Donnelley Beats Despite Y/Y Decline

R.R. Donnelley & Sons Co. (RRD - Analyst Report) reported second quarter 2012 earnings of 49 cents per share, which comfortably exceeded the Zacks Consensus Estimate of 43 cents. However, earnings declined 7.5% year over year in the reported quarter.

Quarter Details

Revenue declined 3.6% year over year to $2.53 billion and was slightly short of the Zacks Consensus Estimate. The shortfall was due to unfavorable foreign exchange, volume decline in certain product lines, declining prices and unfavorable impact of lower pass-through paper sales, which fully offset volume growth in certain product offerings.

Product revenue (87.0% of total revenue) decreased 7.1% year over year to $2.20 billion, partially offset by a 13.0% year over year jump in services revenue (13.0% of total revenue) in the quarter.

U.S.print and related services revenue was down 4.0% from the previous-year quarter to $1.85 billion, due to significant lower volumes along with continued pricing pressure across the segment and lower pass-through paper sales, which fully offset the volume increases in logistics and office products. International sales declined 2.8% year over year to $682.6 million during the quarter.

Operating expenses decreased 4.1% year over year to $2.33 billion, primarily attributed to a lower selling, general & administrative (SG&A) expense (down 10.7% year over year). As a percentage of total revenue, SG&A expense was 10.9% in the reported quarter versus 11.8% in the year-ago quarter. The improvement was primarily attributed to higher productivity and variable cost control, coupled with lower pension expense.

The lower operating expense drove higher margins in the reported quarter. Operating income on a non-GAAP basis improved 3.0% year over year to $198.4 million in the quarter. Operating margin increased to 7.8% from 7.3% in the year-ago period.

However, higher interest expense (up 3.8%) and income tax (up 76.7%) negatively impacted net income in the quarter. Donnelley reported net income of $88.5 million or 49 cents per share (excluding one-time items) compared with $105.6 million or 53 cents in the year-ago quarter.

Donnelley exited the quarter with $369.0 million of cash versus $415.0 million in the previous quarter. Long-term debt was $3.42 billion at the end of June 30, 2012 compared with $3.76 billion at the end of the previous quarter. Cash flow from operations was $9.9 million compared to an outflow of $52.0 million in the previous quarter.

Outlook

Donnelley expects revenue to be in the range of $10.4 billion to $10.5 billion for fiscal 2012. Operating margin is forecasted to remain within the range of 7.2% to 7.3% for the full year.

Donnelley reiterated fiscal 2012 non-GAAP earnings guidance in the range of $1.84 to $1.92 per share. Non-GAAP effective tax rate for 2012 is expected in the range of 30% to 34% (up from prior guidance of 29.0% to 32.0%). For fiscal 2012, free cash flow is expected to be approximately $500.0 million.

Recommendation

We expect Donnelley shares to remain under pressure in the near term due to weak macroeconomic conditions prevailing in most of its current as well as prospective markets. We believe that continuing pricing pressure, volatility in raw material prices and a highly leveraged balance sheet are significant headwinds going forward.

Donnelley continues to face significant threats from digital technologies that enable much easier transfer, designing, resetting and reproduction of data. This affects big projects such as books and journals, in which the number of printed pages are much higher.

Additionally, with publishers increasingly coming out with digital versions of books and sophisticated e-book readers from Amazon.com Inc. (AMZN - Analyst Report) and Barnes & Noble Inc. (BKS - Snapshot Report) becoming increasingly available, the interest in commercially printed paperbacks and hard covers is waning.

In such a scenario, Donnelley is expanding its scope beyond traditional markets primarily through acquisitions. The company’s continued focus on acquisitions will also spur its already dominant market position and drive long-term growth, in our view.

However, until that happens we prefer to remain on the sidelines. We have a Neutral recommendation over the long term (6-12 months). Currently, Donnelley has a Zacks #3 Rank, which implies a Hold rating in the short term (1-3 months).