(Published by Nicholas McCullum on March 16)
When high-quality companies trade at relative lows, it is often worthwhile to assess why the stock price is depressed.
If the companies' long-term investment prospects remain strong, then buying the dips can be rewarding for shareholders.
“Whether we’re talking about socks or stocks, I like buying quality merchandise when it is marked down.” – Warren Buffett
R.R. Donnelley & Sons (RRD, Financial) is trading at a 52-week low. In the past year, this stock has traded as high as ~$23 and was at $13.75 Friday.
Upon further investigation, it appears that the cause of this low stock price is a substantial business reorganization that R.R. Donnelley completed last fall.
Business overview
Recently, R.R. Donnelley has gone through some significant restructuring.
Effective Oct. 1, 2016, the company spun off two large business units which will now trade independently on stock exchanges:
- LSC Communications Inc. (LKSD, Financial): Publishing, print services and office products.
- Donnelley Financial Solutions Inc. (DFIN, Financial): Financial communications and data services.
Existing R.R. Donnelley investors received one share of LSC Communications and one share of Donnelley Financial Solutions for every eight shares of R.R. Donnelley held at the close of business on Sept. 23, 2016.
Immediately following the spinoff, R.R. Donnelley’s common stock completed a reverse 3-for-1 stock split. This means that every three shares of R.R. Donnelley before the event became 1 share.
For both the spinoffs and the reverse stock split, fractional shares were not issued – investors received cash instead.
R.R. Donnelley holds a 19.25% stake in each of the new corporate entities, which it must sell within one year of the spinoff to maintain the tax-free nature of the divestitures.
Here’s what R.R. Donnelley’s CEO has to say about the spinoff in the company’s fourth-quarter earnings release:
"The fourth quarter of 2016 was a pivotal quarter in our history as we completed the previously announced spinoffs of LSC Communications and Donnelley Financial Solutions at the beginning of the quarter and then began operating as a stand-alone company intensely focused on providing integrated multichannel communications, supply chain and logistics solutions to our customers.
"We are pleased with our fourth-quarter results as we grew both our net sales and non-GAAP income from operations. And although we exited the spin with debt leverage above our long-term target range, we remain on track to utilize the proceeds from disposing of our equity stakes in LSC Communications and Donnelley Financial Solutions, as well as cash generated from ongoing operating activities, to reduce our outstanding debt obligations."Â – Dan Knotts, R.R. Donnelley’s president and CEO
The new R.R. Donnelley will operate in three business segments:
- Variable Prints (46% of 2015 sales).
- International (31% of 2015 sales).
- Strategic Services (23% of 2015 sales).
More information about R.R. Donnelley’s current corporate structure can be seen below.
Source: R.R. Donnelley Fourth Quarter Investor Presentation, slide 4
Growth prospects
Qualitatively, one might assume that R.R. Donnelley’s growth prospects would be poor.
Commercial printing could possibly be experiencing a decline as more consumers switch to electronic methods of communication.
This is not the case. The following image presents the actual and expected growth of the commercial printing industry from 2014 to 2019.
Source: R.R. Donnelley Fourth Quarter Investor Presentation, slide 7
The commercial printing industry is growing, particularly in international markets.
This international growth is a trend of which R.R. Donnelley has taken advantage. The company has globalized operations with 377 locations in 28 countries. R.R. Donnelley also has a substantial (42,000) international employee base.
Source: R.R. Donnelley Fourth Quarter Investor Presentation, slide 11
While this international presence exposes it to other risks (such as fluctuations in the value of the U.S. dollar), it allows R.R. Donnelley to leverage the growth of the international commercial printing industry to drive business growth.
Looking ahead, R.R. Donnelley’s future will be largely influenced by the company’s recent business restructuring.
The spinoffs of Donnelley Financial Solutions and LSC Communications were expected to unlock shareholder value. This has not yet occurred.
The following diagram shows how the current value of R.R. Donnelley’s spinoffs compares to the pre-spinoff stock price. This diagram was created by dividing LSC Communications and Donnelley Financial Solutions’ stock price by eight (to account for eight shares being received for each share of pre-spinoff R.R. Donnelley) and dividing post-spinoff R.R. Donnelley’s stock price by 3 (to account for the reverse stock split).
Source: Yahoo! Finance
The cumulative value of the three spun off entities is substantially less than the per-share market value of pre-spinoff R.R. Donnelley. Keep in mind that the above diagram does not account for dividend payments from the three separate entities.
Investors need not be immediately alarmed, though. We are only ~five months since the spinoff, and financial markets are still adjusting to the new corporate structure.
When the company originally announced the spinoffs in 2015, it forecasted positive revenue growth for two of the entities. While they were unnamed at the time, these two entities ended up being the new R.R. Donnelley along with Donnelley Financial Solutions.
Source: R.R. Donnelley Best Ideas Conference Presentation, slide 14
The company with negative expected revenue growth is LSC Communications.
Competitive advantage and recession performance
R.R. Donnelley’s competitive advantage stems from its market leadership in the commercial printing industry. The company has a large global customer base of 52,000 corporations, which includes:
- 97% of Fortune 100 companies.
- 94% of Fortune 500 companies.
- 90% of Fortune 1,000 companies.
Some of R.R. Donnelley’s more iconic companies can be seen in the following slide.
Source: R.R. Donnelley Fourth Quarter Investor Presentation, slide 10
In the past, R.R. Donnelley has not performed well during recessions. Its earnings per share during the 2007-2009 financial crisis can be seen below:
- 2007: adjusted earnings per share of $8.82.
- 2008: adjusted earnings per share of $8.79 (decrease of 0.3%).
- 2009: adjusted earnings per share of $3.09 (decrease of 64.8%).
- 2010: adjusted earnings per share of $5.28 (increase of 70.9%).
R.R. Donnelley’s adjusted earnings per share fell by ~65% during the depths of the financial crisis.
While the company managed to remain profitable, this type of earnings per share dropoff does not inspire confidence among the company’s investors.
This per-share earnings decrease severely affected the safety of the company’s dividend. Although R.R. Donnelley did not raise its dividend payments between 2004 and 2015, the loss of profits during the financial crisis pushed R.R. Donnelley’s dividend payout ratio above 100% during fiscal 2009.
Source: Value Line
Looking ahead, R.R. Donnelley is focused on reducing its leverage levels to create a lower-risk value proposition. The company’s debt-to-EBITDA ratio is above 4x, and management has communicated the intent to lower this to the 2.25x to 2.75x range.
This will likely be completed by retiring outstanding debt. The following slide presents R.R. Donnelley’s debt maturity profile until 2026.
Source: R.R. Donnelley Fourth Quarter Investor Presentation, slide 20
Expect more of this debt to be retired as the company moderates its risk profile.
Valuation and expected returns
R.R. Donnelley’s future expected total returns will come from three sources: dividend yield, earnings-per-share growth and changes in the company’s valuation.
Earlier, we saw that the company had a forward dividend yield of 4.1%.
With regard to improvements in earnings per share, it is unclear exactly how quickly investors can expect the new R.R. Donnelley to grow its business. Based on R.R. Donnelley’s historic performance along with the growth of the commercial printing industry, I would expect bottom line growth in the range of 2% to 4% per year over the medium term.
R.R. Donnelley’s valuation is also a bit tricky as the new company does not have 12 months of earnings per share to calculate a trailing price-earnings (P/E) ratio.
However, it is possible to calculate a forward P/E ratio. Management has guided for non-GAAP diluted earnings per share in the range of 90 cents to $1.20 for fiscal 2017. Taking the midpoint of this guidance ($1.05) gives a forward P/E ratio of 13.0 – well below the average P/E ratio of ~26.
R.R. Donnelley’s valuation will likely expand as the uncertainty surrounding the company’s future is reduced.
To conclude, expected total returns for R.R. Donnelley shareholders will be composed of:
- 4.1% dividend yield.
- 2% to 4% earnings-per-share growth.
Total returns of 6.1% to 8.1% are expected before the effect of valuation changes. Again, it is likely that the company’s valuation will increase as uncertainty diminishes.
Final thoughts
R.R. Donnelley has recently undergone some significant business restructuring. While this was expected to unlock shareholder value, this has not yet occurred, and the company’s future still contains a great deal of uncertainty.
The company’s dividend yield is north of 4%, which will appeal to income-oriented investors. However, I am hesitant to recommend an investment in R.R. Donnelley right now.
This may change when the company’s growth runway becomes more clear.
Disclosure: I am not long any of the stocks mentioned in this article.
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