An Open Book: Inside R.R. Donnelley's Capital Structure

Jan.25.12 | About: R.R. Donnelley (RRD)

RR Donnelley's (NASDAQ:RRD) current woes came as a reaction to their press release on January 16th which stated:

R.R. Donnelley & Sons Company today announced expected full-year 2011 free cash flow (cash flow from operations less capital expenditures) to be in the range of $650 million to $700 million, an increase from the previous guidance that called for free cash flow of approximately $600 million. Revenue is expected to be $10.6 billion, non-GAAP operating margin is expected to be 6.6% to 6.7%, non-GAAP effective tax rate is expected to be 23% to 24% and fully-diluted weighted average share count is expected to be 196 million to 197 million. All other previous guidance issued in November is generally consistent with expected results. (RRD Jan 16 release)

Sounds okay, doesn't it? Well, lets go back to their November 2, 2011 guidance:

  • Revenue in the range of $10.7 billion to $10.8 billion,

  • Non -GAAP Operating margin of 6 8% to 7 0%

  • Free cash flow of approximately $600 million

(RRD Dec 2011 Investor Presentation)

Oops, looks like the company is coming in a little lighter than expected on the top line and margin. The result:

(Yahoo Finance)

Not a good day for long suffering Donnelley shareholders. But this is the type of knock down that piques my curiosity as to potential opportunities within the capital structure. (NOTE: All data taken from company financials and presentations and compiled by me unless otherwise noted).

Company Description:

R.R. Donnelley & Sons Company provides premedia, printing, logistics and business process outsourcing products and services to leading clients in virtually every private and public sector. Donnelley conducts operations through two reportable segments, U.S. Print and Related Services (74% of 9Mo 2011 Sales) and the International segment (26% of 9Mo 2011 Sales).


R.R. Donnelley is the largest player in a declining industry. The company is attempting to transition the business into the digital age while expanding their traditional business to meet the needs of their customer base (and prospective customers). I view Donnelley as a levered company with pressure on every one of their business lines - pressure which will only increase going forward. With that said, the company currently generates a decent amount of cash flow (north of $600MM TTM) and free cash flow (north of $400MM TTM) which it has used for capital expenditures, acquiring businesses and doing share repurchases. The company has also been opportunistic about issuing debt (in June of 2011 they issued $600MM in notes and used the proceeds to buy back some of their outstanding debt). Ultimately, if the company were viewed in isolation, it would resemble a mature company. Unfortunately, the industry is in a secular state of decline, which is different than being a mature industry.

From an equity perspective the yield may be tempting (8.5%), but I do not see a catalyst that will drive the share price higher. If it is yield you are looking for, the debt of the company might be a better option. If you want exposure to the sector, Consolidated Graphics (NYSE:CGX) might be a better option although it does not pay a dividend.

From a debt perspective, I view the company as being too shareholder friendly which will serve to further impact their ratings and their financial health. The company is currently at the upper end of their leverage targets (above them if the pension obligation is considered) and debt reduction does not seem to be a priority. While cash flow is decent, it appears to be allocated to equity and, as a result, does little to enhance the debt perspective. For yield/income investors who are primarily interested in the ultimate repayment of debt, I would look at their shorter duration debt (maybe the 16s) as the company will continue to be healthy (relative to many high yield companies) in the near to intermediate term. For total return investors, the yield - IMHO - will not offset the continued decline and therefore price erosion, so upside is limited at best. I would avoid the intermediate to long maturities as the risk/return is not there at current levels.

Industry Background:

The printing industry is a fragmented and mature industry undergoing a transformational change ad the digital age has been thrust upon it. The company stated industry challenges very well in their last 10Q, which I will summarize here:

The print and related services industry, in general, continues to have excess capacity and remains highly competitive. Despite some consolidation in recent years, the printing industry remains highly fragmented. Across the company's range of products and services, competition is based primarily on price, in addition to quality and the ability to service the special needs of customers.

Technological changes, including the electronic distribution of documents and data, online distribution and hosting of media content, advances in digital printing, print-on-demand and Internet technologies, continue to impact the market for the company's products and services.

As a substitute for print, the impact of digital technologies has been felt mainly in directories, forms and statement printing, as electronic communication and transaction technology has eliminated or reduced the role of many traditional paper forms. Electronic substitution has continued to accelerate in directory printing in part driven by environmental concerns and cost pressures at key customers. In addition, rapid growth in the adoption of e-books is having an increasing impact on consumer print book volume, though only a limited impact on educational and specialty books.

In other words, the company is operating in an industry undergoing significant change and is currently price based - which means very little ability to raise prices. Taking out costs can only achieve so much.

This can also be shown by Fed data on industrial production and capacity utilization within the Printing and Related Support Activities:

The above chart shows that production has been in decline for some time and there is still too much capacity in the industry. While continued pressures will no doubt knock out many of the smaller players and force continued consolidation, this trend will be difficult (if impossible) to reverse.

The chart below was compiled from UCC data provided by Equipment Data Associates (EDA), shows up-to-date UCC activity for all printing equipment. Although UCC filings are a combination of new equipment sales, used equipment sales and re-financings of existing placements, they are still a strong indicator of market activity. This information is extracted directly from EDA's comprehensive database of nearly 30,000 records for purchasers of printing equipment. (found here: Printing Supplies)

Equipment sales also point to a declining industry as new equipment is not being purchased at the same rate - this is evidenced by Donnelly's depreciation and amortization exceeding their capital spending.

Company Financials and Other Considerations:

With a better understanding of the industry in which RRD operates, it is now possible to look at the company in the proper context.

The following is a financial snapshot of RRD:

Source: company financials and ADVFN.

A couple of observations on the company's financial profile:

    • This is a levered company (3x Debt/EBITDA and 69% debt/capital - without pension adjustment) in a declining industry. The current leverage multiple is consistent with the company's target leverage (2.5-3x as per the company investor presentation cited earlier). This is negative for the entire capital structure of the company as it reduces flexibility going forward.,

    • Rather than replace existing equipment as it depreciates, the company has acquired new/bolt-on businesses (more information regarding acquisition activity can be found in the company's 10Q cited earlier). As is obvious from the company's acquisitions over the last two years, RRD recognizes the changing landscape of the printing industry and is in the midst of diversifying their business and transitioning to the "digital age". This, when done properly is shareholder friendly in the near and longer term while it is negative to the debt portion of the capital structure as it is typically cash and debt financed.

    • The quarterly erosion in the current ratio is disconcerting as it reduces the margin of error available to the company. Negative for all segments of the capital structure.

    • The underfunded pension obligation will continue to weigh on the company and should be viewed similar to a debt obligation. As of September 30, 2011 the company's pension was underfunded by over $700MM, which, if viewed as debt, increases their leverage to 3.66x. The de-facto increase in leverage does not help any segment of the capital structure as it is not leverage used to grow the business.

    • Share repurchases have increased as the company's board authorized a $1B repurchase program. Obviously, the company feels buying back shares is the best use of their free cash flow, rather than investing in the business. This is a positive for the equity portion of the capital structure and detrimental to the debt portion of the capital structure.

Now lets look at R.R. Donnelley's capital structure.

Capital Structure:

The following is a snapshot of the company's current capital structure (adjusted for a Jan 2012 maturity):

As of 9/30/11 with the exception of removing the January 2012 maturity.


Equity consists of 187MM shares outstanding with a book value of equity of $1.8B and a market value of $2.3B. The following are key statistics and peer comparisons:

As the above chart illustrates, RRD is by far the biggest player in the space. While this is true, Consolidated Graphics has the premium valuation (by these measures). The company trades at a trailing P/E of 10.7x while CGX trades at a trailing P/E of 15.4x (QUAD and CVO have no "E"). Based on Thomson Reuters, RRD trades at a forward (12/31/12) P/E of 7.0x while CGX trades at a forward (3/31/13) P/E of 11.1x (QUAD and CVO have forward P/Es of 5.9x and 5.1x respectively).

Here is a relative performance chart for the group (from Yahoo! finance):

In the last year, shareholders of RRD have lost a little north of 30%. I have to ask: why will this change? What is the catalyst? As I stated in my summary, I see none.

Debt (Ba1/BB+/BB+):

The following is a table of the company's debt (tradeable debt, credit facility not included):

Source: FINRA Trace

Looking at RRD's debt, the yield is more akin to "B" rated debt (Barclay's HY Index lists "B" rated debt as having a yield to worst of 9.12% while "BB" debt yields 6.84%). As RRD is rated high BB, this gives some cushion against downgrades (which I would somewhat expect). RRD's debt (for the most part) contains change of control covenants and has a limitation on secured debt (principal properties of US restricted subsidiaries) with a 15% carve-out. The 11.25% notes due 2019 have step-up language, currently have a coupon of 11.75% and the potential to step another 150bps should the notes get downgraded to "B".

As I am not fond of the sector, I would stay shorter if I were going to buy the company's bonds. As I stated in the summary, I do not see significant upside in the name, although they should outperform similarly rated bonds due to their higher yield. If the company comes out with decent earnings (after guiding lower) and a compelling story (somewhat more difficult) you could see the bonds add a couple points to get closer to their pre-revision levels. Of the listed bonds, I believe that the 16's are the most compelling as they are cheap on the company's credit curve and have the highest Z spread (zero vol).


In conclusion, an investment in the company is an investment in an industry in decline. While the company is the largest player in the space, I do not see a catalyst to drive prices higher. If choosing my spot within the capital structure, I would be buying into shorter maturity debt.

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