R.R. Donnelley: The Spin-Off Is No Cure To Business Stagnation

| About: R.R. Donnelley (RRD)

Summary

Despite having a positive impact on the companies' debt maturities, the spin-off fails to address the issue of falling revenues.

As a result of the transaction, each of the companies has been left with numerous stagnating business units. The companies need to deliver on their productivity improvement goals.

At current price levels, the excessive valuation of Donnelley Financial Solutions is not justified. A significant correction might follow as soon as the market takes its fundamentals into consideration.

The company

R.R. Donnelley & Sons Company (NASDAQ:RRD) is a Delaware-based company providing business-to-customer communication solutions consisting of publishing and retail, variable print and strategic services.

Source: company's website.

Here is a more detailed segment breakdown that provides an overall understanding of the company's operations as of the end of 2015 - before the spin-off transaction.

Source: made by the author using the 2015 annual report.

Despite demonstrating significant top-line growth for many years, the company has been subject to tremendous earnings volatility, which is to be discussed later.

RRD Revenue (Quarterly) Chart

RRD Revenue (Quarterly) data by YCharts

RRD Net Income (Quarterly) Chart

RRD Net Income (Quarterly) data by YCharts

Another issue was coming from significant margin compression.

RRD Operating Margin (Quarterly) Chart

RRD Operating Margin (Quarterly) data by YCharts

How did the spin-off change the earnings picture?

  • On Aug. 4, 2015, the board of directors' decision to propose spin-offs of Donnelley Financial Solutions (NYSE:DFIN) and LSC Communications (NYSE:LKSD) was publicly announced.
  • On Oct. 1, 2016, the distribution of approximately 80.75% of the total common shares outstanding of these 2 businesses was finished.

Now, let's try to draw a line between the remaining businesses and the businesses R.R. Donnelley has just spun off. The diagram below demonstrates the business segments that have been transferred to LSC Communications and Donnelley Financial Solutions. Arrow colors correspond with those of the previous segment locations.

Source: made by the author using the 2015 annual report.

There were 2 primary reasons why the proposed spin-off made sense. Firstly, the majority of the spun-off businesses have been facing declining revenues of late. While not a large loss for RRD, the dismissal of these businesses allows RRD and the 2 spun-off companies to wholly concentrate on their key strengths and productivity. Secondly, the proceeds from the transaction were intended to be used to reallocate the debt maturities by cutting the notes due in 2017-2019 and 2022 and issuing longer-term debt.

An investment in Donnelley Financial is essentially a bet on a rebound of the financial unit's revenues, which derives its performance from the state of the global market for IPOs, M&A, LBOs, debt offerings and related financial transactions.

Source: made by the author using the 2015 annual report.

In the meantime, investors considering LSC Communications should be quite bullish on office products, books and the company's ability to further improve its operating efficiency.

LSC Communications: a closer look

  • Print segment: serving over 3,000 customers worldwide, the company is a major player in the field and enjoys a rather strong reputation. A quote from the FORM 10-12B/A: "Our long-standing customer relationships in our Print segment include nine of the top ten catalogers, nine of the top ten magazine publishers, and all of the top ten book publishers based in North America and Europe, including the two largest book publishers worldwide in 2016."
  • From its North American facilities, Office products unit produces and distributes filing, note-taking and binder products, as well as tax and stock forms, and envelopes. From the FORM 10-12B/A: "Our Office Products segment serves nine of the top ten office supply retailers and is a top five supplier of both of the office supply superstores."
  • While the company's main focus remains on efficiency improvement, a key threat to the bullish thesis are the variations in demand due to technological changes and rising distribution/postal costs, which LSC mentions in its filings.
  • Whether the company plans to start paying a dividend or not remains a question. From the FORM 10-12B/A: "We cannot assure you that we will pay dividends on our common stock, and our indebtedness could limit our ability to pay dividends on our common stock."
  • Since RRD planned to use the proceeds from the transaction to reduce its indebtedness, LSC had to assume a significant debt burden. Below is the selected financial data for LSC as of June 30, 2016. On September 26, 2016 LSC announced the pricing of its 8.75% Senior Secured Notes due 2023 ($450 million) and $375 million senior secured term loan B facility under its new credit agreement (LIBOR + 6%, s.t. a LIBOR floor of 1%). The figures almost reflect the pro forma debt adjustments stated in the company's Form 10-12B/A.

Selected financial data of LSC Communications, Inc. Source: made by the author using the data from the company's FORM 10-12B/A filing. The Pro Forma figures reflect the post-transaction adjustments.

But what about the company's operating performance? As seen in the chart below, operating margins have been fluctuating quite significantly over the last 2 years.

Source: made by the author using the data from the company's Form 10-12B/A filing.

Despite being slightly offset by the the downtrending capital expenditures, cash generation has been rather sluggish recently.

Source: made by the author using the data from the company's Form 10-12B/A filing.

The print segment, through which LSC generates the majority of its operating income, has been demonstrating declining revenues and requires additional focus. Otherwise, the ongoing margin expansion might cease to compensate for the falling sales. On a more positive note, office products segment has been demonstrating solid growth and might soon become a more significant contributor to the top line if the company's productivity maximization strategy succeeds.

Considering the revenue seasonality, investors might want to pay additional attention to the margins in Q3 and Q4. Finally, of note is the frequency of significant impairment charges. LSC usually performs its goodwill impairment tests as of Oct. 31. Thankfully, only the top-performing businesses - book and office product units - had goodwill as of Oct. 31, 2015. Third quarter results are going to be published on Nov. 10.

Source: made by the author using the data from the company's Form 10-12B/A filing.

Donnelley Financial Solutions: a closer look

The motivation for the spin-off becomes even more apparent when one begins to analyze Donnelley Financial Solutions. The company provides technology and expertise based communication solutions to shareholders, regulators and investors. From the 8-K: "Donnelley Financial is a financial communications and data services company serving both the investment and capital markets worldwide. Our clientele is primarily focused in three areas: global capital markets (GCM), global investment markets (GIM), and language solutions. Our business is diversified across a range of products and services, including content management, multi-channel content distribution, data management and analytics services, collaborative workflow and business reporting tools, and translations and other language services in support of our clients' communication requirements." Here is a brief overview of the company's services from its webpage.

Source: company's website.

As mentioned before, the company's performance is dependent on the state of the global financial activity. The global market for IPOs, M&A, LBOs, debt offerings and related transactions is what drives its revenues. Any negative developments in financial activity, equity valuations and capital flows might pose substantial headwinds to the company's profitability.

This sensitivity is greatly evidenced by the recent earnings picture. DFS is definitely not the stock one would like to stay long over an extended market downturn.

Source: made by the author using the data from the company's Form 10-12B/A filing.

Among the major recent headwinds mentioned in the company's filings were falling transactional and compliance volumes (Capital Markets), and unfavorable mutual funds price dynamics and volumes (Investment Markets unit).

Value investors might become concerned with the fact that goodwill and other intangibles constitute almost a half of the company's total assets, which results in a negative tangible book value per share of about $(9.69) vs. a simple book value of $5.88 - a far cry from the current share price of $22.92.

The book value calculation involved the use of the company's estimates on debt issuance, representing the issuance of $650.0 million in debt at a cost of $15.6 million and a consequent cash transfer of $634.4 million back to RRD. Even though this leaves DFS with a Debt/Equity of about 3.3 as of June 30, 2016, short-term liabilities do not pose any substantial risk. On September 26, 2016, the pricing of 8.250% Senior Notes due 2024 ($300 million) and a $350 million senior secured term loan B facility (LIBOR + 4%, s.t. a LIBOR floor of 1.00%) was announced.

On a less positive note, DFIN has been facing severe cash generation difficulties of late.

Source: made by the author using the data from the company's FORM 10-12B/A filing.

Concluding thoughts on RRD

The table below demonstrates the post-transaction allocation of revenues and expenses between RRD and the spun off companies. Despite retaining the majority of the consolidated company's revenues, RRD fails to keep its share of operating profits proportional. Its operating margins increase to 2.5 from 1.75 percent if one adjusts for the spin-off transaction expenses, however.

Source: made by the author using the data from the company's 8-K.

The pro forma statement of operations from the recent 8-K, which puts the 6-month earnings attributable to the continuing operations of RRD at just $100,000, puts a large emphasis on 2 adjustments:

  • The above-mentioned $24.7 million adjustment related to the spin-off expenses, which is fully justified;
  • A $35.2 million adjustment for the interest expense decrease. According to the 8-K, the adjustment represents the "estimated reduction in interest expense related to approximately $1 billion of debt that the Company tendered in September 2016 or intends to tender in the fourth quarter of 2016."

Source: company's 8-K.

Even though the company has already terminated its debt obligations maturing in 2018 and 2019, it still has to deal with the $250 million 6.125% senior notes due January 15, 2017 and $260 million 7.000% senior notes due February 15, 2022 for the adjustment to be valid.

The majority of the company's businesses are stagnating. However, one should not exclude the possibility of more successful acquisitions such as that of Consolidated Graphics.

Source: made by the author using the data from the company's 10-K.

The issue associated with the negative tangible book value per share is shared by all of the stocks.

Source: made by the author.

Conclusion

As the article's title suggests, the spin-off is no cure to business stagnation in R.R. Donnelley's case. Nonetheless, there are numerous positive aspects of the transaction, too. Of particular note is the impact coming from the debt maturity postponement, which should provide more flexibility and allow for a stronger focus on margin expansion. As far as the companies' expectations are concerned, one should not underestimate the potential of productivity growth in the upcoming quarters, especially considering the historical margin volatility. Finally, successfully implemented acquisitions might substantially change the thesis presented above. A key risk to the thesis lies in the fact that historical earnings of the separated companies - which were essentially "cut out" of the consolidated figures - might not prove to be reliable data to base forecasts on, which the companies acknowledge in their filings.

On a less positive note, (1) stagnating revenues, (2) disappointing operating margin dynamics, (3) weak cash flow generation and excessive valuations from the Price/Book standpoint make the case for a bearish thesis. Despite the positive ratings, I am particularly bearish on DFIN due to the stark revenue cyclicity, margin compression and severe cash generation issues. For as long as the near-term prospects of the global financial activity remain exceptionally uncertain, it would take a lot of optimism to remain bullish on Donnelley Financial.

Even though RRD and LKSD might be viewed as slightly better picks, their fundamentals continue to display multiple weaknesses and should be monitored closely. Of particular importance to the near-term price action might be the changes in analyst ratings. While DFIN and LKSD remain relatively underfollowed and are about to be put on coverage, RRD might experience significant consensus rating changes in the coming months. Finally, institutional accumulation might lead to increased near-term volatility, making the near-term performance of the stocks increasingly uncertain. Even though DFIN seems to receive positive investor attention at this point, lack of fundamental improvement might drag it lower in the coming quarters. Jim Cramer has recently changed his view and now says that he "cannot get too enthusiastic" on the spin-off, and neither do I.

I assign a Sell rating on RRD, DFIN and LKSD. I might also post follow-up articles depending on the near-term price action and upcoming earnings.

Post-spinoff performance

RRD Chart

RRD data by YCharts

Additional Reading

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

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: This is not an investment advice. I am not an investment advisor.

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