Bankruptcy - A Donnelley Tradition
Glen is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
The Blame Game and Recent Headlines
When Google blamed R.R. Donnelley & Sons (NASDAQ: RRD) for pre-releasing their 8-K ahead of schedule, I decided to investigate. I have previously covered the side of the coin where Google doesn't have enough debt in my post Google - A Story of Bad Debt Management. Google's bad debt management is actively preventing equity shareholders from having 40% higher market capitalization than they have today. R.R. Donnelley & Sons presently has around a 10% dividend yield.
R.R. Donnelley & Sons - Cut Your Dividend Before Your Investors Cut You
At first glance, the 10% dividend yield might seem sustainable. The company has around $500M of FCF and is annually paying around $187.5M in dividends at their present dividend rate. That means that their payout ratio is 37.5%. Feel free to argue till you are blue in the face that this is sustainable. The fact remains, that you are blue in the face and you are wrong. You are wrong because you are not looking at the principal repayment schedule or the fact that management is choosing to keep the dividend at the expense of their credit ratings. This is bad. As an investor, it is my obligation to cut poor investment opportunities from my portfolio and if management continues to make bad capital allocation decisions I become increasingly confident in my analysis that creditors will have a field day taking over.
Please take a look at page 26 - their debt Maturity Profile - of their August 2012 investor presentation - below
The first thing that you'll notice is that the company is now stacking up its principal repayments in 2018 and 2019 larger than their Free Cash Flow. Also note that the company as recently as March 13 created the debt that comes due in 2019. The yield on their debt due in 2019 per their report above is 9.29%. That implies that their credit rating is poorly rated. Some would call these bonds junk bonds. I would say that the company is purposely being foolish with their cash flows. They are choosing to pay out a small portion of their free cash flow to equity owners today at the risk of what will be a Chapter 11 filing in a few years. Here is how it works.
When companies are stupid with their cash flow, lenders become less willing to loan money to them. Their willingness to lend is reflected in the interest rate that the company pays on its debt. As you can tell from their most recent debt financing compared to their other sets of notes, lenders are becoming increasingly skeptical. In fact, the interest rates that the company is paying in order to continue their dividend are setting off my fire alarms. This is not in line with mine and Ben Graham's expectation that management is operating under the framework that the optimum capitalization structure for any enterprise includes senior securities to the extent that they may be safely issued and bought for investment. Junk rated debt is not categorizable as "safely issued."
Keep Paying That Dividend and Risk Insolvency
Continuing to pay out the dividend is to ignore that they could face insolvency when it is clear that the principal repayments in 2018-2019 exceed their annual free cash flow. To do so at this point in the game is to choose to do so. This is a choice that I see as purposeful ignorance. The net result is that the bondholders could at some point in the game refuse to refinance the debt and force a recapitalization altogether - taking over ownership of the company. This would leave shareholders with their few bucks in dividends and that's all folks.
I've seen this before, the most recent of which is in the industry of Phone Books, where in aggregate all players were not focusing on principal repayment but instead was focusing on refinancing. Sure, the cash flow is there, but just because the cash flow is there does not prevent the company from defaulting on its equity obligations. Here are two examples: 1 and 2. History tends to repeat itself. I strongly recommend that anyone who owns R.R. Donnelley and Sons sells today and does not buy back until the dividend is cut and the company puts out a memo that it is their fiduciary responsibility to see to it that their credit ratings are investment grade before they begin issuing a dividend and further that if the price of the stock drops to a certain point then they would prefer to buy-back stock than pay out a dividend.
The Good News - What If They Cut Their Dividend to $0 Until They Have Better Credit Ratings?
The good news is that there is good news. R.R. Donnelley and Sons is undervalued if they aren't facing a recapitalization scenario. With FCF of $500M per year at present, I think that there is a lot of future money to be saved if they can pay down their debt until it is highly rated again. Until then, their target leverage of 2.5x-3.0x is too risky. The debt situation is a few steps away from being a real problem and the fact that management is choosing to continue to pay out a pretty hefty dividend knowing that they are doing so at the cost of higher interest rates is a fact that cannot go unnoticed by any investor who requires the return of their investment as well as the return on their investment.
I believe that if they cut their dividend, the company is worth $17+. Further, I'd like to see principal repayments starting on their most expensive debt. If the stock remains cheap and the company's leverage comes down, I'd recommend stock buybacks as opposed to dividends at these levels. Until they cut their dividend, this company is overvalued and is worth a speculative $10. You as the investor need to recognize that the company is walking the fine line of future insolvency for that juicy dividend today though and that you might find that your dividends paid will be less than your principal loss given the present course of events.
Bankruptcy Isn't Always Bad - Enter R. H. Donnelley Company - Now Dex One - Soon to Be Dex Media
R. H. Donnelly Company filed for bankruptcy in June 2009. The equity was effectively worthless. In February 2010, R. H. Donnelley Corporation emerged from bankruptcy as Dex One Corporation (NYSE: DEXO). Guess who is likely heading back for another round of bankruptcy? Dex One. If you are paying attention, this doesn't appear to be the standard bankruptcy scenario that they filed in June 2009 where the equity interests get nothing. This time, bankruptcy is being framed as a tool to force a refinancing of their principal debt repayments to effect the merger with SuperMedia (NASDAQ: SPMD). I am actually a huge fan of the pre-packaged bankruptcy that Dex One and SuperMedia both describe in their SEC filings here and here that I will summarize.
In summary, the merger agreement requires approval of 100 percent of both companies' lenders. Seeing as how 100% appears to be off the table at this point in the negotiations, a pre-pack Chapter 11 bankruptcy requires a majority of the lenders to be on board (66%). 66% is less than 100% and since they can't get 100% and it appears that they have a majority on board, the pre-pack Chapter 11 is the way to go.
The intent of this pre-pack as it is being pursued today is to basically pursue the merger agreement as it has been proposed earlier with the equity interests remaining intact. As a shareholder myself, "Yay!" It is truly a rare occurrence to see bankruptcies where the equity interests remain intact. Frankly, this is a situation that should be bought into and I own personally. I am a fan of the merger and believe that the upside is huge. The market capitalization to free cash flow ratio is presently less than 0.15. It is my perception that soon the market will realize that this company is solvent and profitable as the rate of revenue will slow and eventually I would expect the market cap to FCF multiple of 0.15x to expand past 4x. Even if this happens after a loss of 50% of the free cash flow across the next 5 years --- you still just made over 1000% return. The thesis here is that the worst case scenario is already priced in. The worst case scenario that is priced in seems to include unrelenting declines in print revenue and some pretty extreme dilution at some point in the next 5 years. Anything better than that should make equity owners a fortune. I'm personally betting against the prevailing pessimism and am long the equity.
Bankruptcy - A Donnelley Tradition
I am not terribly certain that Richard Robert Donnelley would be terribly happy with his family name being associated with bankruptcy, but it's better to have and to have lost than to never have at all. R.R. Donnelley should cut their dividend and focus on paying down their debt before they are forced to file for bankruptcy and Dex One should pursue the non-dilutive pre-pack Chapter 11 bankruptcy that is being discussed and merge with SuperMedia. One thing is constant and an unavoidable conclusion at this point. Bankruptcy --- it's a Donnelley tradition!
bradford86 does not own R.R. Donnelley & Sons Company but would like to establish a position in the even that management starts attacking their debt. Glen does own Dex One and SuperMedia and is in full support of the Pre-Pack Chapter 11 as he understands it. The Motley Fool has no positions in the stocks mentioned above. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.