R.R. Donnelley & Sons Company

Welcome to the RRD third quarter 2021 conference call. My name is Amitris, and I will be your operator for today's call. At this time, my participants are in a listen-only mode. After remarks from company representatives, we will conduct a question and answer session by phone. To ask a question, you must be connected by phone, as the webcast is a listen-only platform. If you wish to ask a question by phone, please press star 1 on your touchtone telephone. Please note that this call is being recorded. I will now turn the call over to Johan Nystad, RRD's Senior Vice President of Finance.

Thank you, Amitris, and thank you, everyone, for joining RRD's CERC for 2021 results conference call. Join me to review our financial results and comment on the acquisition news are Dan Knott, RID's President and Chief Executive Officer, and Terry Pearson, our Chief Financial Officer. At the conclusion of today's prepared remarks, Dan, Terry, and I will take questions. As a reminder, we have prepared supplemental slides for today's call, which can be found on the Investors section of our website at RID.com. As we review our results on today's calls, I will be advancing the slides if you are connected by webcast. Alternatively, we will periodically reference page numbers from the supplemental slides for those participants who wish to follow along by advancing the slides themselves. The information reviewed during this call is addressed in more detail in our third quarter and acquisition press releases, copies of which are posted on the investor section of our website at RID.com. This information was also furnished to the SEC in the foreign aid case we filed earlier this morning. In addition, we will also refer to forward-looking statements. including comments on our strategy, which involves risks and uncertainties. Therefore, our actual results could differ materially from our current expectations. For a complete discussion of the factors that could cause our actual results to differ materially, please refer to the cautionary statement, including earnings release, and the risk factors, including our annual report on Form 10-K, our quarterly reports on Form 10-Q, and other filings with the SEC. Further, we will discuss non-GAAP financial information. We believe the presentation of non-GAAP results provide investors with useful supplementary information concerning the campus' ongoing operations. These non-GAAP results are provided for informational purposes only. Any references to non-GAAP financial measures are reconciled to the comparable GAAP financial measures in the Investors section of our website as part of our press release. I will now turn the call over to Dan.

Great. Thanks, Johan. Good morning, everyone. It's great to be with you, and thank you for joining us on our call today. Before we discuss our third quarter results, I'm going to first review the press release we issued earlier this morning, announcing that we have entered into a definitive agreement to be acquired by affiliates of Atlas Holdings for $8.52 per share in cash. The transaction that we announced today represents a total enterprise value of approximately $2.1 billion, including net debt. The $8.52 per share is a 73% premium over the closing price on October 11, 2021, which is the last trading day prior to the announcement of an unsolicited offer by Chatham Asset Management to acquire all of the common stock of RRD not already owned by them. As we stated in our press release, we believe that this transaction is in the best interest of RRD and its stockholders, and after careful and thorough analysis together with our independent advisors, our board of directors unanimously approved the transaction with Atlas. Under the agreement, RRD may solicit superior proposals from third parties for a period of 25 calendar days. In accordance with the agreement, R&D's Board of Directors, with the assistance of its advisors, intends to solicit superior proposals during this period. We will be filing in due course the merger agreement and related materials, and we recommend you review them once they become available. Turn to slide five. Let's now turn to the quarter. Building on our first half momentum, we delivered very strong third quarter results through the consistent execution of our well-defined strategy and underlying strategic initiatives. On the top line, we achieved our second consecutive quarter of organic sales growth with both our business services and marketing solution segments delivering favorable year-over-year performance. On the earnings front, Our adjusted income from operations and operating margin both exceeded last year's third quarter, while also surpassing our 2019 pre-pandemic third quarter adjusted income from operations and operating margin performance. On the balance sheet, our quarter-end debt level was down $508 million from the prior year third quarter, which represents the lowest debt level for any third quarter we've reported since the spin. Our favorable results are a direct result of our sales teams aggressively pursuing targeted opportunities with new and existing clients to drive growth, our client services and operations teams executing at a high level and demonstrating tremendous agility to support our clients' requirements, all while battling labor challenges, and our procurement teams around the world working diligently to combat global supply chain bottlenecks. Truly a collective team effort, and I am appreciative of the entire RRD team's hard work to achieve these positive results. I'd like to provide a little more color on our Q3 performance. Net sales were $1.27 billion, up 5.5% organically versus the prior year. On a segment level, business services reported a 5.9% organic growth rate, led by strong performance across our commercial print, packaging, and labels product categories. Top brands continue to leverage our industry-leading packaging and label solutions to keep pace with growing online sales and differentiate their products on store shelves. They value our end-to-end single-source capabilities, which include our premium folding cartons that were showcased at Pack Expo Las Vegas in September. Including our favorable Q3 performance, we've now achieved five consecutive quarters of net sales growth in these key strategic areas. Marketing solutions achieved 3.8% organic growth for the quarter as client demand continues its recovery from the pandemic lows. Direct marketing and digital print led the overall increase for marketing solutions. We reported $81.5 million in adjusted income from operations, an increase of 10.3% compared to the prior year. and our adjusted operating margin improved by 20 basis points over the prior year due to our continued focus on cost management. Our favorable financial performance underscores the successful execution of our strategic initiatives to strengthen our core, drive revenue growth through higher value offerings, and improve our financial flexibilities. Our teams have been working diligently to increase productivity and become more agile while supporting our clients, first through the pandemic and now through supply chain disruptions, labor shortages, and inflationary challenges. Related to supply chain disruptions, paper and other fiber-based suppliers have implemented allocations and moratorium processes to manage the surge in demand and limited supply. In response, we are providing our clients with product alternatives, including innovative format changes, and are introducing new suppliers to provide optionality for our clients. Our functional teams are working closely together to successfully navigate this volatile supply chain environment and find answers for our clients. To that end, there were many recent client wins across RRD this quarter, and I'd like to share a few examples that reinforce the breadth of our solutions that we are providing to both new and existing clients. On slide six. As you may recall, we provided a broad range of COVID-19 test kit services last year, and that has opened new opportunities for home diagnostics. We secured a new agreement with Tasso Inc., a Seattle-based company that's developed patient-centric technology for anytime, anywhere blood collection. These types of products require supply chain partners who are compliant with HIPAA privacy rules, as well as with FDA regulations involving good manufacturing practices that in addition to having state-of-the-art third-party logistics solutions. This quarter, we will complete our systems integration and begin providing digital communications, kitting, fulfillment, and logistics services for Tasso's blood collection devices. This win is another example of our incubator strategy where we work side-by-side with startups to bring new products to market with the potential to quickly scale and meet increasing demand. Our ongoing investments in our digital print platform continue to drive new business for us as well. We recently established a partnership with Mixtiles, a fast-growing international company that is redefining the way consumers print and hang photos in our homes and offices. We're leveraging our extensive high-quality variable data printing capabilities to produce and ship the company's photo tiles directly to their customers. R&D is committed to continuing to lead the way in print technology innovation and meet the dynamic needs of our clients for personalized on-demand printing. Turning to slide seven, we are supporting a large health insurer who just completed a merger by consolidating the design, production, and fulfillment of welcome kits to new members. We create a standard design for multiple health plans that integrates numerous inserts into an all-in-one book supported by a print-on-demand strategy. Our comprehensive solution drives efficiency and consistency while eliminating costs associated with storage, materials obsolescence, and manual assembly of their welcome kits. As a final example, We recently won a contract with a leading employee benefits administrator who is outsourcing the printing of their critical business communications so that they can focus on their core business model. This client has an innovative digital platform that offers easy-to-use communication tools to assist people in making benefit selections. And under this new agreement, R&D will be providing the printed materials, including annual enrollment communications, new hire packets, benefits information, and other forms as requested by their customers. Going forward, we will leverage our extensive capabilities to support their current and future print requirements as they grow and evolve their business model. Turning to slide eight. Before I turn the call over to Terry, I'd like to highlight two recent honors we received, the first recognizing the high level of quality and service we are providing to our clients, and the second representing our commitment to supplier diversity. First, Hormel Foods recently recognized RRD with the 2020 Spirit of Excellence Award, celebrating our outstanding labeling work for the global branded food company. We were one of 30 suppliers who met or exceeded Hormel's stringent standards for quality customer support in on-time deliveries. Second, JPMorgan Chase publicly recognized R&D for our commitment to increase our spending with diverse suppliers over the next three years. We applaud JPMorgan for urging its business partners to use their collective purchasing power to help minority-owned businesses. Supplier diversity is an important component of our commitment toward a more diverse, equitable, and inclusive world, and we are honored to receive this recognition. And with that, I will turn it over to Terry to take you through the financials.

All right. Thank you, Dan. Our third quarter was strong across the board despite a fourth consecutive quarter of significant foreign exchange headwinds. Our sales, income from operations, and diluted earnings per share all came in better than we had expected. Several of our product and service categories reported growth in the quarter, including labels and packaging, where we also reported our fifth consecutive quarter of organic growth as demand for e-commerce-related products continues to be strong. Adjusted income from operations in the current year was very strong as it not only exceeded our previous expectation and prior year results, but it also exceeded our pre-pandemic 2019 third quarter results despite lower sales. We are seeing a nice flow through to the bottom line on recovering sales due to continued focus on our cost structure, which is driving improved operating margins. From a debt perspective, our debt level is down $508 million versus September of 2020, and we are now sitting at the lowest amount of debt outstanding and leverage that we have ever reported for any third quarter since the 2016 spin. While demand for our products and services continues to strengthen, we, like many companies, are working hard to overcome significant challenges with our supply chain and labor availability. As Dan previously mentioned, we have seen price increases from nearly all of our material suppliers. We have experienced labor shortages and elevated wage pressures for manufacturing workers due to current market conditions. And we have experienced disruptions from the shipping delays caused by container shortages in key domestic and international ports, including China. We have taken numerous actions to overcome these challenges, including working with our clients on product alternatives and new formats. In some cases, we have secured new suppliers, and we continue to work closely with our transportation suppliers. We've also increased inventory levels to help ensure product availability and have adjusted prices for many of our products and services to recover inflationary increases. And lastly, our ongoing efforts to reduce our cost structure have also played an important role in helping to offset the impact of these issues. With that, let me get started with a review of our third quarter performance. Turning to slide nine. Net sales were up 6.4% in the third quarter, which included $10.8 million of a benefit due to foreign exchange. On an organic basis, we reported growth in net sales of 5.5%. We reported sales increases in several of our product categories due to increasing demand for our products and services. For the segments, business services reported another strong quarter with organic growth of 5.9%. This marks the fifth consecutive quarter we have delivered organic growth in our strategic focus areas of packaging and labels as we continue to win new business and grow sales with our existing clients. Also, commercial print products performed exceptionally well in the third quarter, driven by strong demand for trading cards in the U.S. market and other printed products produced in China. As expected, our supply chain management services reported a decline in the quarter due to a couple of large one-time COVID-19-related kitting projects in the prior year. We expect this product category to report another decline in the fourth quarter as the prior year fourth quarter included additional large one-time projects. Marketing Solutions reported organic growth of 3.8% as a result of increases in clients' marketing-related spend. While marketing demand is improving, we continue to see delays in ramping up due in part to the supply chain disruptions our clients are experiencing. On slide 10, adjusted income from operations of $81.5 million was $7.6 million higher than the third quarter of 2020. In addition, the corresponding operating margin increased from the prior year 20 basis points to 6.4% this quarter. Higher sales combined with targeted actions taken to reduce the company's cost structure benefited both our adjusted income from operations and operating margin. And more than offset the impact from last year's one-time COVID-19 related projects. Higher variable incentive compensation expense and approximately $7 million in unfavorable foreign exchange. Adjusted SG&A expense of $141.2 million in the third quarter was up $3.7 million or 2.7%. As a percent of sales, adjusted SG&A expense improved from 11.5% in 2020 to 11.1% this quarter, reflecting the company's ongoing efforts to lower our costs to serve. Adjusted earnings per share from continuing operations was $0.57 in the third quarter, as compared to $0.32 reported in the prior year quarter. The increase was attributable to favorable income taxes, higher adjusted income from operations, and lower interest expense. Our adjusted effective tax rate was 26.8% in the quarter versus 44.9% a year ago. This year's tax rate reflects benefits from a greater interest expense deduction driven by improved U.S. earnings and a favorable discrete benefit. Our GAAP results for the quarter included pre-tax restructuring, impairment, and other charges of $4 million, which were $50.2 million lower than the last year, primarily due to a one-time charge recorded in the prior year for LSD's MEP liability, as well as lower employee termination charges associated with aggressive cost actions taken during 2020 to reduce our cost structure. Turning now to the balance sheet and cash flow on slide 11, as of September 30th, 2021, we had total cash on hand of $223.5 million and total debt outstanding of $1.51 billion. Availability on the credit facility was $515.7 million at the end of the quarter, and total availability, including cash on hand, was $739.2 million. Our gross leverage ratio of 3.7 times at September 30th, 2021 improved from 4.7 times at September 30th, 2020, while the net leverage ratio of 3.2 times improved from 3.7 times a year ago. Cash used in operating activities during the nine months ended September 30th, 2021 was $29 million compared to cash provided by operating activities of $25.2 million in the prior year period. The increase in cash used from operations during 2021 is primarily driven by working capital investments due to increased volume and inflation, $23.9 million of LSC bankruptcy-related payments, higher incentive compensation and tax payments, and a $9.2 million payment to terminate certain interest rate swap agreements. In addition, the prior year results benefited from the deferral of the payroll taxes as part of the CARES Act, and included $15.7 million of positive operating cash flow from discontinued operations. These factors were partially offset by lower restructuring and interest payments. Capital expenditures in the nine months ended September 30th, 2021 of $48.6 million were $5.8 million lower compared to last year. And now operator, let's open up the line for questions.

Thank you. We will now begin the question and answer session. If you have a question, please press star, then the number one on your touchtone phone. If you wish to be removed from the queue, please press the pound sign or the hash key. If you're using a speakerphone, you may need to pick up the handset first before pressing the numbers. Once again, if you have a question, please press star, then the number one on your touchtone phone. Your first question comes from the line of Charles Strauser with CJS Securities.

Hi, good morning. Morning, Charlie. Hi, Charlie. So exciting news, obviously, today, and just wanted to congratulate you guys on getting to this point. And obviously, with the 25-day go shop, it'll be interesting to see how this plays out. But I was wondering if you could talk a little bit, you know, about the process and kind of when it began, how you came about to meet with Atlas. It was something that was ongoing for a while now, and maybe talk a little bit more about that.

Yeah, Charlie, I'll go ahead and take it, and Dan can jump in and fill in some gaps as well. But, you know, our board has taken a strategic review and a strategic look at our assets and our strategic options. It's been several years, really since it's been. They've always taken that part of their responsibility very seriously and have been very, very diligent each year in looking at options. specifically to the Atlas option, that's been a process that has been in place. We've been working on that with them with extensive due diligence and such. It's been a multi-month long process, but I can't really get into too many details about what that process has looked like and who contacted who first. But I will tell you that, you know, obviously we will be preparing for an eventual shareholder meeting where the shareholders will be able to vote on the presented transaction. And as part of those materials, there will be lengthy descriptions and discussions about the process that we followed and the evaluation considerations that the board also considered, including details about a fairness opinion that we did receive from our advisors.

And Charlie, I'd say the R&D board regularly reviews R&D's strategic priorities in the best interest of R&D and our stockholders. We've evaluated numerous strategic options over the past several years. The Atlas announcement, as Terry mentioned, is the result of a multi-month process that included rigorous due diligence. Additional details will be in the background. We provide in the background of the merger section of our proxy filing, so more to come on that. And just to reinforce that the board unanimously believes this transaction is the strongest path forward in the best interest of our RDN and stockholders.

Thanks, Dan. And basically, if you look at the, you know, you've got a 25-day go shop period, is there a breakup fee should, you know, a superior bid be accepted?

Yes, there is a breakup fee payable by RRD in certain circumstances, including for termination for RRD to enter into an alternative agreement for a superior proposal.

Gotcha. And can you quantify that at this point?

The terms of the breakup fee and triggers are set forth in the merger agreement, which is being filed on the 8th.

That will be filed later today. Got it. Great. And then just one housekeeping question on the results. Terry, if you could, would you be able to supply by the products and services the EBITDA margin for each product line?

We do not publish either the margins by the individual product category, so I don't have that, and that's not something that we have produced in the past.

Got it. Any commentary just in terms of how the various product lines have performed in terms of profitability?

Yeah, I mean, I'll tell you that, you know, when we have approached our opportunities for cost reductions and improving our cost structure, you know, we have not focused, you know, in any one or two single areas. We've really kind of taken a very, very broad approach, and we've went across all of our different business lines as well as the SG&A functions in the company. So, you know, I would say that most of our categories, maybe all, but certainly most of those categories, all are seeing some benefit from that. So from a profitability standpoint, they are contributing to improved margins across the board. But if you look at just the business and the product categories, I'd have to call out for this quarter that the strongest performance, certainly from a top line, is in the commercial print category, where you'd see that the That product category for the quarter alone was up over 20%. It's just over $70 million of increase there, and we really had two very, very strong products that led that increase, and it was the trading cards domestically and the commercial print products that we produce in China, many of which are exported back to the U.S. So, again, those are kind of the... standouts for the quarter, but again, many of our products had really nice performance in the quarter, but those were the two portions that were standouts within commercial print.

And Charlie, just to add to that, one of the things we said last year when we were making changes to our cost structure that A significant portion of those changes were going to remain in place, would be changed to our fixed-cost infrastructure, and would not be coming back as volumes returned. Obviously, things like sales commissions and such return with volume, but the cost changes that we made were permanent cost changes and not temporary cost changes, and you're seeing the financial impact of those flow through as volume does recover.

That's fair. Thank you very much for that. And then just lastly, Dan, Any foreseen potential hard spot issues that you could delay in combination with Atlas?

Yeah, not going to speculate on any of those types of issues, Charlie.

Great. Thank you very much, and congratulations. All right. Thanks. Appreciate it.

Your next question comes from the line of Bill Mesteris with Baird.

Thank you. A couple of fixed income questions for you, beginning with the Atlas proposal. Is there any type of detail that you can share on the capital structure with the proposed acquisitions, just in terms of the amount of debt as well as maybe the contribution by the Atlas funds?

Yeah, you know, certainly there were equity commitments from affiliates within Atlas. And then, you know, they have a backstop facility that is led by J.P. Morgan and also participating and named in the press release was Macquarie. So those are in place. We do have firm commitments on all of those items, but details of what that capital structure will look like have not been released yet, so I really cannot comment specifically on that.

I guess then maybe, Terry, more broadly, and it's been well publicized that Chatham has proposed subordinating or equitizing its $654 million high-yield holdings Does the Atlas proposal provide a superior value proposition for holders of your high-yield bonds at this point?

You know, I am going to have to kind of defer you to the information that we'll be publishing in our proxy statement that will be out over the next – you know, in advance of a shareholder meeting. So I can't really comment too specifically on what that's going to look like. But, you know, certainly as the board evaluated the proposal, they, you know, certainly took into consideration what they felt was best for stockholders as well as other stakeholders.

Okay. And I guess, you know, maybe closely related to that and understanding that there may be additional proposals that might come up how far are you willing to stretch leverage in any type of acquisition? What's your comfort level would be another way of stating it.

That's something that I'm really not able to comment on because that would be really a decision that would be made by a buyer. Okay. All right. I just really can't comment on that.

Okay. I can appreciate the constraints. I thank you for what you can provide.

All right, great. Thanks, Bill.

There are no further questions at this time. I would now like to turn the call over to Mr. Dan Knotts.

Great. Thank you again, everyone, for joining today's call. This excitement around what's coming for R&D as we continue to march forward with our strategy, the announced acquisition by Atlas, we believe will further advance our strategic objective of helping our clients better connect with their customers, and we look forward to partnering with Atlas to drive value. To our employees at R&D, thank you for continuing to prioritize the important work we are providing for our clients and the outstanding performances of every single day. Thanks again, everyone, and have a great day. Johan, back to you.

Thanks, Dan. As a reminder, information to access the webcast replay of RRD's third quarter 2021 results can be found on the investors section of our website at rrd.com. Thank you for joining us, and that concludes the RRD third quarter 2021 earnings call.