quality dynamics. These advances are pretty good indications of the frequency and quality of the innovations that have been coming out of our development pipeline. To serve mutual fund variable annuity and retirement product companies, broker, dealers and clearing firms we acquired Prospectus Central which gave us exclusive control over an important e-delivery technology.

In the same financial services space, we just rolled out a second round of enhancements this year to venue, of virtual data room solution. As you know, we help our customer create and manage content. During the quarter, we expanded our reach by taking a minority stake in Helium, an online binding community that generates content that can be used by our publishing customers on websites and in magazines, books, newspapers, catalogs and other communications. This year we rolled out a number of new enhancements to our proprietary custom point portal. This self service internet system allows customers to interact with us online and they are, with order volumes through custom point of 14.6% during Q3, as compared with the same quarter a year ago.

During 2009, we had the capabilities that allow customers to access data pipes through our portal. So, that they can launch direct mail programs that are linked to PURLs or Personalized URLs, combining these PURLs or individualized websites with conventional direct mail can yield substantially improved results.

As everyone's email boxes drown in spam, targeted direct mail is standing out as an effective option for driving prospects to our customer's websites. It's a great example of how digital technologies are reenergizing traditional pay based solutions.

With regard to digital technologies, you'll also find R.R. Donnelley on your iPhone with the first of a plan series of apps. Our first is a consumer app that allows people to find and purchase standard documents from our office product selection. Closely to follow will be apps design to support our right prospectus financial services offering. Planned apps for PDAs include the ability interact with custom point.

We are a 360 degree provider enabling effective marketing compliance and other communications across a broad range of media. As we implemented our digital strategy this, we still continue to bring innovation to our global printing platform. Earlier this year, for example, we introduced a revolutionary new variable trim binding technology that has increased the number of customers and products that can qualify for co-mailing which obviously yields significant and important postal savings for our customers.

I should mention that R.R. Donnelley has continued to be actively involved in the ongoing debate and dialogue about how best to ensure the future of the USPS. All of us in the mailing community are grateful and pleased that the USPS will leave rates largely unchanged in 2010. We thank Postmaster General Potter in the Board of Governors at the USPS for this decision. To recount all the innovations that we've developed and that we've brought out in 2009 will take longer than this call will allow.

But the ones that I have reviewed should give you an indication that we are not solely focused on cost management. We have positioned R.R. Donnelley as a provider of integrated marketing and communication solutions and we believe that out portfolio of capabilities is the right one for 2010 and beyond.

The third area that I wanted to mention is the ongoing dedication of our employees to enacting our strategy. In the face of one of the most turbulent economic cycles that any of us have experienced. I firmly believe that the quality of our work force gives us a competitive advantage, so we remain committed to making R.R. Donnelley a collaborative rewarding place to be employed.

We are pleased that through stringent management of our benefit plans that we will be able to continue our employee benefits with no increase in cost or employees for 2010. As 2009 nears to close it is our hope that our employees will once again be able to share tangibly in the results that they produced through our win-share program.

We also continue to infuse R.R. Donnelley with new talent in particular we are adding to skill sets that reflect our consultative selling approach. We are landing more engagements by undertaking consultative reviews of customer's print and communications programs.

Our people pro actively engaged to perform an assessment and identify specific cost savings opportunities. For example through a total management approach that will reduce obsolescence and maximize the customer's leverage. The assessments recommendations and our ability to execute against these ideas become the basis for being awarded the contract.

This is a very different approach, as opposed to just reacting to bid that are sent to the usual players. This consultative approach has gained so much traction that we have gone out to the business schools and hired the kinds of graduates who might order nearly wind up that one of the leading consulting firms. We have trained them to supplement our team that conducts these consultative assessments. It's just another way that R.R. Donnelley is continuing its transformation to being a provider of integrated communications management services.

And with that, I will turn it over to Miles.

Miles McHugh

Thanks Tom. As Tom noted our non-GAAP earnings per diluted share in the quarter was $0.54. We are pleased with this performance. Before I discuss our results in more detail though, I would like to point out some of the items that impact our year-over-year variances to which I will refer throughout.

These items are also included in this morning's earnings release. The first item is the fee we received for the transition out of the customer contract. This fee resulted in one time revenue of $12.5 million with an operating margin of essentially 100%. The second item is a reduction in our LIFO inventory provision. In the quarter, we reduced the provision lowering our operating expenses by $13.1 million. On a year-over-year basis this represents a $23.1 million increase in operating income as we reported a $10 million increase to the provision in the third quarter of last year.

The third item is the increase in incentive compensation expense in the quarter that I highlighted on our last earnings call. You might recall that in the third quarter of last year, when our expectations for 2008 fell below our internal targets for a full bonus achievement, we reversed a significant portion of the incentive compensation expense that we had recorded in the first half of the year.

In the fourth quarter of last year, we then reversed the remaining expense and did not pay any bonuses for 2008. In aggregate, the third quarter increase in 2009 incentive compensation expense, was $77 million and approximately $40 million expense this year compared to a $37 million expense reversal in last year's third quarter.

With that, I will now review our results in more detail. As Tom mentioned in his opening remarks, we saw modest sequential revenue growth in the quarter of 4.6%. On a year-over-year basis, the 14.0% revenue decline in the third quarter was less than the 18.7% decline we experienced in the first six months of the year due impart to the continued stabilization in demand and also because we had started to feel the impact of the recession at the end of the third quarter last year.

The negative impact of foreign exchanges accounted for 176 basis points in the current quarter, while lower paper prices accounted for approximately 135 basis points of the decline. The contract transition fee to which I referred to earlier resulted in approximately 44 basis points of revenue growth. Excluding these three impacts, our year-over-year revenue decline in the quarter, was approximately 11.3%, primarily due to lower volume, as well as continued price pressure.

This 11.3% decline compares to a decline of 15.1% in the first six months of the year. We expect year-over-year revenue trends to continue to improve in the fourth quarter of this year, as we were more acutely impacted by the recession in the fourth quarter of last year.

GAAP income from continuing operations was $93.4 million in the quarter, compared to $306.4 million in the third quarter of last year. This year's third quarter includes $129.7 million restructuring and $2.0 million of impairment charges, substantially all of which related to the previously announced termination of a significant long-term customer contract in the business process outsourcing unit. This change is unrelated to the $12.5 million contract transition fee that I mentioned earlier today. A full reconciliation of our GAAP to non-GAAP earnings is included in today's press release.

As I discuss our operating results in more detail, I will refer to our non-GAAP results. Our gross margin was 25.2% in the third quarter of this year, compared to 27.0% in the same period last year. This decrease of approximately 179 basis points was primarily due to an increase in incentive compensation, volume and price declines and a lower recovery on print related byproducts which have been negatively impacted by declines in both price and volume. These factors were only partially offset by the benefits of our continued cost management efforts, a decrease in our LIFO inventory provision, a favorable foreign exchange rate impact and the fee received for the contract transition.

Our non-GAAP SG&A, as a percentage of revenue was 10.2%, 44 basis points higher than during the third quarter of 2008. This is largely a function of the lower revenue base, as SG&A expenses actually decreased by $28.3 million on a year-over-year basis, due to continued cost control efforts, a lower bad debt provision and suspension of the 401(k) match, partially offset by higher incentive compensation expense.

We continue to aggressively manage our SG&A expense. Our third quarter expense of $251.5 million is approximately $20 million lower than this year's second quarter and approximately $30 million lower than in the first quarter despite the additional provision for incentive compensation in the current quarter. We generated $370.2 million in non-GAAP EBITDA, a decrease of a $124.3 million from the third quarter of 2008. This equates to a decremental margin of approximately 31% on reported sales.

As we've discussed in our previous calls, there are many factors that determine the margin impact of a given revenue change. Factors such as changes in pricing, duration and severity of revenue change, product mix, foreign exchange, changes in commodity prices and the resulting by-product impact, bad debt and LIFO provisions, benefit plan expenses and incentive compensation to name just a few.

On a normalized basis, we would expect a decremental EBITDA margin in the range of the high 20s to mid 30s. Depreciation and amortization expense of a $145 million in the third quarter was approximately $20 million lower than the same period in 2008, primarily due to the intangible asset impairments recognized in the fourth quarter of 2008 and the continuing lower capital expenditures as compared to historical levels.

Our non-GAAP operating margins, decreased by 237 basis points from the third quarter of 2008 to 9.1%. Higher incentive compensation driven by the combination of this year's $40 million of expense and last year's $37 million expense reversal, accounted for over 300 basis points of the decline. Additionally, we experienced volume and mix declines, price erosion and a lower recovery on print related by-products as a result of both unfavorable pricing and lower volume.

We were able to partially offset these declines with our productivity and cost takeout initiatives, favorable LIFO inventory and bad debt provisions and the fee received for the contract transition. Additionally, changes in foreign exchange rates benefited our non-GAAP operating margins by 32 basis points in the quarter.

Net interest expense was $59.6 million in the quarter, $3.4 million higher than in the third quarter of 2008 primarily due to interest on the $400 million of notes we issued in January of 2009, the acceleration of unamortized discounts related to our debt repurchases and lower international interest income as a result of lower average interest rates partially offset by lower average short-term borrowings.

Our non-GAAP effective tax rate in the third quarter of 2009 was 31.3% and was lower than the non-GAAP effective tax rate of 32.3% in the same period last year due to the different mix of income across tax jurisdictions. In the third quarter of 2009, non-GAAP earnings per diluted share was $0.54 which includes a benefit of approximately $0.04 on the fee received for the contract transition.

Now, we will discuss our operating results by segment. Sales in our U.S. Print and Related Services segment declined 14.9% to $1.8 billion in the quarter, lower paper prices accounted for approximately 181 basis points of decline. While we do expect to see some improvement in revenue trends versus last quarter, we continue to see an experienced reduced demand versus the prior year in our catalog, magazine and retail, four colored books, logistics, office products, commercial print and direct mail product offerings. Price erosion continues as well, especially in our commercial print, catalog magazine and retail and forms and labels businesses.

Non-GAAP operating margin decreased by 498 basis points versus the third quarter of 2008 to 9.2% in the third quarter of 2009. Higher incentive compensation expense accounted for 291 basis points of this decline and volume and price declines and a reduction in by-product recoveries were only partially offset by our continued productivity and cost takeout efforts.

Our International segments reported sales of $638.3 million, reflects a decline of 11.5% of which foreign exchange accounts for approximately 700 basis points, partially offset by approximately 173 basis points of growth related to the contract transition fee. The remaining 6.2% of decline was driven by volume declines across most product lines and continued price pressure in Europe and Asia. Relative to the first half of the year, the year-over-year revenue decline is less significant this quarter, due to improved trends in global turnkey solutions, Europe business process outsourcing and Asia.

Non-GAAP operating margin declined by 52 basis points to 8.6% in the third quarter of 2009. Higher incentive compensation expense accounted for 205 points of the decline partially offset by the favorable impacts of the contract transition fee and foreign exchange rates. While the foreign exchange rates negatively impacted the top line growth, they improved our non-GAAP operating margins by 115 basis points. Excluding the impact of these three factors, operating margin decline by approximately 140 basis points in the third quarter of 2008 as continued volume declines and price pressures were only partially offset by continued productivity initiatives and a lower amortization expense due to the intangible asset impairments in the third and fourth quarter of 2008.

We saw a significant change this quarter in our unallocated corporate expenses, a decrease of $42.4 million from the third quarter of 2008. $23.1 million of this expense was due to the change in our LIFO inventory provision, a $10 million expense in the third quarter of 2008 and a $13.1 million benefit this year. In addition, our corporate results benefited this quarter from continued cost control efforts across all functions. Lower employee related benefit cost including the elimination of the company 401(k) match in 2009 and a reduction in our bad debt provision partially offset by higher incentive compensation expense.

During the quarter, we spent $40.8 million on capital expenditures, a decrease of nearly 50% compared to the third quarter a year ago, driven in part by volume declines and resulting open capacity across most of our operating platforms. On year-to-date basis, our capital expenditures were $132.9 million, more than $100 million lower than during the same period last year.

As we mentioned on our last call, all capital projects and other cash expenditures are subject to a very thorough evaluation process before spending commitments are made, a discipline that has allowed us to manage our cash-flow appropriately and maintain a very strong balance sheet and liquidity profile, even in this particularly challenging economic environment.

As reflected in our earnings release schedules, we ended the quarter with net available liquidity of almost $2.1 billion, an increase of $412 million from a year ago. During the quarter, we successfully completed the tender offers for $640 million of our 2010 and 2012 bond maturities. At the same time, we issued $350 million of seven year notes due August 2016 with a fixed interest rate of 8.6%. These transactions improve our already strong maturity profile and allow us to more efficiently utilize future cash flow as our next significant debt maturity is not until April of 2014.

In the past 12 months, we've reduced our debt by nearly $1 billion. Our remaining debt is approximately 97% fixed, and an average annual interest rate of 6.7%. Maintaining our investment grade credit metrics is very important to us and it is important to our customers as well. We are still targeting a debt-to-EBITDA ratio of 2.0 times, 2.5 times on a sustainable basis, recognizing that in certain economic environments, will be at or above the high end of that ratio.

Our required pension funding for 2009 is currently estimated at $18 million and we do not expect a substantial increase in the cash funding requirement in 2010. The amount of expense however, in 2010 will likely increase if pension discount rates stay low. For 2011 and beyond, investment performance and future discount rates will determine the future required cash contributions. We will continue to evaluate the most opportune time to fund our pension obligations.

I now like to share with you some of what we are expecting in the fourth quarter. We expect a sequential revenue growth rate over the third quarter in the low single digits. Our non-GAAP operating margin is expected to be between 125 and 175 basis points lower than what we reported for the third quarter. The historical seasonal change in product mix between the third and fourth quarters, the normal increase in fourth quarter employee benefit costs and the absence of the one-time benefits we saw in the third quarter for the contract transition fee and the LIFO inventory provision adjustment and somewhat higher corporate spending in the fourth quarter are the primary factors impacting the decline in margin between quarters.

In addition as I mentioned earlier, we did not pay any bonuses to the hourly or salary workforce for 2008 and in 2009, we planned for only a modest level of bonuses and a limited merit increases for our salaried work force. As our performance continues to improve, we hope to reward our employees by increasing the funding for incentive compensation plans, closer to historical levels. We expect depreciation and amortization expense of approximately $145 million, interest expense of approximately $57 million, a non-GAAP tax rate in the range of 34% to 35%, although this is an estimate that could be significantly impacted by business trends affecting different countries in which we do business or by changes in tax law.

We expect fully diluted share base of approximately 209 million shares, capital expenditures of approximately $50 to $65 million, corporate expenses in the range of $25 to $35 million and lastly, we expect our free cash flow or operating cash flow less CapEx to exceed $1 billion for the year.

And with that, I'll return you to Tom.

Tom Quinlan

Miles covered a number of key financial performance numbers, but there is another set of numbers that we also track very carefully. I recognize that these metrics are less directly meaningful to many who follow R.R. Donnelley, but for active employees, we regard them as paramount. They are safety metrics. The economy has created a lot of uncertainty and distraction and then in the face of those distractions and in environment in which a moment's carelessness can have significant consequences, we appreciate our employees continuing commitment to working safely around the world. Safety is a key measure of operational excellence.

A number of R.R. Donnelley people are also in the National Guard and Reserve and we are especially grateful for the safety of these R.R. Donnelley employees who serve more than just our customers. We see responsibility to support them in a number of our locations, we have been very proud to receive recognition from The National Committee for Employer Support of the Guard and Reserve. We thank the National Committee for this honor and for their important work.

Last, before we open it up for questions, all of us at R.R. Donnelley would like to offer our sincere condolences to the Cerutti family on the passing of Madam Tere Cerutti. Most recently, she served as Chairman of OMG Cerutti. She was influential in helping to promote the advancement of gravure printing and our industry will miss her.

With that, Teresa let's open it up for questions.

Question-and-Answer Session


(Operator Instructions). We will pause for just a moment to compile the Q&A roster. Our first question comes from Charlie Strauzer with CJS Securities.

Charlie Strauzer - CJS Securities

Miles, you've given a lot of information there. So, I am hoping that if there is time to go through and calculate all of the information you give out, something you could maybe just fill it down to some very simple numbers. If you kind of back out all of the one time items and various imaginations, what would have been kind of the bottom line number if you could help me because still without with a normalized tax rate, things like that.

Miles McHugh

We can start with the $0.54 per diluted share. The contract transition fee was about $0.04 and then the items below EBIT including the tax rate added about $0.02 a share from the difference and then, so there you got $0.06, so you are at $0.48 there and then there is about, if you take the incentive compensation and all the other one ups and group them together you got about another penny, so you are at about $0.47 if you back out those items. So really that kind of helps, it should.

Charlie Strauzer - CJS Securities

Definitely does. And then looking at the Q4 guidance of operating margins being lower and now historically simply you have lower margin work in Q4, when you kind of look at the trends there, is there anything that could have impact that margin one way or the other, if you see incremental or the lower volumes on [card] the right there?

Miles McHugh

Well, we've talked about our decremental margin on differences in the revenues so we still think that probably the best gauge of how to measure the bottom-line impact for any changes in sales.

Tom Quinlan

Charlie I'd also add to that, we are seeing stabilization as we talked about in the top line in some of our products obviously other products are still not stabilizing, a lot of our publishers are going ahead and putting on the magazine side you have seen some of the actions that have been taken by the couple of the magazine publishers so. There is still some uncertainty out there with certain products but other products I would tell you we are starting to see the word that's been used I think this entire quarter of stabilization.

Charlie Strauzer - CJS Securities

That's a pretty good [segway] in to our next question Tom is that when you see with Mr. Potter's vision with the freezing the postal rates have you seen any sense of relief or potential new orders from some of your customers and especially in (inaudible)?

Tom Quinlan

I mean again the Board of Governors and Jack Potter I think are doing a fantastic job with what they are able to do. They need to go ahead at the end of day and really re-look at that entire model. It's a model that been in place since really the 19th century. So again we have got laws in the United States that prohibit them from taking certain actions that need to be taken that will ultimately result in the mailing community having a better day.

So I think the mailing community given the 2006 Act that was put into place and where we think CPI was going really their announcement was appreciated, but I don't think it would have been good if they would have raised prices, because again I think we believe that as a direct relationship to the amount of volume that's going in. With that said I think the better way to look at is where is the advertising? Is advertising back, is the consumer back is that the way people are looking at it or are people advertising just advertise right now on the fourth quarter.

I think until we have a better picture there we are going to still be sort of in this nimble limbo area as far as when the night advertising comes back. Again as you look at us you have got advertising/branding, you have got compliance working, you got the business model, obviously we would like to see advertising come back stronger than what it is now and I think we'll see as some of the numbers come out over the next couple of days what the Fed is going to do today, and see how that all impacts people spending habits.

Charlie Strauzer - CJS Securities

You talked about the new inkjet technologies and kind of being a game changer and am I reading this correctly that this could be if we bring kind of print on demand to the book publishing world that this is, I am reading this right?

Tom Quinlan

Yeah, I think Charlie we walked through a lot about technologies/digital innovations that we put in place and I wanted to give everyone an idea how we are transforming R.R. Donnelley from a printing company to a unique collaborative [winning] rated communications provider. We occupy unique space in our industry and it is not just printing. We have the financial flexibility that enables us to take advantage of the best opportunities.

We have exceptional customers that we bring value to and I think we manage this business in a disciplined manner that we've proven to you over the last five years that again is a compelling value proposition.

On the book side here with this, it's a model where the book publishers are still trying to figure out. Its great the way we look at it because the book product has gotten so much attention these last couple of months because of the different technology devices that are coming out because of the way the pricing is by some of the other retailers that they are putting out which obviously publishers don't control pricing, but we've got the ability to produce the book, where they want it, when they want it and whatever quantity they want.

So if you want it in a single copy or if you want a couple of managed, run. We've got the ability to do that and even bigger than that, we've got the ability to distribute the content, no one else has that, no one else was building a platform that way, no one else saw this coming. So that to us again with the equipment on the Muller Martini side combined with the presses that we talked, about is going to be something to where our customers are going to look and say okay, hey I have got someone here that is going to add value to my business, help me get a better return on my investment.

Inventory obsolescence has to be taken out of the book market. And I think technology is going to help us do that. People thought that the catalog was going to go away because the internet was created a decade ago. If anything the internet has become a sales channel for the catalog, we at R.R. Donnelley are not looking at technology as being this evil thing that's going to have a complete secular or demise if we think its going to help that book is going to become a video, its going to become audio. There is so many things that the book is going to take on and provided the contents is there.

So, again the business model has to be in place if publishers aren't getting be able to make a profit then again that business model has to be re-looked at. And we think again the technology that we are bring forth to the marketplace is going to be a game changer, is going to help us serve our customers to where it's going to be a good day for them.

Charlie Strauzer - CJS Securities

That's great and just one follow-up to that is if you look at kind of your acquisitions strategy you have been more kind buying heavy iron instead of slight shifting a little bit someone more of that focus towards some of these new initiatives?

Tom Quinlan

I would tell you may be look at its capital expenditures as opposed to acquisitions, I mean acquisitions as you know, we have got three criteria that I always going to constantly talk on and that not changing forever as far as we are concerned. What does it do to the customer? Can we take cost out of it doesn't have capacity that particular property we are looking at.

When you think about the equipment side now, we have got the ability on the equipment side where we have capacity, longer run the tonnage business as [Dave] likes to call it is not, we are not looking at that as all of the study needing breakthrough technology there, breakthrough equipment. We have got the equipment to handle that, the shorter run, the presses, speed, quality being able to have technology that has offset type pricing to it, that's where we are going to focus on and again those are in $20 million or $30 million pieces of capital expenditures that you've got to make. And they don't take up space like the big iron, the football fields that we need. All of that helps us to reduce our cost in our business.


Our next question comes from the line of Craig Hubert.

Craig Hubert

Hey, good morning. I got a few questions I just go one by one if I could. Your corporate expense line, you gave some detail, hoping to get a little bit more, I guess round numbers $2 million benefit versus a $41 million expense a year-ago or average that may be its 32 million expense here. In the first half, that $0.11 to $0.14 swing versus the average that you suppose two quarters of $0.14 positive swing versus a year ago. Can you give us a little more detail of what goes into that?

Miles McHugh

Okay. The corporate segment is where we have our traditional corporate departments and functions as well as where we capture a variety of different companywide cost including some employee benefit costs, pension related LIFO, those type of adjustments. And so that's what's driving the change year-over-year in our corporate cost for the biggest one this period was the $23.3 million change in the LIFO. As inflation rates come down and as we bring down the inventories, our LIFO reserve, the required reserve is decreased so that is the release of reserves in this period versus the increase in the reserves that we had last year as you saw inflation accelerating.

And so that's the biggest driver, then lower bad debt expense and workers compensation and some of the other items also have gone to improve in the year-over-year corporate expenses to the extent that its actually a income item this year its slightly versus what's normally an expense. And then also the corporate portion of incentive compensation are also impact that, because last year we had. A release of incentive conversation a portion of which goes to the corporate category, and this year you had an increase in incentive compensation expense.

Craig Hubert

Yeah that's what I am trying to get to I mean kind of point out the 23.2 million of the LIFO change here, but everything else netted to a positive $20 million benefit to your bottom line. It was then that when you are netting it the incentive comp obviously hurt you year-over-year, so does others [sub-load] bad debt [expansion] workers comp show on the benefit side, obviously was more than $20 million benefit or what parts in there in particular added up to over $20 million benefit in that corporate line. Seeing I am saying the offset this incentive comp seeing etcetera...

Miles McHugh

LIFO is the big driver year-over-year LIFO was $23 million.

Craig Hubert

But the whole thing was roughly $43 million positive swing?

Miles McHugh

Right you have incentive comp and then all of our corporate cost reduction efforts, all of our corporate departments added a little over 10 million probably closer to 12 million of benefit to. So, all the efforts that we have been taking to reduce cost and I think may be to help you kind of look at the run-rate on this, we are estimating between $25 million and $35 million of corporate cost in the fourth quarter which is a lot closer to your normal run rate.

Craig Hubert

Okay. Thank you for that. And then in Brazil…

Tom Quinlan

I mean just given that the incentive comp swing in incentive comp that you are seeing this quarter I mean obviously as we look to the rest of the year we've got our own metrics and targets that we've got to go ahead and hit, and just as I learned many years ago, when you were following another company, you pay for performance, and we pay for results. And as we finish this through nine months we believe we are on track to hitting some of the things that we are looking for, so as you go through we never complain when LIFO goes the other way, we never complain when bad debt goes the other way. This time it's a positive for us and obviously with the rest of the business and the quality of earnings that we've got above the line there we are feeling a heck lot better 10 months into the year than what we did back in January.

Craig Hubert

Fair enough. And I have asked this question in the past Tom, can you ballpark for us for your U.S. Print operation, how much you think unit pricing is down year-over-year, do you think it's down roughly in the three percentage point range?

Tom Quinlan

We haven't talked about that in the past, but I would tell you this year Craig where we've gone ahead our expectations on price have been inline with what's occurred this year. But we are not going to sure we can't do anything, pricing is as brutal as it's ever been in our industry, and certain products worse than others. And we don't see that changing. So we are not again secular versus cyclical.

What are the ways are we going to help offset price, what other products and services can you bring forward to our customers so that we can offset price as we go through this and again the things we talk about from technology standpoint, distribution standpoint, printing is the smallest piece of what anybody is looking at when they go ahead and have expenditures in the communications area. So, we've got to go ahead and try to offset some of the other things that they have got in order to bring our value proposition forward.

Craig Hubert

But, if I sort of think how the pricing is sort of bit down to call it in the rough range of 1% to 5%. Are you sort of inferring to many of the categories that's [beneath] the worse than that right now Tom?

Tom Quinlan

No, I am saying volume is what's down and that shouldn't be a surprise.

Craig Hubert

What about the unit pricing though?

Tom Quinlan

Again, unit pricing I would tell you is inline to where our expectations were when we started out this year.

Craig Hubert

Is that similar to this, well I think of historically pricing unit down to 1% to 5%?

Tom Quinlan

No, it's not dramatically worse than what it's been in the past, and in the past it's been obviously a tough number 1% to 2% that we've talked about.

Craig Hubert

And then, want to talk about restructuring charges here, but I'm not an account expert here, but looking at my model 18 less 19 quarters, you guys have booked the restructuring charge and of course, the years before that as well, but just on a quarterly base 18 less 19 quarters. And in your earnings press release, you always break that out and it gets added back to non-GAAP stuff.

As the analyst here, I would be sympathetic that it if happened, I am not too sure any company it happens once every four, five, six years, but it happens almost every quarter, 18 less 19 quarters and prior years as well. It's an ongoing expense. I know you have set the accounting rules, but why do you break it out when you give the benefit back to yourself when it's an ongoing expense quarter after quarter after quarter?

Tom Quinlan

Right, we break it because, when we book something as restructuring that follow strict guidelines internally to make sure that we're consistently looking at the items the same way and that they need the criteria for exiting a line of business for substantially changing the way we are doing business going forward and so in doing that, we allow folks like yourselves, anybody who is using our financial information to look at the business with or without those as they choose.

And so, in doing that, it allows you to see a clear impact if you want to project that way of what the business would look like going forward without those. And the other way we look at it is, we look at it similar to any other expenditure of capital. We look at it as an investment in lowering our cost to business and I mentioned earlier in my comments that we have strict requirements on rates of return and cash paybacks and that type of things. So, we look at these type of restructuring charges as an investment in lowering the cost of the business going forward.

Miles McHugh

And Craig I know you may say you are not an accountant, but I think you do understand a four letter word cash and if you look over the years, what we've been to do regarding dividend payments since we've been here, regarding payments to bond investors since we've been here, the buying back of stock since we've been here, the paying down of the debt, the reinvesting back into the business. Cash-flow which again, we pride ourselves on has been very, very good over the last five years.

Craig Hubert

And this the third point. And then lastly, you talked a lot Tom of your various issues and stuff. At the end of the day, how much do you think it adds up to in terms of incremental revenues for you say calendar 2010? Is it in the ballpark of 1% to 2% or do you think it could be meaningfully higher than that?

Tom Quinlan

Yeah we are going through budgets right now like everybody else in the corporate world is, and seen how things will lay out we'll have a better picture come February. But again, I think the exciting thing for us is there are dramatic changes taking place at an accelerated rate with our customers that we are helping them drive their business, helping them get the returns that they need. And I think as again, as the economy starts to level out here, I don't know which letter of the alphabet it is, that's above my [pay] grade, I don't know if its WUVXLY, whatever its going to be, is going to dictate what 2010 is going to be for our customers and we've got the multi-channel approach to help them reach out to their customers. So, we're excited about that.


Our next question comes from Scott [Wipperman] with Goldman Sachs.

Unidentified Analyst

I was wondering if you could just comment on you think about M&A in the current environment. You guys have been pretty consistent in explaining how you examine opportunities, but is there a size preference that we should be thinking about. Is it smaller bolt on deals or do you have a preference for doing a larger type transformer's acquisition like a (inaudible) deal would have been?

Tom Quinlan

Again, we are not going to comment about anybody specifically, but I would you, and Scott you may be new to this I am not sure, but we look at it, what does it due to the customers. What does it do to our cost structure? What does it do at the end of the day to capital that we would have to spend? And again, it could range from as you have seen what we've done with respect to central, as you have seen what we have done with the investment of Helium on what I call the small end of the scale to large end of the scale, when you go back to 2007, the Banta acquisition that we went ahead and did.

So, it depends what property is out there and what that particular property does for us. I will tell you that the number of phone calls that we're receiving, the books that we're receiving I do think people's valuations of their particular business are coming in line to where we believe they should be. That doesn't mean we're going to be look to take every nickel off the table. If there is a property out there that makes sense for us, we understand that there is a cost, a premium that has to be paid for that.

But at some point, the premium or the valuation that a prospective seller may have, may not be at all in the ballpark and what we're looking at and at the end of the day, would be a bad investment for our stakeholders. And I think if you look at what's the problem with our industry, historically there people have done acquisitions for the sake of doing acquisitions at any price and they haven't panned out, they haven't worked and they've put the stakeholders behind. So, we obviously are receiving a lot of information regarding prospective properties and we're ploughing through it and see what things look like. But again, hopefully over the last number of years we've demonstrated to you on printing acquisitions, our eyes will not be bigger than our stomachs.

Unidentified Analyst

That's very helpful. Could you also just talk about the competitive situation? Do you feel that you guys are taking market share in this environment more than you expected or less or is there barriers right now that could inhibit you taking market share from competitors?

Tom Quinlan

I would tell you this, I would tell you again, go by product line and thank goodness we have the dozen and half so products and services that we have. If you just got one product that you are selling, that you have, you've got so much pressure on you right now to keep those doors open. You may be cash positive barely, but you're definitely not from a P&L standpoint making any headway. And as I talked about as people are looking at their 2010 budget, they got to be sitting there right now going how the heck are we going to do this.

For us, as we are looking at it, the additional services, the scale that we can bring to our customers separates us out from everybody else because we are able to bring savings to them. We are able to compress their costs and get a return for the customers which at the end of the day, is what this is going to be all about. This is our industry, we're not denying it. Our industry is a mature industry. But we believe we can grow in our industry, whether it's from organic purposes or through the right acquisitions.

Tom Quinlan

Operator we've got time for two more.


Our next question comes from Eugene Fox with Cardinal Capital Management.

Eugene Fox - Cardinal Capital Management

Bad debt expense in the quarter, you referred to it a couple of times Miles. I was just wondering if you could give us the absolute level?

Miles McHugh

Yeah. Let me run it past here.

Eugene Fox - Cardinal Capital Management

While you're grabbing it, could you also give us stock comp expense for it?

Miles McHugh

I am sorry Eugene, what was that the last question, stock comp expense? Eugene? For the bad debt expense, the change quarter-over-quarter was $10 million positive.

Eugene Fox - Cardinal Capital Management

Every, Miles in the quarter?

Miles McHugh

We have less bad debt expense this quarter than the prior quarter in the amount of $10 million.

Eugene Fox - Cardinal Capital Management

Also, had a relatively large provision in the fourth quarter of last year. Is it reasonable to assume that would be unlikely?

Miles McHugh

Bad debt provision? Yeah. It's impossible to tell, I mean we provide based on the latest situation for each of our customer receivables. So, it isn't really hard to tell, it's not very easily to tell.

Tom Quinlan

I mean as we see here today, the world seems like its rotating properly. So, as you see things in the headlines just to understand with our 60,000 plus customers, usually there could be an impact there. It depends on the size.

Eugene Fox - Cardinal Capital Management

[Stock comp number]

Miles McHugh

Stock compensation number? We'll get that for you. Right now, we'll go to your other question. Thanks, Eugene.


Our final question comes from Edward Atorino with Benchmark.

Edward Atorino - Benchmark

I was going to ask you if you could build through the sales trends in some of the key product categories as you are looking at the next couple of month's magazines, books, catalogs, etcetera. Just some qualitative comments if you would?

Tom Quinlan

What I would tell you, obviously the third quarter again, is having the four color book, the catalog magazine and again, this is nothing new from a historical standpoint. That usually a good quarter there, the fourth quarter retail. How are they shopping is usually where we see things take place there. People are still hesitant on branding, not for profits or [while solicitating]. The financial industry is still hesitant on prospecting for customers, but we know at some point that will change the automobile industry.

As I said last quarter, cash for clunkers was good because they started to compete against each other and we're still starting to see some things there that may give the remnants of something coming back their. So, again, I think as more people get comfortable with there financial outlook, the more advertising and branding we'll start to see and again, that will be a good thing for everybody.

Edward Atorino - Benchmark

Well looking at your forecast, things are getting better slowly.

Tom Quinlan

Not a better way to put it for the world Edward.

Miles McHugh

I'll end with answering the question on share based compensation. For the quarter, we had about $5.5 million or so, $5 to $6 million of share based compensation and for the nine month period, we had a little over $19 million which compares to about $20 million, nine months in to last year. So, very comparable to the prior year.

Tom Quinlan

Thank you everyone for joining the call today. We appreciate your support. Have a good day.


This concludes today's conference call. You may now disconnect.

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