R.R. Donnelley's (RRD) yield is above 9%, pointing to a lack of confidence reflected in the market that the dividend is sustainable. Is a cut imminent? To get a better handle on the question we'll examine some important issues that impact the sustainability of the dividend. They are:
- Pension liabilities
RRD's pension was $1 billion underfunded at the end of 2011, approximately a 100% increase over 2010. On November 2, 2011, the Company announced a freeze on further benefit accruals under all of its U.S. pension plans as of December 31, 2011. Beginning January 1, 2012, participants ceased earning additional benefits under the plans and no new participants will enter these plans, limiting future liabilities. The following projection shows the issue is manageable, but the unfunded liability will take years to wind down unless actual return rates are higher and/or the company increases their contributions. The pension does not include the 401(k) and retirement plans.
The company modeled an expected rate of return in excess of 8% in the past. This is aggressive and higher than the discount rate, so we ran the analysis with a 6% return. These numbers are not meant to be exact based on the limited information available. The purpose of this exercise is to determine if a reasonable return rate will reduce the unfunded portion. The important observation is the trend.
The risk is management cannot control Mr. Market. Lower returns or worse, negative returns could require much larger contributions, impacting dividend payouts. Based on the increase in unfunded liabilities in 2011 combined with the risks outside of management's control (reflected in the 2011 actual return) is an argument for reducing the dividend until there is better visibility confirming the trend.
A leverage ratio of 3.2 is based on an estimated 2012 EBITDA of $1.2B and $3.8B of debt. This ratio will fall to 2.8 by the end of the year which is in line with management estimates from the June conference call:
From a leverage perspective, we expect our gross leverage ratio to decline in the back half, ending the year within our targeted range of 2.5 to 3x.
FCF (Free cash flow) is projected at $500 million for 2012, most of which will be generated in the second half. FCF is defined as operating cash flow less CapEx, which is inclusive of approximately $205 million of cash contributions for the pension, 401(k) and postretirement plans.
RRD is generating enough cash to service the near term debt (at least through 2014 as a minimum) and pay the dividend. There appears to be no short term risk to the dividend in regard to the debt.
This represents the largest concern. Some believe the print business is a dying business due to digital technologies. No doubt, the industry is going through major changes, especially when combined with the economic turmoil around the world. The data presented below show the year over year declines in both the U.S. Print and Related Services segment and International segment.
U.S. Print and Related Services segment:
Digital technology is having an effect on top line growth for "Books and directories" among others. What is unknown is quantifying the impact of digital vs. economic conditions.
Management has been able to navigate both the digital revolution going on for many years now and the economic stagnation in the US as shown by an increase in operating margins in both total dollars and percentage growth.
The international side, especially in Europe, has been more of a challenge.
These numbers call into question the visibility past 2012. As economies heal, business should improve, but there is little visibility of significant improvements in the near future. A robust recovery could be years away.
The longer term risks outweigh the benefits of keeping the dividend at current levels. Unfunded pension liabilities depend on factors such as Mr. Market being kind with returns, and RRD is at the mercy of the markets.
Debt is high when considering top line growth, but could continue to shrink going forward. The prudent path would be to strengthen the balance sheet in the short term until longer term visibility is known. The high yield indicates the market is expecting a cut. RRD has not repurchased any shares this year, and given the above information, any share repurchase program will be on hold for the foreseeable future.
When would any cut occur? Management may be waiting to see how the second half proceeds, and if the outlook does not improve, it could come by December. Then the question would be the magnitude of any dividend cut.
Disclosure: I am long RRD.