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In this article, we'll evaluate the dividend of R.R. Donnelley (NASDAQ:RRD). To get started, let's take a look at the front page of our report, which forms the basis of our analysis below (click to enlarge):

Investment Highlights

R.R. Donnelley earns a ValueCreation rating of excellent, the highest possible mark on our scale. The firm has been generating economic value for shareholders for the past few years, a track record we view very positively. Return on invested capital (excluding goodwill) has averaged 24.6% during the past three years.

R.R. Donnelley's valuation is compelling at this time. The firm is trading at a nice discount to our estimate of its fair value, even after considering an appropriate margin of safety. The firm's forward earnings multiple and PEG ratio also look attractive versus peers.

R.R. Donnelley has a good combination of strong free cash flow generation and manageable financial leverage. We expect the firm's free cash flow margin to average about 3.2% in coming years. Total debt-to-EBITDA was 2.8 last year, while debt-to-book capitalization stood at 61.3%.

The firm's shares have underperformed the market benchmark during the past quarter. Although R.R. Donnelley's valuation appears attractive, the company is currently exhibiting characteristics of a potential value trap, and we'd still be cautious at these levels. There may be a better entry point yet.

The firm sports a very nice dividend yield of 7%. We expect the firm to pay out about 56% of next year's earnings to shareholders as dividends. However, let's take a deeper dive into the firm's dividend.

Dividend Considerations

R.R. Donnelley's dividend yield is impressive at about 7%, so we view the name as a nice potential income generator. However, we think the safety of its dividend is very poor, the lowest rating on our scale. We measure the safety of the dividend in a unique but very straightforward fashion. As many know, earnings can fluctuate in any given year, so using the payout ratio in any given year has some limitations. Plus, companies can often encounter unforeseen charges (read hiccups in operations), which makes earnings an even less-than-predictable measure of the safety of the dividend in any given year.

We know that companies won't cut the dividend just because earnings have declined or they had a restructuring charge that put them in the red for the quarter or year. As such, we think that assessing the cash flows of a business allows us to determine whether it has the capacity to continue paying these cash outlays well into the future.

Therefore, we've developed the forward-looking Valuentum Dividend Cushion (read more about this innovative dividend tool here). The measure is a ratio that sums the existing cash a company has on hand plus its expected future free cash flows over the next five years and divides that sum by future expected dividends over the same time period. Basically, if the score is above 1, the company has the capacity to pay out its expected future dividends.

As income investors, however, we'd like to see a score much larger than 1 for a couple reasons: 1) the higher the ratio, the more "cushion" the company has against unexpected earnings shortfalls, and 2) the higher the ratio, the greater capacity a dividend-payer has in boosting the dividend in the future. For R.R. Donnelley, this score is -1.1, indicating that the company doesn’t have a cushion for future dividend growth.

Now on to growth. As we mentioned above, we think the larger the "cushion" the larger capacity it has to raise the dividend. However, such dividend growth analysis is not complete until after considering management's willingness to increase the dividend. As such, we evaluate the company's historical dividend track record. If there have been no dividend cuts in 10 years and the company has a nice growth rate, its future potential dividend growth is excellent, which unfortunately is not the case for R.R. Donnelley. We think R.R. Donnelley's potential dividend growth is very poor.

However, we don't just stop there. By employing a matrix, one can see above that R.R. Donnelley has an unhealthy dividend--the cross section of its very poor safety and very poor future potential growth scores. And because capital preservation is also an important consideration, we assess the risk associated with the potential for capital loss (offering investors a complete picture). In R.R. Donnelley's case, we think the shares are undervalued, so the risk of capital loss is low. This is the only thing income investors have going for them in a position in R.R. Donnelley.

All things considered, we're more interested in R.R. Donnelley's equity valuation than its dividend at this time. Its shares are cheap, but the dividend looks weak.

Read our full report on R.R. Donnelley here.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Source: R.R. Donnelley Looks Cheap, But Its Dividend Is Weak