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RR Donnelley & Sons Co – ‘10-K405’ for 12/31/98

As of:  Wednesday, 3/31/99   ·   For:  12/31/98   ·   Accession #:  950131-99-2019   ·   File #:  1-04694

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  As Of                Filer                Filing    For·On·As Docs:Size              Issuer               Agent

 3/31/99  RR Donnelley & Sons Co            10-K405    12/31/98    9:760K                                   Donnelley R R & S… 03/FA

Annual Report — [x] Reg. S-K Item 405   —   Form 10-K
Filing Table of Contents

Document/Exhibit                   Description                      Pages   Size 

 1: 10-K405     Annual Report -- [x] Reg. S-K Item 405                45    250K 
 2: EX-3.(II)(A)  By-Laws                                             19     75K 
 3: EX-3.(II)(B)  Amend. to By-Laws Adopted 1-28-99                    1      7K 
 4: EX-4.(D)    Five-Year Credit Agmt. Dtd. 12-11-1998               112    414K 
 5: EX-4.(E)    364-Day Credit Agmt.                                 112    420K 
 6: EX-12       Comp. of Ratio of Earnings                             1      6K 
 7: EX-21       Subsidiaries                                           2     12K 
 8: EX-23       Consent of Accountants                                 1      7K 
 9: EX-27       Financial Data Schedule                                2      7K 


10-K405   —   Annual Report — [x] Reg. S-K Item 405
Document Table of Contents

Page (sequential) | (alphabetic) Top
 
11st Page   -   Filing Submission
3Item 1. Business
6Item 2. Properties
"Item 3. Legal Proceedings
"Item 4. Submission of Matters to a Vote of Security Holders
7Executive Officers and Other Principal Officers of R.R. Donnelley & Sons Company
8Item 5. Market for Registrant's Common Equity and Related Stockholder Matters
"Item 6. Selected Financial Data
"Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations
15Year 2000
17Item 7A. Quantitative and Qualitative Disclosures about Market Risk
"Item 8. Financial Statements and Supplementary Data
"Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
"Item 10. Directors and Executive Officers of the Registrant
"Item 11. Executive Compensation
"Item 12. Security Ownership of Certain Beneficial Owners and Management
"Item 13. Certain Relationships and Related Transactions
18Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K
19Signatures
20Item 14(a). Index to Financial Statements and Financial Statement Schedules
25Notes to Consolidated Financial Statements
"Summary of Significant Accounting Policies
26Businesses Held for Sale
28Inventories
31Income taxes
35Net income
36Shareholder Rights Plan
37Industry Segment Information
40Report of Independent Public Accountants
41Unaudited Interim Financial Information, Dividend Summary and Financial Summary
42Report of Independent Public Accountants on Financial Statement Schedule
43Valuation and Qualifying Accounts
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------------------------------------------------------------------------------- ------------------------------------------------------------------------------- UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D. C. 20549 FORM 10-K [X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the fiscal year ended December 31, 1998 OR [_] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from to ------------ ---------- Commission file number 1-4694 R. R. DONNELLEY & SONS COMPANY (Exact name of registrant as specified in its charter) Delaware 36-1004130 (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 77 West Wacker Drive, Chicago, Illinois 60601 (Address of principal executive (ZIP Code) offices) Registrant's telephone number--(312) 326-8000 Securities registered pursuant to Section 12(b) of the Act: Title of each Class Name of each exchange on which registered ----------------------------- ---------------------------------------------- Common (Par Value $1.25) New York, Chicago and Pacific Stock Exchanges Preferred Stock Purchase Rights New York, Chicago and Pacific Stock Exchanges Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to the filing requirements for the past 90 days. Yes X No Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information state- ments incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. [X] As of January 31, 1999, 133,657,005 shares of common stock were outstanding, and the aggregate market value of the shares of common stock (based on the closing price of these shares on the New York Stock Exchange--Composite Trans- actions on January 31, 1999) held by nonaffiliates was $4,795,177,263. DOCUMENTS INCORPORATED BY REFERENCE Portions of the registrant's definitive Proxy Statement dated February 18, 1999, are incorporated by reference into Part III of this Form 10-K. ------------------------------------------------------------------------------- -------------------------------------------------------------------------------
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TABLE OF CONTENTS [Download Table] Form 10-K Item No. Name of Item Page --------- ------------ ---- Part I Item 1. Business................................................. 3 Item 2. Properties............................................... 6 Item 3. Legal Proceedings........................................ 6 Item 4. Submission of Matters to a Vote of Security Holders...... 6 Executive Officers and Other Principal Officers of R.R. Donnelley & Sons Company................................ 7 Part II Item 5. Market for Registrant's Common Equity and Related Stockholder Matters..................................... 8 Item 6. Selected Financial Data.................................. 8 Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations..................... 8 Item 7A. Quantitative and Qualitative Disclosures about Market Risk.................................................... 17 Item 8. Financial Statements and Supplementary Data.............. 17 Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure..................... 17 Part III Item 10. Directors and Executive Officers of the Registrant....... 17 Item 11. Executive Compensation................................... 17 Item 12. Security Ownership of Certain Beneficial Owners and Management.............................................. 17 Item 13. Certain Relationships and Related Transactions........... 17 Part IV Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K................................................ 18 Signatures............................................... 19 Index to Financial Statements and Financial Statement Item 14(a). Schedules............................................... F-1 Index to Exhibits........................................ E-1 2
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PART I ITEM 1. BUSINESS Industry and Company Overview R.R. Donnelley & Sons Company is the largest commercial printer in North America. Our company is a leading provider of printing and related services to the merchandising, magazine, book, directory, financial and healthcare markets. We use our superior skills, scale and technology to deliver solutions that effectively meet our customers' needs. Our common stock (DNY: NYSE) has been publicly traded since 1956. Today, the company has approximately 31,000 employees working in our core printing operations on four continents. We have 49 manufacturing plants with a broad range of capabilities to serve our customers' needs. While 91% of our revenue is generated in the United States, we have extended our core competencies into selected international markets. Commercial printing in the United States is a large and fragmented industry, and includes more than 50,000 firms that employ more than one million people and generate approximately $150 billion in annual revenue. The segment of commercial printing that we serve generates approximately $80 billion in annual revenue. Within this segment, we have leadership positions in all five of our end markets: . Merchandise Media ($1.3 billion, or 26% of 1998 consolidated net sales), serving the consumer and business-to-business catalog, retail insert and direct mail markets; . Magazine Publishing Services ($1.2 billion, or 23% of 1998 consolidated net sales), serving the consumer, trade and specialty magazine markets; . Telecommunications ($822 million, or 16% of 1998 consolidated net sales), serving the global directory needs of telecommunications providers; . Book Publishing Services ($742 million, or 15% of 1998 consolidated net sales), serving the trade, children's, religious and educational book markets; and . Financial Services ($532 million, or 11% of 1998 consolidated net sales), serving the communication needs of the financial markets and healthcare industry. In addition to our U.S. operations, we operate in Mexico, South America, Europe and China. For reporting purposes, revenues from our international facilities primarily serving the directory market are reported within Telecommunications. Revenues from our two Mexico facilities that primarily serve the magazine market are reported within Magazine Publishing Services. Our third Mexico facility serves the book market and is reported within Book Publishing Services. Revenues from other international facilities serving more than one market are included in "Other." The "Other" classification also includes net sales from R.R. Donnelley Logistics Services (DLS), our logistics and distribution operation. DLS serves our print services customers and others by consolidating and sorting mail so that it is delivered to the postal system closer to the final destination, resulting in reduced postage costs and improved on-time delivery. Additionally, DLS delivers magazine newsstand, newspaper inserts and financial services products. Finally, revenue from Stream International Inc., which provides technical and help-line computer support to its customers, is included in "Other." While our printing plants are geographically diverse, the supporting technologies and knowledge base are shared. Our 49 plants have a range of production capabilities to serve the five basic commercial print markets outlined earlier. We manufacture products for these markets with the operational goal of optimizing the efficiency of our common manufacturing platform. As a result, most plants produce work for customers in two or three of our end markets. Commercial printing remains a competitive industry. Consolidation among our customers and in the printing industry has put pressure on prices and increased competition among printers. We expect these industry trends to continue. We will manage these trends by leveraging our market-leading position, streamlining our costs and enhancing the value we deliver to our customers. 3
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A significant portion of our sales are under contract with customers, with the remainder on a single-order basis. For some customers, we print and provide related services for different publications under different contracts. Contracts with our larger customers normally run for a period of years (usually three to five years, but longer in the case of contracts requiring significant capital investment) or for an indefinite period subject to termination on specified notice by either party. These sales contracts generally provide for price adjustments to reflect price changes for materials, wages and utilities. No single customer has a relationship with the company that accounted for 10% or more of our sales in 1998. In each of the fiscal years ended December 31, 1998, 1997 and 1996, international operations represented less than 9% of consolidated net sales, less than 6% of earnings from operations (excluding 1997 and 1996 restructuring charges) and less than 15% of consolidated assets. The various markets of the commercial printing industry in which we are involved are highly competitive. While we have contracts with many of our customers as discussed above, there are many competing companies and renewal of these contracts is dependent, in part, on our ability to continue to differentiate ourself from the competition. Differentiation results, in part, from our broad range of value-added services, which include: conventional and digital preproduction, computerized printing, Selectronic(R) imaging and gathering, and sophisticated pool shipping and distribution services for printed products; information content repackaging into multiple formats, including print, magnetic and optical media; and graphic design and editorial services. Although we believe we are the largest commercial printer in the United States, we estimate that our revenues represent approximately 6% of total sales of the portion of the commercial print industry which we serve. While our plants are well located for the global, national or regional distribution of our products, competitors in some areas of the United States have a competitive advantage in some instances due to such factors as freight rates, wage scales and customer preference for local services. In addition to location, other important competitive factors are price and quality, as well as the range of available services. The primary raw materials we use are paper and ink. In 1998, we spent approximately $1.9 billion on raw materials. We are a large purchaser of paper and our focus is to improve materials performance and total cost management for our customers, which we believe is a competitive advantage. We negotiate with leading suppliers to maximize our purchasing efficiencies, but we do not rely on any one supplier. We have existing paper supply contracts (at prevailing market prices) to cover substantially all of our requirements through 1999; and management believes extensions and renewals of these purchase contracts will provide adequate paper supplies in the future. Ink and ink materials are currently available in sufficient amounts, and we believe that we will have adequate supplies in the future. We also coordinate purchasing activity at both the local plant and corporate levels to increase economies of scale. Our overriding principles in the environmental arena are to create sustainable compliance and an injury-free workplace. Our estimated capital expenditures for environmental controls to comply with federal, state and local provisions, as well as expenditures, if any, for our share of costs to clean hazardous waste sites that have received our waste, will not have a material effect upon our earnings or our competitive position. As of December 31, 1998, we had 31,000 employees in our core printing operations, of whom more than 9,400 had been our employees for 10 to 24 years and more than 3,300 for 25 years or longer. As of December 31, 1998, we employed approximately 26,700 people in the United States, approximately 1,335, or 5%, of whom were covered by collective bargaining agreements. In addition, we employed approximately 4,300 people in our foreign operations, 27% of whom were covered by collective bargaining agreements. We announced two small strategic acquisitions in 1998. In October, we purchased Ediciones Eclipse S.A. de C.V., a Mexico City-based printer of retail inserts. In December, we purchased GTE's St. Petersburg, Florida, directory-printing plant. In addition, we increased our investment in two other international operations. In July, we purchased additional outstanding shares of Editorial Lord Cochrane S.A., the largest printer in Chile, to increase our ownership position to 78% from 55%. In November, we purchased the interests of our partner in our Poland operation, the Polish-American Printing Company, to take 100% ownership. 4
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Stream, CS&T, and MMI In April 1995, our Global Software Services business merged with Corporate Software, Inc. to form Stream International Holdings, Inc. (SIH). We owned approximately 80% of SIH, which included three business units: . Stream International--technical and help-line support, . Corporate Software & Technology--licensing and fulfillment, customized documentation, license administration and user training, and . Modus Media International--software replication, documentation, and kitting and assembly. In December 1997, SIH was reorganized into three separate businesses. Our interest was restructured so that we currently own 87% of the common stock of Stream International Inc., 86% of the common stock of Corporate Software & Technology Holdings, Inc. (CS&T) and non-voting, preferred stock of Modus Media International Holdings, Inc. (MMI). As a result of the restructuring of our interests in the businesses and our intention to dispose of our interest in CS&T in 1998, we had reclassified our interests in CS&T and MMI as discontinued operations. We now expect to sell our interest in CS&T in 1999. Because the sale of CS&T did not occur in 1998 as originally intended, we have eliminated the discontinued operations presentation and restated prior years' financial results to include previously discontinued operations in our earnings from operations. The "Loss from operations of businesses held for sale" on the income statement includes our pre-tax operating losses and pre-tax restructuring and impairment charges related to these previously discontinued operations. In 1998, the "Loss from operations of businesses held for sale" reflects an $80 million impairment charge (with no associated tax benefit) related to the write-down of CS&T goodwill. In 1997, operating results of CS&T and MMI are reflected through the December restructuring. Also, in 1997, we recorded a $100 million ($60 million after-tax) provision to adjust the carrying values of CS&T and MMI to their estimated net realizable values. In 1996, the $123 million loss ($86 million after-tax) reflects a small operating loss from CS&T and MMI and two restructuring charges totaling $119 million ($61 million after-tax) related to the repositioning of MMI and CS&T's worldwide operations and the restructuring of their software, printing, kitting and fulfillment operations. The financial results of Stream International Inc. are reported in our consolidated results. The net assets of CS&T are included as "Net assets of businesses held for sale" in the year-end balance sheet presentation. The non- voting preferred stock in MMI is included in other non-current assets. Special Note Regarding Forward-Looking Statements. Our Annual Report to Shareholders and this Form 10-K are among certain communications that contain forward-looking statements, including statements regarding our financial position, results of operations, market position, product development, regulatory matters and Year 2000 compliance. Our expectation to be Year 2000 compliant in a timely manner and at the costs described could be adversely affected by several factors, including our ability to attract and retain trained personnel or third-party suppliers in this area, the costs to do so, and the ability to identify and correct systems or applications that require remediation. Our failure to achieve Year 2000 compliance or the failure of our key suppliers, vendors or customers to achieve Year 2000 compliance in a timely manner could have a material adverse effect on the company. In addition, when used in such communications, the words "believes," "anticipates," "expects" and similar expressions are intended to identify forward-looking statements. These forward-looking statements are based on our estimates, assumptions, projections and current expectations and are subject to a number of risks and uncertainties. Actual results in the future could differ materially from those described in the forward-looking statements as a result of many factors outside our control, including competition with other printers based on pricing and other factors, fluctuations in the cost of paper and other raw materials we use, changes in postal rates, seasonal fluctuations in overall demand for printing, changes in customer demand, changes in the advertising and printing markets, changes in the capital markets that affect demand for commercial printing, the financial condition of our customers, the general condition of the United States economy, changes in the rules 5
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and regulations to which we are subject, including environmental regulation, and other factors set forth in this Form 10-K and other company communications generally. We do not undertake and specifically decline any obligation to publicly release the results of any revisions to these forward-looking statements that may be made to reflect any future events or circumstances after the date of such statements or to reflect the occurrence of anticipated or unanticipated events. ITEM 2. PROPERTIES Our corporate office is located in a leased office building in Chicago, Illinois. In addition, we lease or own 51 U.S. facilities, including manufacturing plants, which may have multiple facilities and warehouses. These facilities encompass approximately 17.8 million square feet. We have nine plants encompassing approximately 1.2 million square feet in South America, Europe and Asia. Of the total manufacturing and warehouse facilities, approximately 17.1 million square feet of space is owned, while the remaining 1.9 million square feet of space is leased. In addition, we have sales offices across the United States, South America, Europe and Asia. ITEM 3. LEGAL PROCEEDINGS In November, 1996, a purported class action was brought against the company in federal district court in Chicago, Illinois on behalf of current and former African-American employees, alleging that the company racially discriminated against them. The complaint seeks declaratory and injunctive relief, and asks for actual, compensatory, consequential and punitive damages in an amount not less than $500 million. Although the plaintiffs seek nationwide class certification, most of the specific factual assertions of the complaint relate to the closing of our Chicago catalog operations in 1993. Other general claims relate to other company locations. In February, 1999, the magistrate judge ruled that all claims relating to the Chicago catalog operations were untimely. Plaintiffs have appealed this ruling. If the ruling of the magistrate judge is upheld, the claims relating to other locations will still be pending as is plaintiffs' motion for class certification. In December, 1995, a class action was filed against the company in federal district court in Chicago, Illinois alleging that older workers were discriminated against in selection for termination upon closing of the Chicago catalog operations. The suit also alleges that we violated the Employee Retirement Income Security Act (ERISA) in determining benefits payable to retiring or terminating employees. In August, 1997, the court certified classes in each of the age discrimination and ERISA claims limited to former employees of the Chicago operation. In June, 1998, a purported class action was filed against the company in federal district court in Chicago, Illinois on behalf of current and former African-American employees, alleging that the company racially discriminated against them. While making many of the same general discrimination claims contained in the 1996 case, the plaintiffs in this case also claim retaliation by the company for filing discrimination charges or otherwise complaining of race discrimination. The complaint seeks the same relief and damages as sought in the 1996 case. The 1996 and 1995 cases relate primarily to the circumstances surrounding the closing of the Chicago catalog operations. The company believes that it acted properly in the closing of the operations. The company also believes that it has a number of valid defenses to all of the claims made and it will vigorously defend its actions. However, because the cases are in the preliminary stages, management cannot make a meaningful estimate of any loss that could result from an unfavorable outcome of any of the pending cases. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matters were submitted to a vote of security holders during the quarter ended December 31, 1998. 6
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EXECUTIVE OFFICERS AND OTHER PRINCIPAL OFFICERS OF R. R. DONNELLEY & SONS COMPANY [Download Table] Name, Age and Officer Business Experience During Positions with the Company(1) Since Past Five Years(2) ----------------------------- ------- -------------------------- Haven E. Cockerham, 1998 Management responsibilities for 51, Senior Vice President, Compensation; Benefits; Employee Human Resources Relations, Diversity and Corporate Human Resources; Recruiting; and Management and Organizational Development. Prior experience as Vice President, Human Resources, at Detroit Edison Company, a provider of electrical utilities, and as President, Cockerham, McCain & Associates, Inc., a provider of management consulting services. William L. Davis 1997 Management responsibilities as 55, Chairman of the Chairman of the Board and Chief Board and Chief Executive Officer. Prior experience Executive Officer(1) as Senior Executive Vice President at Emerson Electric Company, manufacturer of electrical, electronic and related products. James R. Donnelley 1983 Management responsibilities as Vice 63, Director, Vice Chairman of the Board and for Chairman of the Board Corporate Communication, Community Relations and Government Affairs. Prior management responsibility for Corporate Development. Monica M. Fohrman 1988 Management responsibilities for Legal 49, Senior Vice President, Department and Secretary's Office. General Counsel and Secretary(1) Cheryl A. Francis 1995 Management responsibilities for 45, Executive Vice President Corporate Development, Investor and Chief Financial Officer(1) Relations, Treasury, Financial Reporting and Accounting, Real Estate, Internal Audit and Taxes. Prior management responsibilities for Purchasing. Prior experience as Treasurer at FMC Corporation, a diversified manufacturer of chemicals and machinery. Gary L. Sutula, 1997 Management responsibilities for 54, Senior Vice President Technology Planning and Operations; and Chief Information Officer Applications Solutions Delivery; and the Year 2000 Program. Prior experience as Senior Vice President and Chief Information Officer at Transamerica Financial Services, a provider of international consumer lending services. Jonathan P. Ward 1985 Management responsibilities for 43, President and Merchandise Media, Magazine Chief Operating Officer(1) Publishing Services, Telecommunications, Financial Services, Book Publishing Services, Worldwide Procurement, Donnelley Logistic Services and International Operations. Prior sales and manufacturing responsibility for Merchandise Media and Financial Services. Michael W. Winkel 1999 Management responsibilities for 53, Executive Strategy Planning. Prior experience Vice President, Strategy(1) as Corporate Vice President responsible for corporate planning and global operations at Monsanto Company, a diversified manufacturer of chemicals, pharmaceuticals and agricultural products. -------- (1) Executive officer of the Company. (2) Each officer named has carried on his or her principal occupation and employment in the company for more than five years with the exception of Haven E. Cockerham, William L. Davis, Cheryl A. Francis, Gary L. Sutula, and Michael W. Winkel as noted in the table above. 7
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PART II ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The common stock is listed and traded on the New York Stock Exchange, Chicago Stock Exchange and Pacific Exchange, Inc. As of January 29, 1999, there were 9,695 stockholders of record. Information about the quarterly prices of the common stock, as reported on the New York Stock Exchange-Composite Transactions, and dividends paid during the two years ended December 31, 1998, is contained in the chart below: [Download Table] Common Stock Prices ------------------------------------ Dividends Paid 1998 1997 ----------- ------------------- ---------------- 1998 1997 High Low High Low ----- ----- --------- --------- -------- ------- First Quarter.................. $0.20 $0.19 $42 1/8 $35 1/8 $36 7/8 $29 5/8 Second Quarter................. 0.20 0.19 46 1/4 42 1/16 39 3/4 32 5/8 Third Quarter.................. 0.21 0.20 47 3/4 34 13/16 41 1/16 34 3/8 Fourth Quarter................. 0.21 0.20 44 11/16 34 37 5/8 32 5/8 Full Year...................... 0.82 0.78 47 3/4 34 41 1/16 29 5/8 ITEM 6. SELECTED FINANCIAL DATA SELECTED FINANCIAL DATA (Not Covered by Auditors' Report) (Thousands of dollars, except per-share data) [Download Table] 1998 1997 1996 1995 1994 ---------- ---------- ---------- ---------- ---------- Net sales............... $5,018,436 $4,892,944 $5,063,821 $5,080,775 $4,227,496 Net income (loss)*...... 294,580 130,631 (157,625) 298,793 268,603 Net income (loss) per common share*.......... 2.08 0.89 (1.04) 1.92 1.73 Total assets............ 3,787,819 4,134,166 4,443,828 5,030,680 4,318,787 Non-current liabilities. 1,588,641 1,730,047 2,044,818 2,012,635 1,669,984 Cash dividends per common share........... 0.82 0.78 0.74 0.68 0.60 -------- * Net income (loss) includes the following one-time items: 1998 gains on the sale of the company's remaining interest in two former subsidiaries of $169 million ($101 million after-tax, or $0.71 per diluted share) and loss from operations of businesses held for sale of $80 million (with no associated tax benefit, or $0.56 per diluted share); 1997 restructuring and impairment charges of $71 million ($42 million after-tax, or $0.29 per diluted share) and loss from operations of businesses held for sale of $114 million ($76 million after-tax, or $0.51 per diluted share); 1996 restructuring and impairment charges of $442 million ($374 million after taxes and minority interest, or $2.45 per diluted share), gains on partial divestiture of subsidiaries of $80 million ($48 million after-tax, or $0.31 per diluted share) and loss from operations of businesses held for sale of $123 million ($86 million after-tax, or $0.56 per diluted share). ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Operating Results One-Time Items--We refer to the following one-time items throughout Management's Discussion and Analysis of Operations: 1998 reported net income included: . a gain on the sale of our remaining interest in Metromail Corporation of $146 million ($87 million after-tax), . a gain on the sale of our remaining interest in Donnelley Enterprise Solutions Incorporated (DESI) of $23 million ($14 million after-tax), and 8
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. a loss from operations of businesses held for sale of $80 million (with no associated tax benefit). 1997 reported net income included: . a restructuring and impairment charge of $71 million ($42 million after- tax), and . a loss from operations of businesses held for sale of $114 million ($76 million after-tax). 1996 reported net income included: . a gain on the initial public offering of Metromail of $44 million ($26 million after-tax), . a gain on the initial public offering of DESI of $36 million ($22 million after-tax), . a restructuring and impairment charge of $442 million ($374 million after taxes and minority interest benefit), and . a loss from operations of businesses held for sale of $123 million ($86 million after-tax). Highlights--Excluding one-time items, 1998 net income rose to $273 million, or $1.93 per diluted share, from $249 million, or $1.69 per diluted share, a year ago. The improved results primarily reflect the benefits of our productivity initiatives. Including one-time items, in 1998 we earned $295 million in net income compared with $131 million in 1997. Excluding one-time items, the $92 million earned in the fourth quarter of 1998 compares with $88 million in the same period of 1997. On a diluted per- share basis, adjusted earnings were $0.67 in this fourth quarter compared with $0.60 in the fourth quarter of 1997. Including one-time items, the $92 million earned in the fourth quarter of 1998 compares with a net loss of $9 million in the fourth quarter of 1997. In the fourth quarter of 1997 we recognized the $71 million ($42 million after-tax) restructuring and impairment charge referred to above and the loss from operations of businesses held for sale that included a $100 million ($60 million after-tax) provision to adjust the carrying values of CS&T and MMI. Excluding one-time items, 1996 net income was $255 million, or $1.66 per diluted share. Including one-time items, the net loss was $158 million. Revenue Net sales in 1998 were $5.0 billion, up 2.6% from 1997's net sales of $4.9 billion. Value-added revenue, or net sales less the cost of materials (primarily paper and ink), was $3.1 billion, up 3.8% from 1997. Volume in most of our markets was higher than a year ago. During most of 1998, we benefited from strong magazine advertising; high consumer confidence, which created more demand for catalogs and retail inserts; and strong capital markets. Also, a directory customer moved production from late 1997 into early 1998. These favorable factors were partially offset by lower book sales as the industry continued to work through inventory management issues. Pricing pressure continued in many of our markets, but to a lesser degree than in past years as we continue to differentiate our services. In addition to the growth in sales from a year ago, the composition of revenue was also more favorable. Compared with last year, fewer pass-through sales, or sales of materials and services purchased on our customers' behalf, reduced revenue in 1998 but enhanced margins. Lower paper prices and reduced paper sales to some customers, where our markup for buying the paper for the customer did not cover our costs of financing and storage, resulted in lower pass-through revenue. In addition, we encouraged some customers to buy services directly from third parties rather than through us at a slight markup. With these changes, both the sales and expense are no longer recorded in our financial results. These factors primarily affected Merchandise Media. While net sales were down in Merchandise Media compared with last year, value- added revenue increased. 9
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Net sales for 1996 were 3.5% higher than 1997 but included revenue from Metromail and DESI ($206 million), which were consolidated at that time due to our ownership interest, as well as our discontinued commercial printing operations in the United Kingdom ($59 million). Despite 1997's sales being lower than in 1996, value-added revenue was essentially equal to 1996 levels. Expenses Gross profit in 1998 grew by $108 million. This 11% increase over 1997 came from our focus on productivity initiatives, as well as higher volume. Gross profit as a percentage of sales improved to 21.1% in 1998 compared with 19.4% in 1997. The gross profit ratio in 1996 was 19.2%. Our cost of materials in both 1998 and 1997 was $1.9 billion compared with $2.1 billion in 1996. The primary raw materials we use are paper and ink. Because the price of paper can be volatile, in periods of rising prices the company's revenues and costs for materials increase; in periods of falling prices, revenues and material costs decline. The company purchases or customers supply paper used in the printing process. Customer-supplied paper is reflected in neither our revenues nor cost of materials. If we purchase paper for the customer, we recover the cost as a pass-through cost, at a margin that is lower than the margin we earn for printing and related services. In 1998, the price of paper for grades employed in our manufacturing process declined approximately 6% from the prior year due to oversupply and price competition. We reduced the amount of paper purchased on behalf of customers in selected cases where the markup recovered on the paper did not cover our associated costs. In 1997, the cost of paper ranged from 5% to 10% per short ton higher than 1996 prices. Our results also are affected by the price of scrap (by-product) paper, which we sell. In 1997, the company began to record income from the sale of by-products as a recovery of the cost of materials and reclassified prior-year financial results to more accurately reflect the impact of by-products on operations. In 1998, by-products recovery increased by less than $1 million. In 1997, by-products recovery declined by $1 million from 1996. Selling and administrative expense increased by 11% to $570 million in 1998 compared with the prior year. In addition to volume-related increases and higher consolidated Stream International expenses, most of the increase was related to information systems-related expenditures. (See "Year 2000" discussion on page 15.) The ratio of selling and administrative expense to net sales was 11.4% in 1998 compared with 10.4% in 1997 and 10.2% in 1996. Operating earnings, excluding the loss from operations of businesses held for sale and the $71 million ($42 million after-tax) restructuring and impairment charge in 1997, increased by $49 million from a year ago to reach $488 million in 1998. The 11% increase reflects the company's focus on productivity in our core business. Operating margins, excluding the loss from operations of businesses held for sale and the 1997 restructuring and impairment charge, were 9.7% in 1998 compared with 9.0% in 1997 and 8.9% in 1996. Non-Operating Items Net interest expense for 1998 declined 14% to $78 million due to lower average debt balances associated with improvements in balance sheet management. In 1997, net interest expense declined 5% from the prior year to $91 million, reflecting lower average interest rates and lower average debt balances. Other income for 1998 decreased by $16 million to $10 million. The decline is due to non-recurring gains in 1997 on the sale of investments in our venture-capital portfolio. Other income for 1997 was $9 million higher than in 1996 due to lower corporate-owned life insurance expense, partially offset by lower gains on the sale of non-core investments. 10
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Events Affecting Comparability Restructuring/Impairment Charges Excluding Charges for Operations of Businesses Held for Sale--In December 1997, the company announced a $71 million ($42 million after-tax) restructuring and impairment charge related to the discontinuation of activities no longer aligned with our strategic focus, including: . the sale of our Coris content-management software operation, . the shutdown of our Crawfordsville, Indiana, book fulfillment operations, . the closing of a development office in Singapore, and . the development of certain manufacturing information systems. During 1996, the company recorded two restructuring charges--totaling $442 million ($374 million after taxes and minority interest benefit)--to restructure various operations and write down certain impaired assets, including equipment, intangibles and investments in non-core businesses. Approximately $195 million of the charge related to restructuring and realigning our gravure operations in North America, including the costs of closing facilities in Casa Grande, Arizona, and Newton, North Carolina. Approximately $122 million was related to other manufacturing restructuring, including: . discontinuing catalog and magazine printing in the United Kingdom, leading to the consolidation of two facilities into a single directory printing facility, . discontinuing book prepress operations in Barbados, and . consolidating a stand-alone book bindery in Scranton, Pennsylvania, into an existing facility. The remaining $125 million was for write-downs of equipment, intangibles and investments in non-core businesses in accordance with Statement of Financial Accounting Standards (SFAS) 121, Accounting for Impairment of Long-Lived Assets. Restructuring/Impairment Charges for Operations of Businesses Held for Sale--In the second quarter of 1998, the company recorded an $80 million impairment charge related to the write-down of goodwill on the books of CS&T. We did not recognize a tax benefit from this charge because we were unable to absorb the unrealized capital loss. In the fourth quarter of 1997, we recognized a $100 million ($60 million after-tax) provision to adjust the carrying costs of CS&T and MMI to their estimated net realizable values. (See "Stream, CS&T and MMI" discussion on page 5 for additional details.) In 1996, we recognized two restructuring charges to reposition the worldwide operations of CS&T and MMI that totaled $119 million ($61 million after taxes and minority interest benefit). In March 1996, we recorded an $86 million charge ($44 million after taxes and minority interest benefit), which included provisions for the closing of a plant in Wetherby, England, and MMI's Crawfordsville, Indiana, documentation printing and diskette replication operations. In July 1996, we took an additional $33 million charge ($17 million after taxes and minority interest benefit) to further restructure MMI's operations. Divestitures--Metromail, which had been wholly owned by the company, completed an initial public offering of its common stock in June 1996, which reduced our interest in Metromail to approximately 38%. In March 1998, Metromail entered into a merger agreement with The Great Universal Stores, P.L.C. (GUS), and we committed to sell our remaining interest in Metromail to GUS. In April 1998, we received approximately $297 million, or $238 million after-tax, for our remaining interest in Metromail. DESI, which had been wholly owned by the company, completed an initial public offering of its common stock in November 1996, which reduced our interest in DESI to approximately 43%. In May 1998, DESI entered into a merger agreement with Bowne & Co., Inc. (Bowne), and we committed to sell our remaining interest in DESI to Bowne. In July 1998, we received approximately $45 million, or $36 million after-tax, for our remaining interest in DESI. 11
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We used proceeds from the Metromail and DESI transactions to repurchase shares. (See "Share Repurchase" discussion below.) Corporate-Owned Life Insurance (COLI)--We have used COLI to fund employee benefits for several years. In 1996, the United States Health Care Reform Act eliminated the deduction for interest from loans borrowed against COLI programs. 1998 was the final year of the phase-out period for deductions. Without the COLI deduction, we anticipate a higher effective tax rate in 1999 and future years. The Internal Revenue Service (IRS), in its routine audit of the company, has disallowed the COLI interest deductions we claimed in our 1990 to 1992 tax returns. The company has challenged this position in a formal protest filed with the IRS Appeals division. We expect to resolve the issue eventually in a manner that does not materially affect our financial position and results of operations. Share Repurchase--In 1998, we purchased 13.2 million shares of our stock for approximately $544 million in open-market and privately negotiated transactions. These repurchases were part of two share repurchase programs we announced in 1998. In January 1998, the Board of Directors authorized the repurchase of up to $500 million of company stock, and in September the board authorized the repurchase of up to $300 million of additional company stock. These programs were authorized to be completed by December 1999; the first was completed in 1998. Both programs include shares purchased to issue under our various stock option plans. In 1997, we purchased approximately 2.3 million shares to issue under various stock option plans. The number of diluted shares outstanding as of December 31, 1997, was 147 million, while the full-year average number of diluted shares outstanding was 148 million. In 1996, we repurchased $250 million of common stock in addition to purchasing approximately 2.3 million shares to issue under various stock option plans. The number of diluted shares outstanding as of December 31, 1996, was 147 million, while the full-year average number of diluted shares outstanding was 154 million. Loss from Operations of Businesses Held for Sale--In 1998, the loss from operations of businesses held for sale was $80 million (with no associated tax benefit), or $0.56 per diluted share, which reflects the second-quarter impairment charge recorded to write down CS&T's goodwill. In 1997, the after- tax loss from operations of businesses held for sale was $76 million, or $0.51 per diluted share. This amount includes the $100 million ($60 million after- tax) provision to adjust the carrying values of CS&T and MMI to their net realizable values. In 1997, there were also $16 million in after-tax operating losses from CS&T and MMI. In 1996, the after-tax loss from operations of businesses held for sale was $86 million, or $0.56 per diluted share. This amount includes the two restructuring and impairment charges to reposition the worldwide operations of CS&T and MMI that totaled $119 million ($61 million after taxes and minority interest benefit). The 1996 loss also includes $25 million of after-tax operating losses related to CS&T and MMI. Cash Flow Operating Activities--The company's main source of liquidity is cash from operating activities. In 1998, cash provided from operating activities was $733 million, down slightly from 1997's $742 million, which was principally driven by the initial success of our program begun in 1997 to reduce working capital. The 1998 levels of working capital were lower than a year ago despite higher sales. The cash conversion cycle (days sales outstanding plus days inventory on hand minus days payables outstanding) continued to improve to 38 days from 43 days a year ago and 47 days in 1996. The ratio of working capital to sales has also continued to improve to 6.3% in 1998 from 8.0% in 1997 and 10.3% in 1996. 12
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Investing Activities--Our principal recurring investing activities are capital expenditures to improve our productivity of operations and to expand in specific markets. In 1998, capital expenditures totaled $225 million, a $135 million decline from 1997. Spending levels in 1998 reflect our disciplined investment process, which includes evaluating a broad range of alternatives, and our focus on productivity, which tends to emphasize less costly process-enhancement investments. In 1998, we also invested in some systems-related and other improvements that were expensed rather than capitalized. In 1999 and future years, we expect annual capital spending to increase to between $300 million and $350 million, still well below levels of recent years, reflecting the improved discipline and process supporting our investment activities. During 1998, we continued our initiative to sell operations and assets no longer aligned with our strategic priorities. In 1998, we generated $301 million net of taxes from these activities, which included selling our remaining interests in Metromail and DESI, in addition to $26 million associated with the sale of other assets. In 1997, we generated $51 million net of taxes from selling our interest in three European joint ventures and disposing of interests from our venture-capital portfolio. In 1996, the company generated, net of taxes, $277 million and $23 million from transactions related to its partial disposition of its ownership in Metromail and DESI, respectively, and an additional $32 million from other dispositions. During 1998, we increased our investment in two of our international operations. In July, we purchased additional outstanding shares of Editorial Lord Cochrane S.A., the largest printer in Chile, to increase our ownership position to 78% from 55%. In November, we purchased the interests of our partner in our Poland operation, the Polish-American Printing Company, to take 100% ownership. Previously, we owned 51%. These actions give us the ability to better control the future direction of these growing operations, which are strategically important. Results historically have been consolidated for both entities, as our ownership was higher than 50%. We announced two small, strategic acquisitions in 1998. In October, we purchased Ediciones Eclipse S.A. de C.V., a Mexico City-based printer of retail inserts. This acquisition complements our existing capabilities in nearby San Juan del Rio, Mexico, and makes us the largest commercial printer in this emerging country. In December, we purchased GTE's St. Petersburg, Florida, directory-printing plant. The agreement included a long-term contract to print certain GTE directories. This acquisition brings us important geographic and operating benefits by extending our core directory-printing capabilities into the southeastern United States. This allows us to reposition work within our U.S. operations and produce directories closer to final distribution points, simplifying logistics and accelerating delivery for directory publishers. Financing Activities--Financing activities include net borrowings, dividend payments and share repurchases. The company's net borrowings declined by $156 million in 1998, $226 million in 1997 and $160 million in 1996. The decline in 1998 was a result of strong working capital management, lower capital spending and cash generated from the disposition of assets no longer aligned with the company's strategic priorities, partially offset by share repurchase activity. Commercial paper is our primary source of short-term financing. On December 31, 1998, we had $122 million outstanding in commercial paper borrowing. In addition, at December 31, 1998, we had a $400 million unused revolving credit facility with a number of banks. This facility provides support for issuing commercial paper and other credit needs. Management believes the company's cash flow and borrowing capability are sufficient to fund its operations. Cash used to repurchase common stock, net of dispositions, was $457 million in 1998 (see "Share Repurchase" discussion on page 12). In 1997, $36 million of net cash was used to purchase common stock, primarily to cover options granted to employees. In 1996, $274 million of net cash was used to repurchase shares. Dividends to shareholders totaled $115 million in 1998, $115 million in 1997 and $113 million in 1996. 13
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Financial Condition--Our financial position remains strong as evidenced by our year-end balance sheet. Our total assets were $3.8 billion, $346 million lower than in 1997, due to the increased focus on managing capital. We have reduced capital expenditures through disciplined investing while more aggressively managing working capital and disposing of assets no longer aligned with our strategic focus. 1998 average invested capital (total debt and equity, less our investment in businesses held for sale, computed on a 12- month average) was $2.5 billion, a $197 million decline from 1997. Increased earnings, excluding one-time items, in conjunction with the decrease in invested capital, have contributed to a 150 basis point improvement in return on average invested capital to 12.9% in 1998. At year-end 1998, the debt-to-capital ratio increased to 45%, from 43% in 1997. The company's year-end debt-to-total-market-value decreased to 19% from 22% a year ago. Over long periods of time, our goal for an optimal capital structure is to manage this ratio within a range of 20% to 25%. Other Information Human Resources--As of December 31, 1998, approximately 31,000 full-time employees worked for the company in our core printing operations. Stream International employed another 5,300 people. In our core printing operations, approximately 86% of our employees work in the United States, and approximately 5% of those are covered by collective bargaining agreements. Of the approximately 4,300 people working in our international operations, 27% are covered by collective bargaining agreements. While the number of U.S. employees decreased slightly from a year ago, minority and female representation among professionals, officials and managers increased by 26% and 18%, respectively. Minority representation is now 12% among our U.S. professionals, officials and managers while female representation is now 34%. Minorities represent 14% of our U.S. workforce and females represent 33%. Technology--We remain a technology leader, investing not only in print- related technologies such as computer-to-plate, customer connectivity and digital imaging capabilities, but also in Internet-based business models, such as our SelectSource(R) and HouseNet(R) services. These businesses help our customers effectively deliver their content on the Internet. SelectSource and HouseNet address the online needs of catalogers and publishers, respectively. SelectSource offers content conversion and site development services for catalog and retail customers. HouseNet, an online community of interest focused on home improvement topics, aggregates content around the themes of home, garden, crafts and money management to offer a one- stop information resource for consumers. HouseNet was recently named Yahoo's number-one site for home improvement information for 1998. Book Publishing Services also applies technology to create solutions that enable our customers to manage and distribute content in multiple media formats. In 1998, we signed a contract with a major customer to create a global, digital archive, as well as a new custom publishing solution allowing education customers to build books online. In addition, Book Publishing Services is the leading supplier of conversion services to the emerging electronic book marketplace. In the production process for print, increased digitization allows us to implement world-class manufacturing techniques. Digital workflows, coupled with on-press instrumentation and advanced statistical process control techniques, will allow us to more effectively manage both our manufacturing assets and our raw material inputs. Additionally, new digital imaging capabilities are allowing higher levels of customization, enabling highly personalized printed products to be delivered to consumers. We are focused on investing in technologies that help us deliver products, services and solutions that are valued by our customers and thereby contribute to our financial performance. 14
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Year 2000 Process control and information systems are becoming increasingly important to the effective management of the company. Increased spending on new systems and updating of existing systems will be necessary. In the near term, we are focusing these efforts on ensuring that processes and systems are Year 2000 compliant. In addition, the company is focused on an initiative to upgrade and standardize the company's information technology infrastructure, which has the incidental effect of addressing certain of the company's Year 2000 compliance issues. We have deferred a number of other infrastructure and systems initiatives that would support continuous productivity improvements and enhanced service capabilities until after the company completes its Year 2000 efforts. The Year 2000 compliance issue stems from the computer industry's practice of conserving data storage by using two digits to represent a year. Systems and hardware using this format may process data incorrectly or fail with the use of dates in the next century. These types of failures can influence applications that rely on dates to perform calculations (such as an accounts receivable aging report), as well as facility systems (such as building security and heating) and manufacturing equipment. The company's efforts to address Year 2000 compliance issues in our core business include: . evaluating internal computing infrastructure, business applications and shop-floor systems for Year 2000 compliance, . replacing or renovating systems and applications as necessary to assure such compliance, and . testing the replaced or renovated systems and applications. Our efforts in these respects are well under way, and we currently expect that all phases of such efforts will be completed by mid-1999. In addition to our internal remediation activities, we are continuing to evaluate compliance by key suppliers, vendors and other external companies, including customers whose systems interact with ours. We expect to substantially complete this evaluation in early 1999. Separate Year 2000 compliance programs are in progress at Stream International and CS&T. Although the company expects internal systems to be Year 2000 compliant as described above, we intend to prepare a contingency plan that will specify what we plan to do if critical systems, processes, suppliers, vendors and external companies encounter Year 2000 issues. We have launched a contingency planning effort focused on these areas and the establishment of processes, structures and procedures for coordinating our contingency response efforts. Specific plans will be developed throughout the course of the year. Company employees, assisted by the expertise of external consultants where necessary, staff the Year 2000 compliance efforts. Actual spending on our Year 2000 initiative in 1998 was $45 million, which is reflected in administrative expense. Management expects 1999 expenses to be similar. These estimated expenses do not include costs being capitalized with respect to the company's information and technology infrastructure upgrade and standardization initiative or estimated costs associated with Year 2000 initiatives at Stream International or CS&T. Litigation In 1996, a purported class action was brought against the company on behalf of current and former African-American employees alleging that the company racially discriminated against them. The complaint seeks declaratory and injunctive relief, and asks for actual, compensatory, consequential and punitive damages in an amount not less than $500 million. Although the plaintiffs seek nationwide class certification, most of the specific factual assertions of the complaint relate to the closing of our Chicago catalog operations in 1993. Other general claims relate to other company locations. In February, 1999, the magistrate judge ruled that all claims relating to the Chicago catalog operations were untimely. Plaintiffs have appealed this ruling. If the ruling of the magistrate judge is upheld, the claims relating to other facilities will still be pending as is plaintiffs' motion for class certification. 15
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In 1995, a class action was filed against the company alleging that older workers were discriminated against in selection for termination upon closing of the Chicago catalog operations. The suit also alleges that we violated the Employee Retirement Income Security Act (ERISA) in determining benefits payable to retiring or terminating employees. In August, 1997, the court certified classes in each of the age discrimination and ERISA claims limited to former employees of the Chicago operation. In 1998, a purported class action was filed against the company on behalf of current and former African-American employees, alleging that the company racially discriminated against them. While making many of the same general discrimination claims contained in the 1996 case, the plaintiffs in this case also claim retaliation by the company for the filing of discrimination charges or otherwise complaining of race discrimination. The complaint seeks the same relief and damages as sought in the 1996 case. The 1996 and 1995 cases relate primarily to the circumstances surrounding the closing of the Chicago catalog operations. The company believes that it acted properly in the closing of the operations. The company also believes that it has a number of valid defenses to all of the claims made and it will vigorously defend its actions. However, because the cases are in the preliminary stages, management cannot make a meaningful estimate of any loss that could result from an unfavorable outcome of any of the pending cases. Environmental Regulations Our business is subject to various laws and regulations relating to employee health and safety and to environmental protection. Our policy is to comply with all laws and regulations that govern protection of the environment and employee health and safety. Our overriding principles are to create sustainable compliance and an injury-free workplace. We do not anticipate that compliance will have a material adverse effect on our competitive or consolidated financial positions. Outlook The commercial printing industry in the United States (our primary geographic market) is highly competitive in most product categories and geographic regions. Competition is largely based on price, quality and servicing the special needs of customers. Industry analysts believe that there is overcapacity in most commercial printing markets. Therefore, competition is fierce. We are a large user of paper, bought by us or supplied to us by our customers. The cost and supply of certain paper grades used in the manufacturing process will continue to affect our financial results. However, management currently does not see any disruptive conditions affecting prices and supply of paper in 1999. Postal costs are a significant component of our customers' cost structure. Changes in postal rates, which became effective in January 1999, are not expected to negatively affect the company. In fact, postal rate increases enhance the value of Donnelley Logistic Services to our customers, as we are able to improve the cost and efficiency of mail processing and distribution. This ability to deliver mail on a more precise schedule and at a lower cost should enhance our position in the marketplace. In addition to paper and postage costs, consumer confidence and economic growth are key drivers of print demand. While current economic conditions remain favorable, there is uncertainty around 1999's business environment. A significant change in the economic outlook could affect demand for the company's products, particularly in the financial printing market. In the longer term, technological changes, including the electronic distribution of information, present both risks and opportunities for the company. We believe that with our competitive strengths, including our comprehensive service offerings, technology leadership, depth of management experience, customer relationships and economies of scale, we can develop the most valuable solutions for our customers, which should result in growth in shareholder value throughout the next year and into the new millennium. 16
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ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK The company is exposed to market risk from changes in interest rates and foreign exchange rates. However, the company generally maintains more than half of its debt at fixed rates (approximately 70% at December 1998), and therefore its exposure to short-term interest rate fluctuations is immaterial to the consolidated financial statements of the company as a whole. The company's exposure to adverse changes in foreign exchange rates also is immaterial to the consolidated financial statements of the company as a whole, and the company occasionally uses financial instruments to hedge exposures to foreign exchange rate changes. The company does not use financial instruments for trading purposes and is not a party to any leveraged derivatives. Further disclosure relating to financial instruments is included in the Debt Financing and Interest Expense note in the Notes to Consolidated Financial Statements. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The financial information required by Item 8 is contained in Item 14 of Part IV and listed on page F-1. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None PART III ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT Information concerning the directors and officers of the company is contained on pages 6 and 14-15 of the company's definitive Proxy Statement dated February 18, 1999, and is incorporated herein by reference. See also the list of the company's officers and related information under "Executive Officers and Principal Officers of R.R. Donnelley & Sons Company" at the end of Part I of this annual report. ITEM 11. EXECUTIVE COMPENSATION Information concerning executive compensation for the year ended December 31, 1998, and, with respect to certain of such information, prior years, is contained on pages 21-24 and 28-30 of the company's definitive Proxy Statement dated February 18, 1999, and is incorporated herein by reference. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Information concerning the beneficial ownership of the company's common stock is contained on pages 18-20 of the company's definitive Proxy Statement dated February 18, 1999, and is incorporated herein by reference. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS None 17
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PART IV ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a)1. Financial Statements The financial statements listed in the accompanying index (page F-1) to the financial statements are filed as part of this annual report. 2. Financial Statement Schedule The financial statement schedule listed in the accompanying index (page F-1) to the financial statements is filed as part of this annual report. 3. Exhibits The exhibits listed on the accompanying index to exhibits (pages E-1 through E-2) are filed as part of this annual report. (b)Reports on Form 8-K No current Report on Form 8-K was filed during the quarter ended December 31, 1998. (c)Exhibits The exhibits listed on the accompanying index (pages E-1 through E-2) are filed as part of this annual report. (d)Financial Statements omitted-- Certain schedules have been omitted because the required information is included in the consolidated financial statements or notes thereto or because they are not applicable or not required. 18
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SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, on the 31st day of March, 1999. R. R. DONNELLEY & SONS COMPANY /s/ Gregory A. Stoklosa By __________________________________ Gregory A. Stoklosa, Vice President and Controller Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities indicated, on the 31st day of March, 1999. Signature and Title Signature and Title /s/ William L. Davis /s/ Thomas S. Johnson ------------------------------------- ------------------------------------- William L. Davis Thomas S. Johnson Chairman of the Board and Director Chief Executive Officer, Director (Principal Executive Officer) /s/ George A. Lorch ------------------------------------- /s/ Cheryl A. Francis George A. Lorch ------------------------------------- Director Cheryl A. Francis Executive Vice President and /s/ M. Bernard Puckett Chief Financial Officer ------------------------------------- (Principal Financial Officer) M. Bernard Puckett Director /s/ Gregory A. Stoklosa ------------------------------------- /s/ Oliver R. Sockwell Gregory A. Stoklosa ------------------------------------- Vice President and Controller Oliver R. Sockwell (Principal Accounting Officer) Director /s/ Joseph B. Anderson, Jr. /s/ Bide L. Thomas ------------------------------------- ------------------------------------- Joseph B. Anderson, Jr. Bide L. Thomas Director Director /s/ Martha Layne Collins /s/ Stephen M. Wolf ------------------------------------- ------------------------------------- Martha Layne Collins Stephen M. Wolf Director Director /s/ James R. Donnelley ------------------------------------- James R. Donnelley Director /s/ Judith H. Hamilton ------------------------------------- Judith H. Hamilton Director 19
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ITEM 14(a). INDEX TO FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES [Download Table] Page(s) ------- Consolidated Statements of Income for each of the three years ended December 31, 1998..................................................... F-2 Consolidated Balance Sheets at December 31, 1998 and 1997.............. F-3 Consolidated Statements of Cash Flows for each of the three years ended December 31, 1998..................................................... F-4 Consolidated Statements of Shareholders' Equity for each of the three years ended December 31, 1998......................................... F-5 Notes to Consolidated Financial Statements............................. F-6 Report of Independent Public Accountants............................... F-21 Unaudited Interim Financial Information, Dividend Summary and Financial Summary............................................................... F-22 Report of Independent Public Accountants on Financial Statement Schedule.............................................................. F-23 Financial Statement Schedule II--Valuation and Qualifying Accounts................................ F-24 F-1
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R.R. DONNELLEY & SONS COMPANY AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME Thousands of Dollars, Except Per-Share Data [Download Table] Year Ended December 31 ---------------------------------- 1998 1997 1996 ---------- ---------- ---------- Net sales.................................. $5,018,436 $4,892,944 $5,063,821 Cost of sales.............................. 3,960,239 3,942,339 4,092,895 ---------- ---------- ---------- Gross profit............................... 1,058,197 950,605 970,926 Selling and administrative expenses........ 569,779 511,115 518,288 Restructuring and impairment charge........ -- 70,702 441,709 Loss from operations of businesses held for sale...................................... 80,067 113,594 122,789 ---------- ---------- ---------- Earnings from operations................... 408,351 255,194 (111,860) Other income (expense): Interest expense......................... (78,166) (90,765) (95,482) Gain on sale of investments and stock offerings of subsidiaries............... 168,903 -- 80,041 Other, net............................... 10,217 25,742 16,821 ---------- ---------- ---------- Earnings (loss) before income taxes........ 509,305 190,171 (110,480) Income taxes............................... 214,725 59,540 47,145 ---------- ---------- ---------- Net Income (Loss)...................... $ 294,580 $ 130,631 $ (157,625) ========== ========== ========== Net Income (Loss) per Share of Common Stock Basic.................................... $ 2.11 $ 0.90 $ (1.04) Diluted.................................. 2.08 0.89 (1.04) See accompanying Notes to Consolidated Financial Statements. F-2
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R.R. DONNELLEY & SONS COMPANY AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS Thousands of Dollars, Except Share Data [Download Table] December 31 ---------------------- 1998 1997 ---------- ---------- Assets Cash and equivalents................................. $ 66,226 $ 47,814 Receivables, less allowances for doubtful accounts of $14,279 in 1998 and $16,259 in 1997................. 843,094 814,664 Inventories.......................................... 182,931 201,402 Prepaid expenses..................................... 52,742 82,691 ---------- ---------- Total Current Assets............................... 1,144,993 1,146,571 ========== ========== Net property, plant and equipment, at cost, less accumulated depreciation of $2,667,827 in 1998 and $2,426,649 in 1997.................................. 1,700,927 1,788,116 Goodwill and other intangibles, net of accumulated amortization of $183,589 in 1998 and $150,563 in 1997................................................ 381,394 396,604 Other non-current assets............................. 515,029 648,168 Net assets of businesses held for sale............... 45,476 154,707 ---------- ---------- Total Assets....................................... $3,787,819 $4,134,166 ========== ========== Liabilities Accounts payable..................................... $ 331,257 $ 291,666 Accrued compensation................................. 188,187 152,235 Short-term debt...................................... 60,000 45,000 Current and deferred income taxes.................... 76,605 58,888 Other accrued liabilities............................ 242,251 264,833 ---------- ---------- Total Current Liabilities.......................... 898,300 812,622 ========== ========== Long-term debt....................................... 998,978 1,153,226 Deferred income taxes................................ 284,908 229,538 Other non-current liabilities........................ 304,755 347,283 ---------- ---------- Total Non-current Liabilities...................... 1,588,641 1,730,047 ========== ========== Shareholders' Equity Common stock at stated value ($1.25 par value) Authorized shares: 490,000,000; Issued: 140,889,050 in 1998 and 150,889,050 in 1997..................... 308,462 320,962 Retained earnings.................................... 1,325,634 1,528,406 Cumulative translation adjustments................... (55,050) (45,782) Unearned compensation................................ (6,118) (9,414) Reacquired common stock, at cost..................... (272,050) (202,675) ---------- ---------- Total Shareholders' Equity......................... 1,300,878 1,591,497 ---------- ---------- Total Liabilities and Shareholders' Equity......... $3,787,819 $4,134,166 ========== ========== See accompanying Notes to Consolidated Financial Statements. F-3
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R.R. DONNELLEY & SONS COMPANY AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS Thousands of Dollars [Download Table] Year Ended December 31 ------------------------------- 1998 1997 1996 --------- --------- --------- Cash flows provided by (used for) operating activities: Net income (loss)........................... $ 294,580 $ 130,631 $(157,625) Loss from operations of businesses held for sale, net of tax........................... 80,067 75,894 86,142 Gain on sale of investments and stock offerings of subsidiaries, net of tax...... (101,342) -- (80,041) Restructuring and impairment charges, net of tax and minority interest.................. -- 42,421 374,449 Depreciation................................ 317,432 327,770 316,290 Amortization................................ 50,371 50,160 48,986 Gain on sale of assets...................... (13,446) (16,028) (17,758) Net change in operating working capital..... 79,146 117,386 (20,355) Net change in other assets and liabilities.. 40,657 20,023 30,735 Other....................................... (14,630) (6,019) (12,856) --------- --------- --------- Net Cash Provided by Operating Activities. 732,835 742,238 567,967 ========= ========= ========= Cash flows provided by (used for) investing activities: Capital expenditures........................ (225,222) (360,195) (370,906) Proceeds from collection of advances to affiliates................................. -- -- 277,013 Proceeds from stock offering of subsidiary.. -- -- 23,492 Other investments including acquisitions, net of cash acquired....................... (91,184) (47,526) (24,165) Disposition of assets....................... 26,498 51,276 31,563 Disposition of investments, net of tax...... 274,079 -- -- --------- --------- --------- Net Cash Used For Investing Activities.... (15,829) (356,445) (63,003) ========= ========= ========= Cash flows provided by (used for) financing activities: Net decrease in borrowings.................. (155,545) (225,967) (160,329) Disposition of reacquired common stock...... 82,710 45,762 53,058 Acquisition of common stock................. (539,434) (82,041) (327,130) Cash dividends paid......................... (114,898) (114,934) (112,645) --------- --------- --------- Net Cash Used for Financing Activities.... (727,167) (377,180) (547,046) ========= ========= ========= Effect of exchange rate changes on cash and equivalents.................................. (592) (775) (395) --------- --------- --------- Net Increase in Cash from Businesses Held for Sale......................................... 29,165 18,659 41,551 --------- --------- --------- Net Increase (Decrease) in Cash and Equivalents.................................. 18,412 26,497 (926) --------- --------- --------- Cash and Equivalents at Beginning of Year..... 47,814 21,317 22,243 --------- --------- --------- Cash and Equivalents at End of Year........... $ 66,226 $ 47,814 $ 21,317 ========= ========= ========= Changes in operating working capital, net of acquisitions and divestitures: 1998 1997 1996 --------- --------- --------- Decrease (increase) in assets: Receivables--net............................ $ (27,041) $ 103,077 $ 149,048 Inventories--net............................ 18,846 (3,496) 42,919 Prepaid expenses............................ 29,972 5,116 (78,086) Increase (decrease) in liabilities: Accounts payable............................ 37,352 6,249 (81,477) Accrued compensation........................ 30,049 30,347 17,606 Other accrued liabilities................... (10,032) (23,907) (70,365) --------- --------- --------- Net Change in Operating Working Capital....... $ 79,146 $ 117,386 $ (20,355) ========= ========= ========= See accompanying Notes to Consolidated Financial Statements. F-4
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R.R. DONNELLEY & SONS COMPANY AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY Thousands of Dollars, Except Share Data [Enlarge/Download Table] Reacquired Common Unearned Common Stock Stock Compensation Other --------------------- ---------------------- Restricted Retained Comprehensive Shares Amount Shares Amount Stock Earnings Income Total ----------- -------- ----------- --------- ------------ ---------- ------------- ---------- Balance at December 31, 1995................... 158,608,800 $330,612 (4,656,261) $(142,243) $(9,297) $2,023,131 $(29,033) $2,173,170 Net loss................ (157,625) (157,625) Translation adjustments. 2,453 2,453 ---------- Comprehensive income.... (155,172) Treasury stock purchases.............. (2,333,691) (77,131) (77,131) Cash dividends.......... (112,645) (112,645) Common shares issued under stock programs... 1,654,697 48,880 3,895 283 53,058 Common shares retired under repurchase plan.. (7,719,750) (9,650) (240,349) (249,999) ----------- -------- ----------- --------- ------- ---------- -------- ---------- Balance at December 31, 1996................... 150,889,050 320,962 (5,335,255) (170,494) (5,402) 1,512,795 (26,580) 1,631,281 Net income.............. 130,631 130,631 Translation adjustments. (19,202) (19,202) ---------- Comprehensive income.... 111,429 Treasury stock purchases.............. (2,293,757) (82,041) (82,041) Cash dividends.......... (114,934) (114,934) Common shares issued under stock programs 1,857,792 49,860 (4,012) (86) 45,762 ----------- -------- ----------- --------- ------- ---------- -------- ---------- Balance at December 31, 1997................... 150,889,050 320,962 (5,771,220) (202,675) (9,414) 1,528,406 (45,782) 1,591,497 Net income.............. 294,580 294,580 Translation adjustments. (9,268) (9,268) ---------- Comprehensive income.... 285,312 Treasury stock purchases.............. (13,196,393) (543,743) (543,743) Cash dividends.......... (114,898) (114,898) Common shares issued under stock programs 2,400,991 78,444 3,296 970 82,710 Common shares retired under repurchase plan (10,000,000) (12,500) 10,000,000 395,924 (383,424) -- ----------- -------- ----------- --------- ------- ---------- -------- ---------- Balance at December 31, 1998................... 140,889,050 $308,462 (6,566,622) $(272,050) $(6,118) $1,325,634 $(55,050) $1,300,878 =========== ======== =========== ========= ======= ========== ======== ========== See accompanying Notes to Consolidated Financial Statements. F-5
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R.R. DONNELLEY & SONS COMPANY AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Summary of Significant Accounting Policies Basis of Consolidation--The consolidated financial statements include the accounts of the company and its majority-owned subsidiaries. Minority interests in the income (loss) of consolidated subsidiaries ($4 million of expense, $6 million of expense and $2 million of income in 1998, 1997 and 1996, respectively) are included in other expense on the Consolidated Statements of Income. Intercompany items and transactions are eliminated in consolidation. The company held investments in unconsolidated affiliates, including the net assets of businesses held for sale, of $132 million and $430 million at December 31, 1998 and 1997, respectively. Nature of Operations--The company provides a wide variety of print and print-related services and products for specific customers, primarily under contract. Some contracts provide for progress payments from customers as certain phases of the work are completed; however, revenue is not recognized until the earnings process has been completed in accordance with the terms of the contracts. Some customers furnish paper for their work, while in other cases the company purchases the paper and resells it to the customer. Cash and Equivalents--The company considers all highly liquid debt instruments purchased with original maturities of three months or less to be cash equivalents. Inventories--Inventories include material, labor and factory overhead and are stated at the lower of cost or market. The cost of approximately 78% and 80% of the inventories at December 31, 1998 and 1997, respectively, has been determined using the Last-In, First-Out (LIFO) method. This method reflects the effect of inventory replacement costs in earnings; accordingly, charges to cost of sales reflect recent costs of material, labor and factory overhead. The remaining inventories are valued using the First-In, First-Out (FIFO) or specific identification methods. Capitalization, Depreciation and Amortization--Property, plant and equipment are stated at cost. Depreciation is computed principally on the straight-line method based on useful lives of 15 to 33 years for buildings and 3 to 15 years for machinery and equipment. Maintenance and repair costs are charged to expense as incurred. Major overhauls are capitalized as reductions to accumulated depreciation. When properties are retired or disposed, the costs and accumulated depreciation are eliminated and the resulting profit or loss is recognized in income. Goodwill ($174 million and $156 million, net of accumulated amortization, at December 31, 1998 and 1997, respectively) is amortized over periods ranging from 10 to 40 years. Other intangibles represent primarily the cost of acquiring print contracts and volume guarantees and are amortized over the periods in which benefits will be realized. Use of Estimates--The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Comprehensive Income--In 1998, the company adopted SFAS 130, Reporting Comprehensive Income. This statement establishes rules for the reporting of comprehensive income and its components. Comprehensive income consists of net income and foreign currency translation adjustments and is presented in the Consolidated Statements of Shareholders' Equity. The adoption of SFAS 130 had no impact on total shareholders' equity. Reclassifications--Certain prior year amounts have been reclassified to conform to the 1998 presentation. F-6
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R.R. DONNELLEY & SONS COMPANY AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) Businesses Held for Sale During 1996, Stream International Holdings, Inc. (SIH), an 80%-owned equity investment of the company, reorganized into three independent businesses: Stream International, which provides outsource technical support services; Corporate Software & Technology (CS&T), a software distribution company; and Modus Media International (MMI), a global manufacturing and fulfillment business. CS&T and MMI comprised substantially all of the company's investment and net income in SIH. On December 15, 1997, SIH's businesses became separate companies and the company's ownership interest in SIH was restructured. The company converted its equity and debt positions in Stream International into 87% of the common stock of that business. Additionally, the company converted its equity and debt positions in CS&T into 86% of the common stock of CS&T and sold its equity and debt positions in MMI for non-voting preferred stock of MMI. The disposition of the company's interest in CS&T will be effected through the sale of the business, which is planned to occur during 1999. In connection with the planned disposition of CS&T and the restructuring of the company's interest in MMI, the company has reported its interests in CS&T and MMI as businesses held for sale. During December 1998, the net assets and results of operations of businesses held for sale were reclassified from discontinued operations because the planned sale of CS&T did not occur in 1998, as originally intended. The net assets of CS&T were included in net assets of businesses held for sale, as of December 31, 1998 and 1997. The non- voting preferred stock in MMI was included in other non-current assets as of December 31, 1998 and 1997. During 1998, the company recorded an $80 million (with no associated tax benefit) impairment charge related to the write-down of goodwill on the books of CS&T. Additionally, the company recorded a fourth-quarter 1997 impairment charge of $100 million ($60 million after-tax) to adjust the carrying costs of CS&T and MMI to their estimated net realizable values. As part of the restructuring program announced in the first half of 1996, the company recorded restructuring and impairment charges of $119 million ($61 million after-tax) for businesses held for sale. The charges primarily related to the repositioning of MMI and CS&T's worldwide operations and the restructuring of their software manufacturing, printing, kitting and fulfillment operations. Summary financial information of businesses held for sale has been disclosed within the "Industry Segment Information" footnote (see F-18). Divestitures On June 19, 1996, Metromail Corporation (the company's previously wholly owned subsidiary, which is a leading provider of market-oriented consumer information and reference services) completed an initial public offering of 13.8 million shares of its common stock at $20.50 per share. As a result of the offering, the company's interest in Metromail was reduced to approximately 38% (37% as of December 31, 1997). Approximately $250 million of the proceeds from the completed offering were used by Metromail to retire certain indebtedness owed to the company. The company in turn used the payment from Metromail to pay down debt and for general corporate purposes. The transaction resulted in a pre-tax gain for the company of $44 million and a tax provision of $18 million. As a result of this transaction, the company changed its method of accounting for Metromail from consolidation to the equity method, effective July 1, 1996. Under the equity method, the company recognizes in income its proportionate share of the net income of Metromail. Metromail's 1996 net sales and operating earnings were $126 million and $13 million, respectively, through the date of the initial public offering. F-7
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R.R. DONNELLEY & SONS COMPANY AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) In March 1998, Metromail entered into a merger agreement with The Great Universal Stores, P.L.C. (GUS), pursuant to which GUS initiated a tender offer for the outstanding shares of Metromail. In conjunction with the merger, the company committed to sell its remaining interest in Metromail to GUS. On April 13, 1998, the company received $297 million, or approximately $238 million after-tax, for its remaining interest in Metromail. The company recognized a pre-tax gain of $146 million ($87 million after-tax) from this transaction. On November 4, 1996, Donnelley Enterprise Solutions Incorporated (DESI), formerly a wholly owned subsidiary of the company and a single-source provider of integrated information-management services to professional service organizations, completed an initial public offering of 2.9 million shares of its common stock at $25.00 per share, of which 1.0 million were offered by the company. As a result of the offering, the company's interest in DESI was reduced to approximately 43%. The company received approximately $52 million from the net proceeds of the shares sold and from repayment of amounts owed by DESI, which was used for general corporate purposes. The transaction resulted in a pre-tax gain of $36 million, or $22 million after taxes. As a result of this transaction, the company changed its method of accounting for DESI from consolidation to the equity method, effective November 1, 1996. In May 1998, DESI entered into a merger agreement with Bowne & Co., Inc. (Bowne), pursuant to which Bowne initiated a tender offer to acquire all outstanding shares of DESI. In conjunction with the merger, the company committed to sell its remaining interest in DESI to Bowne. On July 7, 1998, the company received $45 million, or approximately $36 million after-tax, for its remaining interest in DESI. The company recognized a pre-tax gain of $23 million ($14 million after-tax) from this transaction. Acquisitions During 1998, the company increased its investment in subsidiaries located in South America and Poland, in addition to acquiring other smaller, print- related businesses. The aggregate cost of these investments was $86 million in cash, of which $69 million was paid in 1998 and $17 million will be paid in 1999. All of these acquisitions have been accounted for as purchases. Restructuring and Impairment Charges In the first half of 1996, the company provided for the restructuring and realignment of its gravure printing operations in North America, the repositioning of other businesses, the write-down of certain equipment and the impairment of intangible assets and investments in non-core businesses. These actions resulted in pre-tax charges of $442 million ($374 million after taxes and minority interest benefit). Approximately $195 million of the charges were related to its gravure platform realignment and approximately $122 million were related to other manufacturing restructuring. The charges also included $125 million in write-downs of equipment, intangibles and investments in non- core businesses. In December 1997, the company provided for the impairment of assets and restructuring costs related primarily to the elimination of activities that no longer support the company's strategic focus. These included the impaired development costs of certain manufacturing systems, the sale of Coris, the company's content-management software subsidiary, and the shutdown of book fulfillment operations in Crawfordsville, Indiana. Impairment losses related to the 1996 and 1997 charges totaled $385 million pre-tax and were calculated based on the excess of the carrying amount of assets over the assets' fair values. The fair value of an asset is generally determined as the discounted estimate of future cash flows generated by the asset. As of December 31, 1998, the company's restructuring programs are substantially complete. F-8
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R.R. DONNELLEY & SONS COMPANY AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) Inventories The components of the company's inventories were as follows: [Download Table] December 31 ------------------ 1998 1997 -------- -------- In thousands Raw materials and manufacturing supplies.................... $121,490 $123,280 Work in process............................................. 150,775 153,142 Finished goods.............................................. 1,220 1,047 Progress billings........................................... (42,217) (31,715) LIFO reserve................................................ (48,337) (44,352) -------- -------- Total................................................... $182,931 $201,402 ======== ======== The company's cost of sales was increased by LIFO provisions of $4.5 million in 1998 and $0.6 million in 1997, and decreased by $7.5 million in 1996. The company uses the external-index method of valuing LIFO inventories. Property, Plant and Equipment The following table summarizes the components of property, plant and equipment (at cost): [Download Table] December 31 --------------------- 1998 1997 ---------- ---------- In thousands Land...................................................... $ 32,336 $ 33,755 Buildings................................................. 617,029 634,114 Machinery and equipment................................... 3,719,389 3,546,896 ---------- ---------- Total................................................. $4,368,754 $4,214,765 ========== ========== Commitments and Contingencies As of December 31, 1998, authorized expenditures on incomplete projects for the purchase of property, plant and equipment totaled $233 million. Of this total, $93 million has been contractually committed. The company has a variety of commitments with suppliers for the purchase of paper, ink and other materials for delivery in future years at prevailing market prices. The company has operating lease commitments totaling $322 million extending through various periods to 2009. The lease commitments total $54 million for 1999, range from $34 million to $47 million in each of the years 2000-2003 and total $108 million for years 2004 and thereafter. The company also has future annual commitments totaling $32 million to invest in various affordable housing limited partnerships that provide cumulative annual tax benefits and credits in amounts greater than the investments. The company is not exposed to significant accounts receivable credit risk, due to its customer diversity with respect to industry classification, distribution channels and geographic locations. On November 25, 1996, a purported class action was brought against the company in federal district court in Chicago, Illinois, on behalf of all current and former African-American employees, alleging that the company racially discriminated against them in violation of the Civil Rights Act of 1871, as amended, and the U.S. F-9
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R.R. DONNELLEY & SONS COMPANY AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) Constitution (Jones, et al. v. R.R. Donnelley & Sons Co.). The complaint seeks declaratory and injunctive relief, and asks for actual, compensatory, consequential and punitive damages in an amount not less than $500 million. Although plaintiffs seek nationwide class certification, most of the specific factual assertions of the complaint relate to the closing by the company of its Chicago catalog operations in 1993. Other general claims relate to other company locations. On February 11, 1999, the magistrate judge ruled that all claims relating to the Chicago catalog operations were untimely. Plaintiffs have appealed this ruling. If the ruling of the magistrate judge is upheld, the claims relating to other locations will still be pending as is plaintiffs' motion for class certification. On December 18, 1995, a class action was filed against the company in federal district court in Chicago alleging that older workers were discriminated against in selection for termination upon the closing of the Chicago catalog operations (Gerlib, et al. v. R.R. Donnelley & Sons Co.). The suit also alleges that the company violated the Employee Retirement Income Security Act (ERISA) in determining benefits payable to retiring or terminated employees. On August 14, 1997, the court certified classes in both the age discrimination and ERISA claims limited to former employees of the Chicago catalog operations. On June 30, 1998, a purported class action was filed against the company in federal district court in Chicago on behalf of current and former African- American employees, alleging that the company racially discriminated against them in violation of Title VII of the Civil Rights Act of 1964 (Adams, et al. v. R.R. Donnelley & Sons Co.). While making many of the same general discrimination claims contained in the Jones complaint, the Adams plaintiffs are also claiming retaliation by the company for the filing of discrimination charges or otherwise complaining of race discrimination. The complaint seeks the same relief and damages as sought in the Jones case. Both the Jones and Gerlib cases relate primarily to the circumstances surrounding the closing of the Chicago catalog operations. The company believes that it acted properly in the closing of the operations. Further, with regard to all three cases, the company believes it has a number of valid defenses to all of the claims made and will vigorously defend its actions. However, management is unable to make a meaningful estimate of any loss that could result from an unfavorable outcome of any of the pending cases. In addition, the company is a party to certain litigation arising in the ordinary course of business which, in the opinion of management, will not have a material adverse effect on the operations or financial condition of the company. Retirement Plans The company's restated Retirement Benefit Plan (the Plan) is a non- contributory defined benefit plan. Substantially all U.S. employees age 21 or older are covered by the Plan. Normal retirement age is 65, but reduced early retirement benefits are paid to fully vested participants at or after age 55. As required, the company uses the projected unit credit actuarial cost method to determine pension cost for financial reporting purposes. In conjunction with this method, the company amortizes deferred gains and losses (using the corridor method) and prior service costs over the average remaining service life of its active employee population. In addition, a transition credit (the excess of Plan assets plus balance sheet accruals over the projected obligation as of January 1, 1987) is amortized over 19 years. For tax and funding purposes, the entry age normal actuarial cost method is used. Plan assets include primarily government and corporate debt securities, marketable equity securities, commingled funds and group annuity contracts purchased from a life insurance company. In the event of Plan termination, the Plan provides that no funds can revert to the company and any excess assets over Plan liabilities must be used to fund retirement benefits. F-10
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R.R. DONNELLEY & SONS COMPANY AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) In addition to pension benefits, the company provides certain healthcare and life insurance benefits for retired employees. Substantially all of the company's regular full-time U.S. employees become eligible for these benefits upon reaching age 55 while working for the company and having 10 years of continuous service at retirement. The company funds a portion of the liabilities associated with these plans through a tax-exempt trust. The assets of the trust are invested primarily in life insurance covering some of the company's employees. The following represents the obligations and plan assets at fair value for the company's pension and postretirement plans at December 31: [Download Table] Postretirement Pension Benefits Benefits -------------------- ------------------ 1998 1997 1998 1997 ---------- -------- -------- -------- In Thousands Benefit obligation at end of prior year.................................. $ 950,223 $838,005 $233,437 $220,970 Service cost........................... 38,030 31,886 9,508 8,585 Interest cost.......................... 65,317 61,337 15,626 16,010 Plan participants' contributions....... -- -- 1,848 1,618 Amendments............................. 9,651 (1,640) -- -- Actuarial loss/(gain).................. 33,794 70,610 (1,894) 3,616 Acquisitions/plan initiations/curtailments.............. 3,008 -- 244 380 Expected benefits paid................. (50,794) (49,975) (18,115) (17,742) ---------- -------- -------- -------- Benefit obligation at end of year.. $1,049,229 $950,223 $240,654 $233,437 ========== ======== ======== ======== [Download Table] Postretirement Pension Benefits Benefits ---------------------- ----------------- 1998 1997 1998 1997 ---------- ---------- -------- -------- In Thousands Fair value of plan assets at end of prior year.......................... $1,421,849 $1,238,315 $262,813 $219,719 Actual return on plan assets......... 100,024 233,509 54,773 43,094 Acquisition.......................... 4,099 -- -- -- Employer contribution................ -- -- -- -- Plan participants' contributions..... -- -- -- -- Expected benefits paid............... (50,794) (49,975) -- -- ---------- ---------- -------- -------- Fair value of plan assets at end of year......................... $1,475,178 $1,421,849 $317,586 $262,813 ========== ========== ======== ======== The following represents the funded status of these plans at December 31: [Download Table] Postretirement Pension Benefits Benefits -------------------- ------------------ 1998 1997 1998 1997 --------- --------- -------- -------- In Thousands Funded status........................ $ 425,949 $ 471,626 $ 76,933 $ 29,376 Unrecognized transition obligation... (68,948) (78,798) -- -- Unrecognized net actuarial (gain)/loss......................... (143,023) (192,562) (77,739) (43,638) Unrecognized prior service cost...... 29,219 22,908 (18,215) (24,950) --------- --------- -------- -------- Prepaid (accrued) benefit cost... $ 243,197 $ 223,174 $(19,021) $(39,212) ========= ========= ======== ======== The weighted average assumptions used in the actuarial computations that derived the above amounts were as follows: [Download Table] Pension Postretirement Benefits Benefits ---------------- ---------------- 1998 1997 1996 1998 1997 1996 ---- ---- ---- ---- ---- ---- Discount rate............................... 6.75% 7.00% 7.50% 6.75% 7.00% 7.50% Expected return on plan assets.............. 9.50 9.50 9.50 9.00 9.00 9.00 Average rate of compensation increase....... 4.00 4.00 4.00 4.00 4.00 4.00 F-11
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R.R. DONNELLEY & SONS COMPANY AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) For the measurement purposes of other retirement benefits, a 7.6% annual rate of increase in the per-capita cost of covered healthcare benefits was assumed for 1999. The rate was assumed to decrease gradually to 5.0% for 2008 and remain at that level thereafter. The components of the net periodic benefit cost and total income and expense were as follows: [Enlarge/Download Table] Pension Benefits Postretirement Benefits ------------------------------ ---------------------------- 1998 1997 1996 1998 1997 1996 --------- --------- -------- -------- -------- -------- In thousands Service cost............ $ 38,030 $ 31,886 $ 32,619 $ 9,508 $ 8,584 $ 8,626 Interest cost........... 65,317 61,337 58,121 15,626 16,010 14,712 Expected return on plan assets................. (115,769) (104,516) (96,497) (20,671) (18,304) (16,509) Amortization of transition obligation.. (9,850) (9,850) (9,850) -- -- -- Amortization of prior service cost........... 2,249 1,803 1,804 (6,345) (6,463) (6,754) --------- --------- -------- -------- -------- -------- Net periodic benefit cost............... (20,023) (19,340) (13,803) (1,882) (173) 75 Curtailment (gain)/loss. -- (1,400) (1,426) 244 -- (4,166) --------- --------- -------- -------- -------- -------- Total (income)/expense... $ (20,023) $ (20,740) $(15,229) $ (1,638) $ (173) $ (4,091) ========= ========= ======== ======== ======== ======== Assumed healthcare cost trend rates have a significant effect on the amounts reported for postretirement benefits. A 1-percentage-point change in assumed healthcare cost trend rates would have the following effects for the year ended December 31, 1998: [Download Table] 1% Increase 1% Decrease ----------- ----------- In Thousands Effect on total of service and interest cost components..................................... $ 526 $ (514) Effect on postretirement benefit obligation..... 7,460 (7,236) Income Taxes Cash payments for income taxes were $152 million, $60 million and $76 million in 1998, 1997 and 1996, respectively. The components of income tax expense for the years ending December 31, 1998, 1997 and 1996, were as follows: [Download Table] 1998 1997 1996 -------- -------- -------- In Thousands Federal Current.......................................... $139,180 $ 68,909 $ 84,340 Deferred......................................... 35,222 (17,675) (38,720) State.............................................. 40,323 8,306 1,525 -------- -------- -------- Total.......................................... $214,725 $ 59,540 $ 47,145 ======== ======== ======== F-12
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R.R. DONNELLEY & SONS COMPANY AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) The significant deferred tax assets and liabilities were as follows: [Download Table] December 31 ----------------- 1998 1997 -------- -------- In Thousands Deferred tax liabilities: Accelerated depreciation................................... $170,343 $160,779 Investments................................................ 67,122 61,303 Pensions................................................... 83,521 84,710 Other...................................................... 60,183 42,290 -------- -------- Total deferred tax liabilities........................... 381,169 349,082 -------- -------- Deferred tax assets: Postretirement benefits.................................... 15,685 15,685 Accrued liabilities........................................ 64,726 78,832 Investments................................................ 73,301 49,036 Other...................................................... 29,689 49,679 -------- -------- Total deferred tax assets................................ 183,401 193,232 -------- -------- Valuation allowance.......................................... 44,949 15,980 -------- -------- Net deferred tax liabilities................................. $242,717 $171,830 ======== ======== The company has used corporate-owned life insurance (COLI) to fund employee benefits for several years. In 1996, the United States Health Care Reform Act was passed, eliminating the deduction for interest from loans borrowed against COLI programs. 1998 was the final year of the phase-out period for deductions. Without the COLI deduction, the company anticipates a higher effective tax rate in 1999 and future years. The Internal Revenue Service (IRS), in its routine audit of the company, has disallowed the $34 million of tax benefit that resulted from the COLI interest deductions claimed by the company in its 1990 to 1992 tax returns. The company has challenged this position in a formal protest filed with the IRS Appeals division. The company expects to resolve the issue eventually in a manner that does not materially impact its financial position and results of operations. The following table outlines the reconciliation of differences between the U.S. statutory tax rates and the rates used by the company in determining net income: [Download Table] 1998 1997 1996 ---- ----- ----- Federal statutory rate.................................... 35.0% 35.0% (35.0)% Restructuring and impairment charges...................... -- -- 78.9 Foreign tax rates......................................... -- (2.6) (3.0) State and local income taxes, net of U.S. federal income tax benefit.............................................. 5.1 2.8 12.8 Goodwill amortization..................................... 0.3 0.3 5.6 Benefits resulting from corporate-owned life insurance programs................................................. (1.5) (7.0) (7.5) Affordable housing investment credits..................... (3.9) (10.4) (17.6) Change in valuation allowance............................. 5.3 6.6 11.0 Other..................................................... 1.9 6.6 (2.5) ---- ----- ----- Total................................................. 42.2% 31.3% 42.7% ==== ===== ===== F-13
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R.R. DONNELLEY & SONS COMPANY AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) Debt Financing and Interest Expense The company's debt consisted of the following: [Download Table] December 31 --------------------- 1998 1997 ---------- ---------- In Thousands Commercial paper......................................... $ 121,500 $ 258,020 Medium-term notes due 1999-2005 at a weighted average interest rate of 6.93%.................................. 370,000 409,000 9.125% debentures due December 1, 2000................... 199,862 199,790 8.875% debentures due April 15, 2021..................... 80,807 149,692 8.82% debentures due April 15, 2031...................... 68,898 -- 7.0% notes due January 1, 2003........................... 109,843 109,804 Other.................................................... 108,068 71,920 ---------- ---------- Total................................................ $1,058,978 $1,198,226 ========== ========== Based upon the interest rates currently available to the company for borrowings with similar terms and maturities, the fair value of the company's debt exceeds its book value at December 31, 1998, by approximately $87 million. The company's notes and debentures are not actively traded and contain no call provisions. At December 31, 1998, the company had available credit facilities of $400 million with a group of domestic and foreign banks, of which $200 million expires December 10, 1999. The remaining $200 million expires December 10, 2003. The credit arrangements provide support for the issuance of commercial paper and other credit needs. As of December 31, 1998, there has been no borrowing under these credit facilities. The company pays an annual commitment fee on the total unused credit facilities of 0.06% for the 364-day facility and 0.08% for the 5-year facility. At December 31, 1998, the company had $283 million of commercial paper and short-term debt outstanding, of which $223 million is classified as long-term since the company has the ability and intent to maintain such debt on a long- term basis. The weighted average interest rate on all commercial paper debt outstanding during 1998 was 5.44% (4.92% at December 31, 1998). Annual maturities of long-term debt (excluding commercial paper and short-term debt) are as follows: 2000--$248 million, 2001--$9 million, 2002--$72 million, 2003--$128 million and thereafter $319 million. The following table summarizes interest expense included in the Consolidated Statements of Income: [Download Table] 1998 1997 1996 ------- -------- -------- In Thousands Interest incurred................................. $83,162 $100,724 $107,198 Amount capitalized as property, plant and equipment........................................ (4,996) (9,959) (11,716) ------- -------- -------- Total......................................... $78,166 $ 90,765 $ 95,482 ======= ======== ======== Interest paid, net of capitalized interest, was $79 million, $90 million and $93 million in 1998, 1997 and 1996, respectively. F-14
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R.R. DONNELLEY & SONS COMPANY AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) Earnings per Share In accordance with SFAS 128, Earnings per Share, the company has computed basic and diluted earnings per share (EPS) using the treasury stock method. [Download Table] 1998 1997 1996 -------- -------- --------- In Thousands, Except Per- Share Data Average shares outstanding........................ 139,624 145,929 151,830 Effect of dilutive securities--options............ 2,241 1,579 1,811 -------- -------- --------- Average shares outstanding, adjusted for dilutive effects.......................................... 141,865 147,508 153,641 ======== ======== ========= Net income (loss)................................. $294,580 $130,631 $(157,625) Basic EPS....................................... $ 2.11 $ 0.90 $ (1.04) Diluted EPS..................................... 2.08 0.89 (1.04) ======== ======== ========= Stock and Incentive Programs for Employees Restricted Stock Awards--At December 31, 1998 and 1997, respectively, the company had outstanding 400,000 and 542,000 restricted shares of its common stock granted to certain officers. These shares are registered in the names of the recipients, but are subject to conditions of forfeiture and restrictions on sale or transfer for one to seven years from the grant date. Dividends on the restricted shares are paid currently to the recipients and, accordingly, the restricted shares are treated as outstanding shares. The expense of the grant is recognized evenly over the vesting period. The value of the restricted stock awards was $18 million and $20 million based on the closing price of the company's stock at each year-end ($43.81 and $37.25 at December 31, 1998 and 1997, respectively). During 1998, a total of 33,000 shares of restricted stock were issued with a grant date fair value of $2 million. Charges to expense for this stock plan were $4 million, $5 million and $2 million in 1998, 1997 and 1996, respectively. Stock Purchase Plan--The company has a stock purchase plan for selected managers and key staff employees. Under the plan, the company is required to contribute an amount equal to 70% of participants' contributions, of which 50% is applied to the purchase of stock and 20% is paid in cash. Amounts charged to expense for this plan were $9 million in 1998. In 1996 and 1997, the company failed to meet performance targets required under the plan, and no expenses were incurred. Incentive Compensation Plans--In 1998, the company implemented a new management incentive plan designed to provide incentive compensation to executive officers that is closely tied to the creation of value for company shareholders. Awards under the new plan are largely based on the achievement of Economic Value Added (EVA) improvement targets, along with earnings per share objectives and other individual and strategic targets. The new plan combines aspects of both an annual and long-term plan by adding a "banking" feature, in which a portion of the amount earned in the year is paid out to participants and a portion is deferred for payout in subsequent years. The company has accrued for both the portion currently payable and the deferred component. Prior to 1998, the company had both an annual incentive plan and a long-term incentive plan for its executive officers. The company's incentive compensation plans for other officers, managers and supervisors are primarily based on annual improvements in EVA. Stock Options--The company has incentive stock option plans for its employees. Under these plans, the options vest from three to nine and one-half years after date of grant and may be exercised, once vested, up to 10 years from the date of grant. Under authorized Stock Incentive Plans, a maximum of 5.4 million shares were F-15
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R.R. DONNELLEY & SONS COMPANY AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) available for future grants of stock options and restricted stock awards as of December 31, 1998. The company accounts for employee stock options under Accounting Principles Board (APB) Opinion 25, Accounting for Stock Issued to Employees, under which no compensation cost has been recognized. Had compensation cost been determined consistent with SFAS 123, Accounting for Stock-Based Compensation, the company's net income and respective earnings per share would have been reduced to the following pro forma amounts: [Download Table] 1998 1997 1996 -------- -------- --------- In Thousands, Except Per- Share Data Net income As reported..................................... $294,580 $130,631 $(157,625) Pro forma....................................... 278,924 115,437 (171,333) Basic earnings per share: As reported..................................... $ 2.11 $ 0.90 $ (1.04) Pro forma....................................... 2.00 0.79 (1.13) Diluted earnings per share: As reported..................................... $ 2.08 $ 0.89 $ (1.04) Pro forma....................................... 1.97 0.78 (1.13) The fair value of each option granted during the year is estimated on the date of grant using the Black Scholes option-pricing model with the following range of assumptions: [Download Table] 1998 1997 1996 -------- -------- -------- Dividend yield.................................... 1.98% 2.24% 2.16% Expected volatility............................... 26.51% 25.10% 22.92% Risk-free interest rate........................... 5.28% 6.32% 6.39% Expected life..................................... 10 Years 10 Years 10 Years A summary of the status of the company's option activity is presented below: [Enlarge/Download Table] 1998 1997 1996 -------------------- -------------------- -------------------- Weighted Weighted Weighted Average Average Average Shares Exercise Shares Exercise Shares Exercise (thousands) Price (thousands) Price (thousands) Price ----------- -------- ----------- -------- ----------- -------- Options outstanding at beginning of year...... 13,958 $33.04 14,916 $31.68 14,246 $30.98 Options granted......... 1,627 41.81 1,485 40.28 3,320 34.09 Options exercised....... (2,387) 29.77 (1,535) 25.25 (1,245) 21.41 Options forfeited....... (800) 33.47 (908) 35.60 (1,405) 39.39 ------ ------ ------ ------ ------ ------ Options outstanding at end of year............ 12,398 $34.80 13,958 $33.05 14,916 $31.68 ====== ====== ====== ====== ====== ====== Options exercisable at end of year............ 7,344 $31.93 6,397 $28.57 6,618 $27.18 ====== ====== ====== ====== ====== ====== Weighted average fair value of options granted with: Exercise price equal to stock price on grant date........... $15.01 $11.20 $11.64 Exercise price exceeding stock price on grant date........ N/A $ 8.10 $ 7.74 F-16
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R.R. DONNELLEY & SONS COMPANY AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) The following summarizes information about stock options outstanding at December 31, 1998: [Download Table] Options Outstanding Options Exercisable -------------------------------- -------------------- Average Weighted Weighted Remaining Average Average Shares Contractual Exercise Shares Exercise (thousands) Life Price (thousands) Price ----------- ----------- -------- ----------- -------- $17.72-$38.06............. 9,284 6.00 Years $31.24 6,524 $30.29 $38.07-$76.96............. 3,114 8.40 Years $45.40 820 $44.93 ------ ---------- ------ ----- ------ $17.72-$76.96............. 12,398 6.61 Years $34.80 7,344 $31.93 ====== ========== ====== ===== ====== Other Information--Under the stock programs, authorized unissued shares or treasury shares may be used. The company intends to reacquire shares of its common stock to meet the stock requirements of these programs in the future. Preferred Stock The company has 2 million shares of $1.00 par value preferred stock authorized for issuance. The Board of Directors may divide the preferred stock into one or more series and fix the redemption, dividend, voting, conversion, sinking fund, liquidation and other rights. The company has no present plans to issue any preferred stock. One million of the shares are reserved for issuance under the "Shareholder Rights Plan" discussed below. Shareholder Rights Plan The company maintains a Shareholder Rights Plan (the Plan) designed to deter coercive or unfair takeover tactics, to prevent a person or group from gaining control of the company without offering fair value to all shareholders and to deter other abusive takeover tactics that are not in the best interest of shareholders. Under the terms of the Plan, each share of common stock is accompanied by one right; each right entitles the shareholder to purchase from the company one one-thousandth of a newly issued share of Series A Junior Preferred Stock at an exercise price of $140. The rights become exercisable 10 days after a public announcement that an acquiring person (as defined in the Plan) has acquired 15% or more of the outstanding common stock of the company (the Stock Acquisition Date), 10 business days after the commencement of a tender offer that would result in a person owning 15% or more of such shares or 10 business days after an adverse person (as defined in the Plan) has acquired 10% or more of such shares and such ownership interest is likely to have a material adverse impact on the company. The company can redeem the rights for $0.01 per right at any time until 10 days following the Stock Acquisition Date (under certain circumstances, the 10-day period can be shortened or lengthened by the company). The rights will expire on August 8, 2006, unless redeemed earlier by the company. If, subsequent to the rights becoming exercisable, the company is acquired in a merger or other business combination at any time when there is a 15% or more holder, the rights will then entitle a holder (other than a 15% or more shareholder or an adverse person) to buy shares of the acquiring company with a market value equal to twice the exercise price of each right. Alternatively, if a 15% holder acquires the company by means of a merger in which the company and its stock survives, if any person acquires 15% or more of the company's common stock or if an adverse person acquires 10% or more of the company's common stock and such ownership is likely to have a material adverse impact on the company, each right not owned by a 15% or more shareholder or an adverse person would become exercisable for common stock of the company (or, in certain circumstances, other consideration) having a market value equal to twice the exercise price of the right. F-17
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R.R. DONNELLEY & SONS COMPANY AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) Industry Segment Information The company operates exclusively in the commercial printing industry. Substantially all revenues result from the sale of printed products to customers in the following markets: Book Publishing Services, Financial Services, Magazine Publishing Services, Merchandise Media and Telecommunications. The company's management has aggregated its commercial print businesses as one reportable segment due to strong similarities in the economic characteristics, nature of products and services, production processes, class of customer and distribution methods used. The company's investment in businesses held for sale has been disclosed as a separate reportable segment, as the revenues generated from these businesses are unrelated to the commercial printing industry. (See the "Businesses Held for Sale" footnote (F-7) for additional information.) The company has disclosed earnings (loss) from operations as the primary measure of segment earnings (loss). This is the measure of profitability used by the company's chief operating decision-maker that is most consistent with the presentation of profitability reported within the consolidated financial statements. The accounting policies of the business segments reported are the same as those described in the "Summary of Significant Accounting Policies" (F-6). F-18
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R.R. DONNELLEY & SONS COMPANY AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) [Enlarge/Download Table] Commercial Businesses Consolidated Print Held for Sale(3) Corporate(1) Other(2) Combined Adjustments(3) Total ---------- ---------------- ------------ -------- ---------- -------------- ------------ In Thousands 1998 Sales................... $4,804,824 $ 881,473 $ -- $213,612 $5,899,909 $ (881,473) $5,018,436 Restructuring and impairment charges..... -- 80,067 -- -- 80,067 (80,067) -- Earnings (loss) from operations............. 497,337 (80,067) (7,246) (1,673) 408,351 -- 408,351 Earnings (loss) before income taxes........... 519,070 (80,067) 71,663 (1,361) 509,305 -- 509,305 Assets.................. 3,152,190 294,782 499,067 91,086 4,037,125 (249,306) 3,787,819 Depreciation and amortization........... 351,061 10,745 -- 16,742 378,548 (10,745) 367,803 Capital expenditures.... 198,822 5,664 9,700 16,700 230,886 (5,664) 225,222 1997 Sales................... $4,706,098 $1,547,765 $ -- $186,846 $6,440,709 $(1,547,765) $4,892,944 Restructuring and impairment charges..... 70,702 100,000 -- -- 170,702 (100,000) 70,702 Earnings (loss) from operations............. 332,602 (113,594) 28,850 7,336 255,194 -- 255,194 Earnings (loss) before income taxes........... 343,210 (113,594) (45,741) 6,296 190,171 -- 190,171 Assets.................. 3,502,461 348,252 389,849 87,149 4,327,711 (193,545) 4,134,166 Depreciation and amortization........... 363,537 40,344 -- 14,393 418,274 (40,344) 377,930 Capital expenditures.... 319,249 43,597 21,500 19,446 403,792 (43,597) 360,195 1996 Sales................... $4,908,323 $1,526,369 $ -- $155,498 $6,590,190 $(1,526,369) $5,063,821 Restructuring and impairment charges..... 435,209 118,924 -- 6,500 560,633 (118,924) 441,709 (Loss) earnings from operations............. (4,665) (122,789) 23,015 (7,421) (111,860) -- (111,860) Earnings (loss) before income taxes........... 11,339 (122,789) 7,326 (6,356) (110,480) -- (110,480) Assets.................. 3,496,768 690,864 483,940 76,987 4,748,559 (304,731) 4,443,828 Depreciation and amortization........... 352,652 44,033 -- 12,624 409,309 (44,033) 365,276 Capital expenditures.... 348,792 35,258 2,100 20,014 406,164 (35,258) 370,906 -------- (1) Corporate earnings primarily consist of the following unallocated items: net earnings of benefit plans (excluding service cost) of $74 million, $71 million and $61 million in 1998, 1997 and 1996, respectively, which were offset by general corporate, management and information technology costs. In addition to earnings from operations, corporate earnings before income taxes include: 1998 interest expense of $83 million and gains on the sale of the company's remaining interest in two former subsidiaries of $169 million; 1997 interest expense of $101 million and gains on the sale of assets of $16 million; and 1996 interest expense of $107 million, gains on the sale of assets of $18 million and gains on the partial divestitures of subsidiaries of $80 million. Corporate assets primarily consist of the following unallocated items at December 31: 1998 benefit plan assets of $285 million and investments in affordable housing of $120 million; 1997 benefit plan assets of $289 million and investments in affordable housing of $102 million; 1996 benefit plan assets of $298 million and investments in affordable housing of $81 million. (2) Represents other operating segments of the company. (3) Refer to "Businesses Held for Sale" footnote (F-7), which describes the separate presentation of the net assets and the results of operations of businesses held for sale. F-19
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R.R. DONNELLEY & SONS COMPANY AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) Geographic Area Information [Download Table] Domestic International Combined(1) ---------- ------------- ----------- In Thousands 1998 Sales...................................... $5,118,959 $ 780,950 $5,899,909 Long-lived assets(2)....................... 2,250,739 364,962 2,615,701 1997 Sales...................................... 5,407,617 1,033,092 6,440,709 Long-lived assets(2)....................... 2,584,285 354,583 2,938,868 1996 Sales...................................... 5,582,266 1,007,924 6,590,190 Long-lived assets(2)....................... 2,618,086 480,246 3,098,332 -------- (1) Includes net sales and long-lived assets of the company and businesses held for sale. Refer to "Businesses Held for Sale" footnote (F-7), which describes the separate presentation of the net assets and the results of operations of businesses held for sale. (2) Includes net property, plant and equipment, goodwill and other intangibles, and other non-current assets. F-20
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REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS We have audited the accompanying consolidated balance sheets of R.R. Donnelley & Sons Company (a Delaware corporation) and Subsidiaries as of December 31, 1998 and 1997, and the related consolidated statements of income, shareholders' equity and cash flows for each of the three years in the period ended December 31, 1998. These financial statements are the responsibility of the company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of R.R. Donnelley & Sons Company and Subsidiaries as of December 31, 1998 and 1997, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 1998, in conformity with generally accepted accounting principles. Arthur Andersen LLP Chicago, Illinois January 28, 1999 (except with respect to the matter discussed in paragraph 5 in the commitments and contingencies footnote, as to which the date is February 11, 1999) F-21
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UNAUDITED INTERIM FINANCIAL INFORMATION, DIVIDEND SUMMARY AND FINANCIAL SUMMARY In Thousands, Except Per-Share Data [Enlarge/Download Table] Year Ended December 31 ------------------------------------------------------------------------ First Second Third Fourth Quarter Quarter Quarter Quarter Full Year ---------- ---------- ---------- ---------- ---------- 1998 Net sales............... $1,173,598 $1,155,963 $1,274,479 $1,414,396 $5,018,436 Gross profit............ 218,059 240,748 294,020 305,370 1,058,197 Net income.............. 44,206 58,737 99,244 92,393 294,580 Net income per diluted share.................. 0.30 0.41 0.71 0.67 2.08 Stock market high....... 42 1/8 46 1/4 47 3/4 44 11/16 47 3/4 Stock market low........ 35 1/8 42 1/16 34 13/16 34 34 Stock market closing price.................. 41 1/16 45 3/4 35 3/16 43 13/16 43 13/16 1997 Net sales............... $1,111,438 $1,146,521 $1,221,743 $1,413,242 $4,892,944 Gross profit............ 193,103 208,837 260,529 288,136 950,605 Net income (loss)....... 29,341 37,676 72,157 (8,543) 130,631 Net income (loss) per diluted share.......... 0.20 0.25 0.49 (0.06) 0.89 Stock market high....... 36 7/8 39 3/4 41 1/16 37 5/8 41 1/16 Stock market low........ 29 5/8 32 5/8 34 3/8 32 5/8 29 5/8 Stock market closing price.................. 34 7/8 36 5/8 35 7/16 37 1/4 37 1/4 Stock prices reflect New York Stock Exchange composite quotes. Dividend Summary [Download Table] 1998 1997 1996 1995 1994 ------ ------ ------ ------ ------ Quarterly rate per common share*............ $0.205 $0.195 $0.185 $0.170 $0.150 Yearly rate per common share................ 0.82 0.78 0.74 0.68 0.60 -------- * Averages (1998--$0.20 first two quarters and $0.21 last two quarters; 1997--$0.19 first two quarters and $0.20 last two quarters; 1996--$0.18 first two quarters and $0.19 last two quarters; 1995--$0.16 first two quarters and $0.18 last two quarters; 1994--$0.14 first two quarters and $0.16 last two quarters). Financial Summary [Download Table] 1998 1997 1996 1995 1994 ---------- ---------- ---------- ---------- ---------- In Thousands, Except Per-Share Data Net sales............... $5,018,436 $4,892,944 $5,063,821 $5,080,775 $4,227,496 Net income (loss)**..... 294,580 130,631 (157,625) 298,793 268,603 Net income (loss) per common share**......... 2.08 0.89 (1.04) 1.92 1.73 Total assets............ 3,787,819 4,134,166 4,443,828 5,030,680 4,318,787 Non-current liabilities. 1,588,641 1,730,047 2,044,818 2,012,635 1,669,984 -------- ** Net income (loss) includes the following one-time items: 1998 gains on the sale of the company's remaining interest in two former subsidiaries of $169 million ($101 million after-tax, or $0.71 per diluted share) and loss from operations of businesses held for sale of $80 million (with no associated tax benefit, or $0.56 per diluted share); 1997 restructuring and impairment charges of $71 million ($42 million after-tax, or $0.29 per diluted share) and loss from operations of businesses held for sale of $114 million ($76 million after-tax, or $0.51 per diluted share); 1996 restructuring and impairment charges of $442 million ($374 million after taxes and minority interest, or $2.45 per diluted share), gains on partial divestiture of subsidiaries of $80 million ($48 million after-tax, or $0.31 per diluted share) and loss from operations of businesses held for sale of $123 million ($86 million after-tax, or $0.56 per diluted share). F-22
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REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS ON FINANCIAL STATEMENT SCHEDULE To the Shareholders of R.R. Donnelley & Sons Company: We have audited, in accordance with generally accepted auditing standards, the financial statements included in the Company's Annual Report to Shareholders included in this Form 10-K, and have issued our report thereon dated January 28, 1999. Our audit was made for the purpose of forming an opinion on those statements taken as a whole. The schedule listed in the index to the financial statements and financial statement schedules is the responsibility of the Company's management and is presented for purposes of complying with the Securities and Exchange Commission's rules and is not part of the basic financial statements. This schedule has been subjected to the auditing procedures applied in the audit of the basic financial statements and, in our opinion, fairly states in all material respects the financial data required to be set forth therein in relation to the basic financial statements taken as a whole. Arthur Andersen LLP Chicago, Illinois January 28, 1999 F-23
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SCHEDULE II Valuation and Qualifying Accounts Transactions affecting the allowances for doubtful accounts during the years ended December 31, 1998, 1997 and 1996 were as follows: [Download Table] 1998 1997 1996 -------- ------- ------- Thousands of dollars Allowance for trade receivable losses: Balance, beginning of year.................. $ 16,259 $14,205 $18,059 Balance, companies (sold) acquired during year....................................... -- -- (4,834) Provisions charged to income................ 12,551 10,676 9,877 -------- ------- ------- 28,810 24,881 23,102 Uncollectible accounts written off, net of recoveries................................. (14,531) (8,622) (8,897) -------- ------- ------- Balance, end of year........................ $ 14,279 $16,259 $14,205 ======== ======= ======= F-24
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INDEX TO EXHIBITS* Description Exhibit No. ------- -------- Agreement between R. R. Donnelley & Sons Company and Bain Cap- 2 ital, Inc.(1)................................................. Restated Certificate of Incorporation(2)....................... 3(i) By-Laws........................................................ 3(ii)(a) Amendment to By-Laws adopted January 28, 1999 ................. 3(ii)(b) Form of Rights Agreement, dated as of April 25, 1996 between R. R. Donnelley & Sons Company and First Chicago Trust Com- pany of New York(3)........................................... 4(a) Instruments Defining the Rights of Security Holders(4)......... 4(b) Indenture dated as of November 1, 1990 between the Company and Citibank, N.A. as Trustee(5).................................. 4(c) Five-Year Credit Agreement dated December 11, 1998 among R. R. Donnelley & Sons Company, the Banks named therein and The First National Bank of Chicago, as Administrative Agent....... 4(d) 364-Day Credit Agreement dated December 11, 1998 among R. R. Donnelley & Sons Company, the Banks named therein and The First National Bank of Chicago, as Administrative Agent....... 4(e) Retirement Policy for Directors, as amended(6)**............... 10(a) Directors' Deferred Compensation Agreement, as amended(6)**.... 10(b) Donnelley Shares Stock Option Plan, as amended(7).............. 10(c) 1993 Stock Ownership Plan for Non-Employee Directors, as 10(d) amended(8)**................................................... Senior Management Annual Incentive Plan, as amended(6)**....... 10(e) Form of Severance Agreement for Senior Officers, as amend- 10(f) ed(9)**....................................................... 1993 Stock Purchase Plan for Selected Managers and Key Staff Employees, as amended(8)**.................................... 10(g) 1986 Stock Incentive Plan, as amended(8)**..................... 10(h) 1991 Stock Incentive Plan, as amended(8)**..................... 10(i) 1995 Stock Incentive Plan, as amended(6)**..................... 10(j) Forms of option agreement with certain executive officers and directors, as amended(10)**................................... 10(k) Form of option agreement with non-employee directors, as 10(l) amended(6)**.................................................. Unfunded Supplemental Benefit Plan(5)**........................ 10(m) Amendment to Unfunded Supplemental Benefit Plan adopted on 10(n) April 25, 1991(11)**.......................................... Employment Agreement between R. R. Donnelley & Sons Company and William L. Davis(12)**.................................... 10(o) Premium-Priced Option Agreement between R. R. Donnelley & Sons Company and William L. Davis(12)**............................ 10(p) Employment Agreement between R. R. Donnelley & Sons Company and Cheryl A. Francis(7)**.................................... 10(q) Agreement between R. R. Donnelley & Sons Company and W. Ed Ty- 10(r) ler(1)**...................................................... Computation of Ratio of Earnings to Fixed Charges.............. 12 Subsidiaries of R. R. Donnelley & Sons Company................. 21 Consent of Independent Public Accountants dated March 31, 23 1999.......................................................... Financial Data Schedule........................................ 27 E-1
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-------- *Filed with the Securities and Exchange Commission. Each such exhibit may be obtained by a shareholder of the Company upon payment of $5.00 per exhibit. **Management contract or compensatory plan or arrangement. (1) Filed as Exhibit to Annual Report on Form 10-K for the year ended December 31, 1997, filed on March 4, 1998, and incorporated by reference. (2) Filed as Exhibit to Quarterly Report on Form 10-Q for the quarterly period ended March 31, 1996, filed on May 3, 1996, and incorporated herein by reference. (3) Filed as Exhibit to Form 8-A filed on June 5, 1996, and incorporated herein by reference. (4) Instruments, other than that described in 4(c) and 4(d), defining the rights of holders of long-term debt not registered under the Securities Exchange Act of 1934 of the registrant and of all subsidiaries for which consolidated or unconsolidated financial statements are required to be filed are being omitted pursuant to paragraph (4)(iii)(A) of Item 601 of Regulation S-K. Registrant agrees to furnish a copy of any such instrument to the Commission upon request. (5) Filed as Exhibit with Form SE filed on March 26, 1992, and incorporated herein by reference. (6) Filed as Exhibit to Quarterly Report on Form 10-Q for the quarterly period ended September 30, 1998, filed on November 12, 1998, and incorporated herein by reference. (7) Filed as Exhibit to Annual Report on Form 10-K for the year ended December 31, 1996, filed on March 10, 1997, and incorporated herein by reference. (8) Filed as Exhibit to Quarterly Report on Form 10-Q for the quarterly period ended September 30, 1996, filed on November 1, 1996, and incorporated herein by reference. (9) Filed as Exhibit to Annual Report on Form 10-K for the year ended December 31, 1993, filed on March 28, 1994. (10) Filed as Exhibit to Form S-3 filed on January 15, 1998, and incorporated herein by reference. (11) Filed as Exhibit with Form SE filed on May 9, 1991 and incorporated herein by reference. (12) Filed as Exhibit to Quarterly Report on Form 10-Q for the quarterly period ended March 31, 1997, filed on May 7, 1997, and incorporated herein by reference. E-2

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