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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, 2002

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)

Registrant’s telephone number—(312) 326-8000

Securities registered pursuant to Section 12(b) of the Act:

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         ü                    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 statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.    ¨

Indicate by check mark whether the registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2).    Yes         ü                    No                      

As of February 5, 2003, 113,320,074 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 Transactions on February 5, 2003) held by nonaffiliates was $2,125,250,800.

DOCUMENTS  INCORPORATED  BY  REFERENCE

Portions of the registrant’s definitive Proxy Statement dated February 24, 2003, are incorporated by reference into Part III of this Form 10-K.

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TABLE  OF  CONTENTS

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PART  I

ITEM  1.    BUSINESS

Industry and Company Overview

R.R. Donnelley & Sons Company (NYSE:DNY) prepares, produces and delivers integrated communications services that efficiently and effectively produce, manage and deliver our customers’ content, regardless of the communications medium. While our print capabilities remain the foundation of the company, our recent focus on expanding our range of offerings with value-added services allows us to create additional value.

We provide solutions designed to enhance the effectiveness of our customers’ communications. Our services include:

Our 138-year history as a printing industry leader positions us well for the future. We expect print advertising to remain among the most cost-effective ways for our customers to deliver their messages and generate revenue as they use words and images to inform, educate, entertain and sell to their audiences.

We believe that print will remain integral to successful marketing given its unique capabilities, such as portability and high-quality graphics that cannot be duplicated by other communications methods. We also believe that the nature of print will continue to evolve. The ability of print to be targeted, timely, flexible and integrated with other communications media will become even more critical.

End Market Descriptions

We operate primarily in the commercial print portion of the printing industry, with related service offerings designed to offer customers complete solutions for communicating their messages to targeted audiences. While our manufacturing plants, financial service centers and sales offices are located throughout the U.S. and selected international markets, the supporting technologies and knowledge base are common. Our locations have a range of production capabilities to serve our customers and end markets. We manufacture products with the operational goal of optimizing the efficiency of the common manufacturing and distribution platforms. As a result, most plants produce work for customers in two or three of our end markets.

The following describes the end markets we serve:

Magazines, Catalogs and Retail    R.R. Donnelley is a leader in the North American magazine, catalog and retail markets. These markets are characterized by demand for large, cost-effective print runs with opportunity for

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differentiation among competitors through services such as Premedia Technologies and Donnelley Logistics. Our U.S. customers include the majority of the top 10 magazine titles, and a majority of the largest consumer catalog companies and retailers. Contracts typically span from three to five years.

We are also a leader in providing short-run publishers, catalogers and associations with comprehensive communications solutions. We serve customers with highly targeted audiences and typical production runs from 15,000 to 200,000 copies. We offer full-service and cost-effective solutions for business-to-business and consumer magazine and catalog publishers, as well as journal, association and academic publishers.

Telecommunications    R.R. Donnelley is the worldwide leader in the directory market. We serve the global directory needs of telecommunications providers, including three of the four U.S. Regional Bell Operating Companies (SBC, Verizon and Qwest), independent directory publishers such as Feist, RHD, White Directories and Yell USA and leading international directory publishers such as Yell and Shanghai Telephone. Directory contracts typically span five to 12 years, with our current major contracts expiring between 2006 and 2015.

Book Publishing Services    R.R. Donnelley, the leader in the North American book market, serves the consumer, religious, educational and specialty book segments. We are a key services provider for the majority of the top 10 U.S. book publishers and we typically print more than 50% of The New York Times’ adult best-seller titles. We also print approximately one-third of all textbooks used in U.S. classrooms.

Premedia Technologies    R.R. Donnelley’s Premedia Technologies business partners with customers to effectively create, manage, prepare and distribute customer content. We offer services in both conventional and digital photography, creative and color services, page production, ad management, facilities management and content management. Integrating these core competencies enables us to help customers efficiently, consistently and successfully deliver their messages across multiple channels, including print and the Internet. We leverage our experience in content production and workflow optimization to link customers’ creative processes with today’s technologies. Facilities located in key markets provide close customer contact with nationwide scale up capabilities. Premedia Technologies’ services are used by leading-edge companies in the advertising, catalog, corporate, magazine, retail and telecommunications markets.

Financial Services    R.R. Donnelley Financial, a leader in the U.S. and international financial services markets, supports the communications needs of corporations, and their investment banks and law firms, as those corporations access the global capital markets. We also are a leading provider of customized communications solutions for investment management, banking, insurance, and managed care companies.

Our global service network, manufacturing platform and distribution system give us unique advantages in servicing the capital markets, particularly for large financial deals, including initial public offerings and mergers. To meet our clients’ needs for speed, confidentiality and convenience, we have developed technology for virtual deal management and are experts in EDGAR HTML filings. In addition, in 2002, we introduced NET.Filer, an online self-service application designed to help clients meet the accelerated Form 4 filing requirements mandated by the U.S. Securities and Exchange Commission (SEC).

Our customized communications solutions business enables investment management, banking, managed care, and insurance clients to manage and produce their stakeholder communications, from compliance documents to marketing material, more efficiently. We provide an integrated suite of information management, content assembly and delivery solutions designed to give our clients closer and longer-lasting relationships with their customers.

RRD Direct    RRD Direct offers expertise in a wide range of direct marketing print and related services, to guide customers smoothly and cost-effectively through direct-marketing projects. Our full-service solutions include content creation, database management, premedia, printing, personalization, finishing and distribution. We produce highly personalized and sophisticated direct mail pieces that generate results for our customers.

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International    We have extended our core competencies for high-quality print and related services into non-U.S. geographic markets. These markets tend to be emerging, with favorable demographic trends such as rising education levels and increasing disposable income. Our operations in Latin America, Poland and China, where we produce magazines, books and telephone directories, are reported as “International.” Financial Services’ international revenue is included in “Financial Services.” Directory revenues from England are included in “Telecommunications.”

R.R. Donnelley Logistics    R.R. Donnelley is one of the largest users of the USPS, handling over 20 billion print and mail pieces, and over 160 million packages each year. Distribution costs are a significant component of our customers’ cost structures, and our ability to deliver mail and packages more predictably and cost-effectively than competitors is a key differentiator.

Donnelley Logistics continues to focus on growing the package delivery part of its operation, which complements its long-standing core competency of print logistics. By leveraging our national network as well as the USPS infrastructure to make the final delivery to households and businesses, we provide more economical logistics services to both markets. Through “zone skipping,” greater postal discounts are obtained, and we provide more economical, reliable and easy-to-use delivery services for our customers.

In addition to delivering packages and printed material, Donnelley Logistics also provides package return services and expedited distribution of time-sensitive and secure material (expedited services). Together, these services help merchandisers and other businesses manage their supply chains more effectively and at a lower cost.

Beginning January 1, 2002, we revised our segment reporting to reflect changes in how we operate and internally report our businesses. As a result of these changes, we disclose the following two reportable segments: Donnelley Print Solutions and Logistics Services.

Financial and other information relating to these business segments is included in Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations, and in Note 18, “Industry Segment Information,” to the consolidated financial statements. Within the Donnelley Print Solutions segment, our business is concentrated geographically in the U.S., where we have 33 operating facilities as of December 31, 2002 that generated $3.1 billion in net sales in 2002. Within the Logistics Services segment, we have 20 operating facilities within the U.S. as of December 31, 2002 that generated $784 million in net sales in 2002. Within the Other segment, Financial Services has six operating facilities as of December 31, 2002 that generated $427 million in net sales in 2002. RRD Direct, also in the Other segment, has five operating facilities as of December 31, 2002 that generated $139 million in net sales in 2002. In addition to our U.S. facilities, we operate 13 plants in Latin America, Europe and China. Information relating to our international operations is included in Note 19, “Geographic Area Information,” to the consolidated financial statements.

Commercial printing remains a competitive industry. Consolidation among our customers and in the printing industry, as well as over capacity in the industry as a whole, has put pressure on prices and increased competition among printers. Our logistics businesses, which leverage the USPS delivery system, face competition generally from smaller, regional carriers. We will compete by leveraging our position and size, generating continued productivity improvements and enhancing the value we deliver to our customers by offering them products and services that improve their effectiveness and reduce their total delivered cost. While we have contracts with many of our print customers as discussed below, 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. While our manufacturing and distribution facilities are well located for the global, national or regional distribution of our products, competitors in some areas of the U.S. may 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.

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Demand in several of the end markets served by our print and logistics businesses is affected by advertising and consumer spending trends. Historically, our businesses which serve the Magazines, Catalogs and Retail and Book Publishing Services end markets generate higher revenues in the second half of the year, driven by increased advertising pages within magazines, and holiday catalog, retail and book volumes. These same factors drive higher revenues in the second half of the year for both our print and package logistics businesses.

Approximately 60% of our total company sales are under contracts 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 had a relationship with the company that accounted for 10% or more of our sales in 2002.

The primary raw materials we use in our print businesses are paper and ink. In 2002, we spent approximately $1.4 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 2003, and management believes extensions and renewals of these purchase contracts will provide adequate paper supplies in the future. Ink and related 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 the local facility and corporate levels to increase economies of scale.

Our overriding objectives in the environmental, health and safety arenas are to create sustainable compliance and an injury-free workplace. We believe that 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 on our results of operations or our competitive position.

As of December 31, 2002, we had approximately 30,000 employees. Approximately 7,700 employees in our U.S. workforce have been our employees for 10 to 24 years, and more than 2,800 have been our employees for 25 years or longer. As of December 31, 2002, we employed approximately 24,000 people in the United States, approximately 350, or 1.4%, of whom were covered by collective bargaining agreements. In addition, we employed approximately 6,000 people in our international operations, approximately 1,400, or 23.8%, of whom were covered by collective bargaining agreements.

We did not make any business acquisitions during 2002 or 2001. During 2000, we made several business acquisitions to extend our geographic reach and expand our range of capabilities. Within the Donnelley Print Solutions segment, in January 2000, we acquired Omega Studios-Southwest, Inc., a photography studio offering digital photography and creative services. In February 2000, we acquired Iridio, Inc., a Seattle-based full-services premedia technologies company. Both of these acquisitions are included within our Premedia Technologies operations. Within the Logistics Services segment, in February 2000, we acquired CTC Distribution Services L.L.C. (package logistics), a consolidator of business-to-home packages. In the Other segment, in February 2000, we acquired EVACO Inc., a Florida-based financial printer, included within our Financial Services operations. In July 2000, we also acquired Circulo do Livro, a Brazilian book printer, included within our International operations. See Note 3, “Acquisitions and Investments,” to the consolidated financial statements for more details.

During 2002 and 2001, we announced the closure of several of our facilities within the Donnelley Print Solutions segment, Financial Services and International operations to improve the effectiveness and efficiency of our overall print platform. During 2001, we also closed several start-up operations, including Red Rover Digital, that were included in the Other operating segment. See Note 4, “Restructuring and Impairment,” to the consolidated financial statements for more details.

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In November 2001, we sold our remaining investment in the common stock of Stream International Inc. (Stream) for approximately $10 million in cash.

In June 2000, we sold our 100% interest in R.R. Donnelley (India) Ltd. and its 25.37% owned subsidiary, Tata Donnelley Limited, to Tata Sons Limited for approximately $13 million in cash.

Available Information    We maintain an Internet website at www.rrdonnelley.com where our Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K and all amendments to those reports are available without charge, as reasonably practicable following the time they are filed with or furnished to the SEC.

Special Note Regarding Forward-Looking Statements    Our Annual Report to Shareholders, including 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 and regulatory matters. 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 war or acts of terrorism affecting the overall business climate; competition with other communications services providers based on pricing and other factors; fluctuations in the cost of paper, other raw materials and fuel we use; changes in postal rates and postal regulations; seasonal fluctuations in overall demand for services; changes in customer demand; changes in the advertising and printing markets; changes in the capital markets that affect demand for financial printing; the financial condition of our customers; our ability to continue to obtain improved operating efficiencies; our ability to continue to develop new solutions for our customers; the general condition of the U.S. economy and the economies of other countries in which we operate; changes in the rules and regulations to which we are subject and the cost of complying with these rules and regulations, including environmental and health and welfare benefit regulations; changes in the costs of healthcare and other benefits provided to our employees; changes in the rules and regulations to which our customers are subject, particularly those affecting privacy or the printing requirements of Financial Services or Telecommunications customers; 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 leased office space in a building in Chicago, Illinois. In addition, as of December 31, 2002, we lease or own 64 U.S. facilities, some of which have multiple buildings and warehouses. The U.S. facilities encompass approximately 17.6 million square feet. We lease or own 13 international facilities encompassing approximately 2.4 million square feet in Latin America, Europe and Asia. Of the U.S. and international manufacturing and warehouse facilities, approximately 17.4 million square feet of space is owned, while the remaining 2.6 million square feet of space is leased. In addition, we have sales offices across the U.S., Latin America, Europe and Asia.

ITEM  3.    LEGAL  PROCEEDINGS

On November 25, 1996, a 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 in violation of Section 1981 of the Civil Rights Act of 1871, as amended, and the U.S. 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.

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Although plaintiffs sought 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 brought by certain named individuals relate to other company locations.

On June 30, 1998, a 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 also claim retaliation by the company for the filing of discrimination charges or otherwise complaining of race discrimination.

On April 6, 2001, in an amended opinion, the district court judge in the Jones and Adams cases certified three plaintiff classes in the actions: a class consisting of African-American employees discharged in connection with the shutdown of the Chicago catalog operations; a class consisting of African-American employees of the Chicago catalog operations after November 1992 who were other than permanent employees; and a class consisting of African-Americans subjected to an allegedly hostile working environment at the Chicago catalog operations, the Chicago Financial, Pontiac or Dwight, Illinois, manufacturing operations. The judge also consolidated the Jones and Adams cases for pretrial purposes.

In a decision issued September 16, 2002, the Seventh Circuit Court of Appeals overturned a ruling by the trial court and held that a two year statute of limitations applies to the claims filed under Section 1981 of the Civil Rights Act. The court of appeals remanded the case for further proceedings consistent with its opinion, and on November 21, 2002, the court of appeals denied plaintiffs’ petition for rehearing. Absent the trial court’s adoption of plaintiffs’ theories tolling the statute of limitations, the ruling of the court of appeals, unless reversed on appeal, will bar the claims of the classes in the Jones case.

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 alleged that the company violated the Employee Retirement Income Security Act (ERISA) in determining benefits payable under its Retirement Benefit and Separation Pay Plans to retiring or terminated employees. The complaint sought recalculation of pension benefits and separation pay due plaintiffs since their termination dates, as well as actual damages for, and reinstatement to correct, the alleged discrimination. On August 14, 1997, the court certified classes in both the age discrimination and ERISA claims limited to certain former employees of the Chicago catalog operations.

On December 28, 2000, a purported class action was brought against the company and certain of its benefit plans in federal district court in Chicago on behalf of certain former employees of the Chicago catalog operations (Jefferson, et al. v. R.R. Donnelley & Sons Co., et al.). The suit alleged that enhanced pension benefits were not paid to plaintiffs and that plaintiffs are being required to contribute to the costs of retiree medical coverage, both allegedly in violation of plan documents and ERISA. The complaint sought recalculation of pension benefits due plaintiffs since their retirement dates, reimbursement of any amounts paid by plaintiffs for medical coverage, interest on the foregoing amounts, as well as a declaration as to the benefits due plaintiffs in the future.

The Gerlib and Jefferson cases raised many of the same claims for recalculation of benefits due employees and are before the same district court judge. In an order dated October 26, 2001, further clarified in an order dated January 25, 2002, the district court judge ruled that permanent employees who were eligible and elected to receive special augmented separation pay in conjunction with the closure of the Chicago catalog operations were not eligible to also receive regular separation pay, and that employees other than those considered permanent employees at the date of closure were not eligible to receive special augmented separation pay. In the same order, the judge ruled that under the terms of the company’s plans, permanent employees who were eligible and elected to receive enhanced retirement benefits were also entitled to receive regular separation pay. In an order dated

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June 11, 2002, the district court judge found that employees who were otherwise not eligible to receive enhanced retirement benefits at the date of closure of the Chicago catalog operations but whose combined age and service equaled 75 years or more at the date of their termination were entitled to receive enhanced retirement benefits, and that employees of the Chicago catalog operations in 1994 who were in surplus occupations were entitled to receive enhanced retirement benefits regardless of their age at the date of termination. In the June 2002 order, the judge further ruled that members of the classes who elected to receive augmented separation pay in connection with the closure of the Chicago catalog operations were not entitled to also receive enhanced retirement benefits.

As to other claims of the plaintiffs in the cases, by order dated January 4, 2002, the district court judge granted summary judgment on the Jefferson claim relating to medical benefits, finding that retirees from the Chicago catalog operations were not entitled to non-contributory medical benefits for life. Following a two week trial on the age discrimination claim raised in Gerlib, on August 2, 2002, a jury reached a verdict in the company’s favor, finding that the company did not discriminate against older workers in the shutdown of the Chicago catalog operations. On August 12, 2002, plaintiffs filed a motion seeking a new trial on the age discrimination claim, alleging that the jury verdict is contrary to the weight of the evidence. That motion was denied on November 7, 2002.

The Jones, Gerlib and Jefferson cases relate primarily to the circumstances surrounding the closure of the Chicago catalog operations. The company believes that it acted properly and without discriminating in closing the operations, and that the adverse rulings of the district court judge are based on language contained in the company’s plan documents rather than on wrongdoing of the company. Further, the company does not believe that it discriminated against any of the plaintiffs who have made allegations surrounding other operations of the company. However, rather than continue to litigate the issues in Gerlib and Jefferson through the appellate process and begin the multiple trials required to decide the claims raised in the Adams case, the parties reached agreement on the terms for settlement. The settlements, which must be approved by the district court following fairness hearings, resolve all of the issues in the Adams, Gerlib and Jefferson cases, and resolve the issues in Jones which relate to claims arising in locations other than the Chicago catalog operations, without any admission of wrongdoing by the company. The total amount to be paid in connection with the settlements is $21 million, of which $9 million will be paid by the company’s Retirement Benefit Plan. The total pretax charge during 2002 related to these settlements was $16 million, and is included in Cost of Sales in the consolidated statements of income on F-2.

While the settlements described will dispose of the Adams, Gerlib and Jefferson cases, and a portion of the Jones litigation, the issue relating to the application of the statute of limitations to certain of the discrimination claims in the Jones case has not been finally decided. Management is unable to make a meaningful estimate of the overall loss that could result in the event of an unfavorable final determination of this matter.

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.

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, 2002.

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EXECUTIVE OFFICERS OF R.R. DONNELLEY & SONS COMPANY

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PART  II

ITEM 5.    MARKET FOR R.R. DONNELLEY & SONS COMPANY’S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS

Our common stock is listed and traded on the New York Stock Exchange, Chicago Stock Exchange and Pacific Exchange, Inc.

As of February 5, 2003, there were 8,388 stockholders of record. Quarterly prices of our common stock, as reported on the New York Stock Exchange-Composite Transactions, and dividends paid per share during the two years ended December 31, 2002, are contained in the chart below:

ITEM 6.    SELECTED FINANCIAL DATA

SELECTED FINANCIAL DATA

(Thousands of dollars, except per-share data)

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ITEM  7.    MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following discussion of our financial condition and results of operations should be read together with our consolidated financial statements and notes to those statements included in Item 15 of Part IV of this Form 10-K.

Significant Accounting Policies and Critical Estimates

The preparation of financial statements in conformity with generally accepted accounting principles requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities, the 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. The SEC has defined a company’s most critical accounting policies as those that are most important to the portrayal of its financial condition and results of operations, and which require the company to make its most difficult and subjective judgments, often as a result of the need to make estimates of matters that are inherently uncertain. Based on this definition, we have identified the following critical accounting policies and judgments. Although we believe that our estimates and assumptions are reasonable, they are based upon information available when they are made. Actual results may differ significantly from these estimates under different assumptions or conditions.

Revenue Recognition

We recognize print revenue when title and risk of loss transfers to the customer and the earnings process is complete. Approximately 60% of our business is under contract. Contracts typically specify F.O.B. shipping point terms. We recognize revenue upon final shipment for a print job and not on a partial shipment basis. For most print jobs, it is common for customers to inspect the quality of the product at our facilities up to and including at the time of shipment. Our products are not shipped subject to any contractual right of return provisions. Absent specific contract terms, we recognize revenue upon final delivery of the product or upon completion of the service performed.

Revenues related to our Premedia Technologies operations, which include digital content management such as photography, color services and page production, are recognized in accordance with the terms of the contract, typically upon shipment of the completed product if sold as a part of a final printed product, or once the service has been performed and accepted by the customer if sold separately (e.g., digital photography). With respect to Donnelley Logistics, whose operations include the delivery of packages and printed material, we recognize revenue upon completion of the delivery services we provide.

Accounting for Goodwill and Certain Other Intangibles

In assessing the recoverability of goodwill and other intangible assets with indefinite lives, management must make assumptions regarding estimated future cash flows and other factors to determine the fair value of the respective assets. If these estimates and related assumptions change in the future, we may be required to record impairment charges not previously recorded. On January 1, 2002, we adopted Statement of Financial Accounting Standards (SFAS) No. 142, Goodwill and Other Intangible Assets, and are required to assess goodwill and intangible assets with indefinite lives for impairment at a minimum annually, using a two-step process that begins with an estimation of the fair value of the reporting unit. The first step is a screen for impairment, and the second step measures the amount of any impairment. These tests utilize fair value amounts that are determined by discounting estimated future cash flows developed by management. We completed the transitional test for impairment in the second quarter of 2002 and the annual test for impairment during the fourth quarter of 2002. We did not record any goodwill impairment in conjunction with these reviews.

Commitments and Contingencies

We are subject to lawsuits, investigations and other claims related to environmental, employment and other matters. Periodically, we review the status of each significant matter and assess potential financial exposure. If

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the potential loss from any claim or legal proceeding is considered probable and the amount can be estimated, we accrue a liability for the estimated loss. Because of uncertainties related to these matters, accruals are based on the best information available at the time. As additional information becomes available, we reassess the potential liability related to pending claims and may revise our estimates. See Note 8, “Commitments and Contingencies,” to the consolidated financial statements for a description of certain legal proceedings.

Long-lived Assets

We are required to assess potential impairments of long-lived assets in accordance with SFAS No. 144, Accounting for Impairment of Long-Lived Assets, if events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. An impaired asset is written down to its estimated fair value based upon the most recent information available. Estimated fair market value is generally measured by discounting estimated future cash flows developed by management. Long-lived assets that are held for disposal are recorded at the lower of the carrying value or the fair market value less the estimated cost to sell. Our long-lived assets primarily include property, plant and equipment and other noncurrent assets (primarily the costs of acquiring print contracts and volume guarantees that are amortized to net sales over the periods in which benefits will be realized).

Investments in affordable housing, which are included in other noncurrent assets, are recorded at cost, as adjusted for any declines in the fair value of the underlying properties that are deemed to be other than temporary. Our basis for determining fair value of the underlying properties requires applying management’s judgment using a significant number of estimates. We derive our estimates of fair value using remaining future tax credits to be received and expected residual values upon sale or disposition of our ownership interests. Expected residual values are developed from industry assumptions and cash flow projections provided by the underlying partnerships, which include certain assumptions with respect to operating costs, debt levels and certain market data related to the properties such as assumed vacancy rates. Should these assumptions differ from actual results in the future, we may be required to further writedown our carrying value of these investments. See Note 1, “Summary of Significant Accounting Policies,” and Note 3, “Acquisitions and Investments,” to the consolidated financial statements for additional information.

Accounting for Income Taxes

Significant judgment is required in determining our effective tax rate. In the ordinary course of business, there are transactions and calculations where the ultimate tax outcome is uncertain. Additionally, our tax returns are subject to audit by various domestic and foreign tax authorities. Although we believe that our estimates are reasonable, no assurance can be given that the final tax outcome will not be materially different than that which is reflected in our historical income tax provisions and accruals.

Defined Benefit Retirement Plans

We present the status of our defined benefit obligations and related plan assets in Note 9, “Retirement Plans,” to the consolidated financial statements. Plan assets, which consist primarily of marketable equity securities and corporate and government fixed income securities, are valued using market quotations. Plan obligations and annual pension and postretirement benefit income are determined by actuaries using a number of key assumptions. Key assumptions include the discount rate, the estimated future return on plan assets, and the anticipated rate of future salary increases. We determine the discount rate to be used for purposes of computing annual income or expense as of the beginning of the year (using a measurement date of September 30), based on high-quality corporate bond yields as of that date. The weighted average discount rates assumed for determining annual pension and postretirement income in 2002 were 6.9% and 7.0%, respectively. We expect to lower the discount rates for purposes of determining pension and postretirement income to 6.7% and 6.8%, respectively, in 2003 due to a decline in high-quality corporate bond yields as of September 30, 2002.

We determine the estimated return on plan assets primarily based on long-term historical returns of equity and fixed income markets according to our respective plan allocations. The weighted average expected asset

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return for our pension plans as of the end of 2002 was 9.4%. Plan assets for our pension plans are generally allocated as follows: domestic equity (70%); non-U.S. equity (20%) and fixed income securities (10%). By assuming historic returns of 10% for equity and 6% for fixed income securities as a benchmark, the weighted average expected return based on our pension plan asset allocation would be 9.6% compared with our assumed rate of 9.4%. While we have assumed no change in targeted asset allocation percentages for 2003, we intend to lower our expected long-term rate of return to 9.0% based on declines in equity market performance, primarily over the last three years, versus long-term historical averages.

The weighted average expected asset return for our postretirement benefit plans as of the end of 2002 was 9.0%. Plan assets for our postretirement benefit plans are generally allocated as follows: domestic equity (55%), non-U.S. equity (20%) and fixed income securities (25%). By assuming historic returns of 10% for equity and 6% for fixed income securities, the weighted average expected return based on our postretirement benefit plan allocation would be 9.0%, which is consistent with our assumptions. While we have assumed no change in asset allocation percentages for 2003, we intend to lower our expected long-term rate of return to 8.5% based on declines in equity market performance, primarily over the last three years, versus long-term historical averages.

As a result of the expected assumption changes for 2003 as noted above, we anticipate pension and postretirement income to be reduced by approximately $17 million in 2003. We do not expect to make any significant cash contributions to the plans during 2003.

Other Matters

Other than non-cancelable operating lease commitments, we do not have off-balance sheet arrangements, financings, or other relationships with unconsolidated entities or other persons, also known as “special purpose entities.” The consolidated financial statements include the accounts of the company and its majority-owned subsidiaries. Minority interests in the income or loss of consolidated subsidiaries are included in other income (expense) in the consolidated income statement. Intercompany items and transactions are eliminated in consolidation.

Financial Review

In the financial review that follows, we discuss our results of operations, financial condition and certain other information. This discussion should be read in conjunction with our consolidated financial statements and related notes that begin on page F-1.

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Items Affecting Comparability of 2002 with 2001

The following significant items affect comparability of the consolidated statements of income and segment operating results:

Restructuring and impairment: Operating results for 2002 and 2001 were affected by the following restructuring and impairment items:

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For a further description of restructuring activities and cumulative activity since inception of the restructuring plans, see Note 4, “Restructuring and Impairment,” to the consolidated financial statements.

Gain on sale of assets: 2002 included a $7 million pretax gain on the sale of our York, England manufacturing facility following the opening of our newly-constructed plant in Flaxby, England, included in the Donnelley Print Solutions segment.

Provision for litigation: 2002 included a $16 million pretax provision for the settlement of certain litigation included in the Corporate segment; see Note 8, “Commitments and Contingencies,” to the consolidated financial statements.

Gain on sale of businesses and investments: 2002 included a $6 million pretax gain from the collection of a note receivable that had been previously reserved in connection with the sale of our investment in Modus Media International (MMI) in 1999 and which was included within the Corporate segment. 2001 included a pretax gain of $7 million related to the sale of our remaining interest in Stream and was included in the Other segment.

Affordable housing write-downs: 2002 included a pretax charge of $26 million to write down the carrying value of our investments in affordable housing compared with a pretax charge of $8 million in 2001. The write-downs reflected declines in the underlying estimated fair value of our affordable housing investments and were included in the Corporate segment; see Note 3, “Acquisitions and Investments,” to the consolidated financial statements for further discussion.

Other investment write-downs: 2001 included a pretax loss of $19 million on the write-down of several Internet technology-related investments and was included in the Other segment; see discussion under the caption “Restructuring and Impairment and Other Items,” below.

Reversal of excess COLI tax reserves: 2002 included an after-tax benefit of $30 million from the reversal of excess tax reserves related to our settlement with the Internal Revenue Service (IRS) for disputed COLI deductions; see Note 10, “Income Taxes,” to the consolidated financial statements.

Impact of Goodwill Amortization:    As discussed in Note 5, “Goodwill and Other Intangible Assets,” to the consolidated financial statements, we adopted SFAS No. 142, Goodwill and Other Intangible Assets as of January 1, 2002. Under SFAS No. 142, goodwill is no longer amortized after the date of adoption of the standard. SFAS No. 142 does not permit the restatement of previously issued financial statements, but does require disclosure of the impact on prior results adjusted to exclude amortization expense related to goodwill and intangible assets which are no longer being amortized. 2001 results included $18 million ($13 million after-tax, or $0.11 per diluted share) of goodwill amortization expense. Goodwill amortization expense by segment for 2001 was as follows: Donnelley Print Solutions: $5 million; Logistics Services: $8 million; and Other:  $5 million.

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A summary analysis of expense trends is presented below:

Results of Operations—2002 compared with 2001

Consolidated net sales decreased $543 million, or 10.2%, to $4.8 billion compared with $5.3 billion in 2001, driven by the decline in net sales of our Donnelley Print Solutions segment of 11.8%. Net sales of our Logistics Services segment were up 1.1% between years, with an 8.3% increase in net sales for the package logistics business partially offset by a decrease of 7.8% in net sales from print logistics excluding expedited services.

For our print-related businesses, value-added revenue represents net sales less the cost of materials. For some customers, we purchase paper used in the printing process and pass through this cost (referred to as “pass through material sales”) at a margin that is lower than print and related services; other customers furnish their own paper. The value of customer-furnished paper is not reflected in our financial results. For our Logistics Services segment, value-added revenue represents net sales less the cost of transportation and postage. By measuring value-added revenue, we eliminate the effect of material prices and transportation costs, as well as mix issues related to customer-furnished versus Donnelley-furnished paper.

Consolidated value-added revenue decreased $244 million, or 8.1%, to $2.8 billion compared with $3.0 billion in 2001, primarily driven by the decline in value-added revenue of our Donnelley Print Solutions segment of 8.4%. Donnelley Print Solutions’ percentage decline in value-added revenue was less than the decline in net sales, primarily due to higher customer-furnished paper and improved material yield during 2002. In addition, value-added revenue is affected by the price of by-product paper we sell. Income from the sale of by-products is recorded as a reduction in cost of materials. During 2002, we recognized a reduction in cost of materials of $46 million from by-product revenues, compared with $41 million a year ago. Value-added revenue of our Logistics Services segment increased 11.3% between years, due to a 21.2% increase in value-added revenue for package logistics.

Gross profit as a percentage of net sales (gross margin) was 18.2% in 2002 compared with 17.2% in 2001, primarily due to higher gross margins within our Donnelley Print Solutions segment, partially offset by the net effect of several significant items within the Corporate segment. Donnelley Print Solutions’ gross margin in 2002 benefited from restructuring and productivity gains, the impact of lower goodwill amortization ($5 million), higher by-product revenues ($5 million) and gain on sale of assets ($7 million), which more than offset the gross margin impact from lower net sales. Logistics Services’ gross margin increased between years, driven by the improved performance of both package and print logistics, and lower goodwill amortization ($8 million). Negatively impacting gross margin in 2002 within the Corporate segment was a provision for litigation ($16 million), partially offset by a lower LIFO provision ($8 million).

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Selling and administrative expenses decreased $34 million, or 6.0%, to $534 million compared with $568 million in 2001. Reductions in volume-based incentives (sales commissions), restructuring savings from workforce reductions, lower bad debt expense ($11 million), and lower spending to build complementary businesses ($21 million) in 2002 were partially offset by higher management incentive compensation expense ($5 million), higher expenses to build marketing capabilities ($8 million) and higher benefit expenses, including medical, pension and postretirement benefit costs. Selling and administrative expenses as a percentage of net sales was 11.2% in 2002 compared with 10.7% in 2001.

Net interest expense decreased 11.8% to $63 million in 2002, primarily due to lower effective interest rates on outstanding debt. Other expense, net, was $6 million in 2002 compared with $1 million in 2001. The primary components of other expense, net, in 2002 were as follows: affordable housing write-downs ($26 million) and foreign currency transaction losses, net ($3 million), partially offset by earnings from investments ($6 million); gain on sale of businesses and investments ($6 million) and other miscellaneous income ($11 million). The primary components of other expense, net, in 2001 were as follows: other investment write-downs ($19 million); affordable housing write-downs ($8 million) and foreign currency transaction losses, net, ($5 million), partially offset by gain on sale of businesses and investments ($7 million) and other miscellaneous income ($24 million).

Earnings before income taxes in 2002 were $176 million compared with $75 million in 2001. Earnings before income taxes included $89 million and $196 million in restructuring and impairment charges for 2002 and 2001, respectively, and the other significant items affecting comparability as noted above. The effective tax rate in 2002 was 19.1% compared with 66.6% in 2001. The 2002 effective tax rate included a $30 million benefit from the reversal of excess tax reserves related to our settlement with the IRS surrounding our COLI program (see Note 10, “Income Taxes,” to the consolidated financial statements). Net income was $142 million, up $117 million from $25 million in 2001. Diluted earnings per share of $1.24 increased $1.03 from $0.21 in 2001.

The following table shows the trends in net sales and value-added revenue by end market:

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Operating Results by Business Segment—2002 compared with 2001

Net sales of our Donnelley Print Solutions segment decreased $413 million in 2002, or 11.8%, from 2001. Net sales for Magazines, Catalogs and Retail decreased 15.5% between years, which primarily reflected volume decreases and price deterioration across all major markets. The continued economic slowdown during 2002 resulted in lower volumes and more customer bankruptcies within the Catalog and Retail markets, and lower advertising pages for both trade and consumer magazines. The net sales decline in Premedia Technologies was driven by these same factors. Depressed volumes in these markets drove increased competition and pricing pressures, and certain customer work lost due to bankruptcy or other factors has been replaced with lower-priced work. Book Publishing Services’ net sales were relatively flat between years due to volume decreases in the religious and specialty markets and more customer-furnished paper, offset by volume increases in the consumer and education markets. Net sales for Telecommunications were down 12.6% between years, primarily due to a shift to more customer-furnished paper.

Net sales of our Logistics Services segment increased $9 million, or 1.1%, from a year ago. Net sales of print logistics, excluding expedited services, were down 7.8% for 2002, driven by lower volumes from a continued slow economy. Net sales of package logistics were up 8.3% between years. Unit volumes for package logistics were up 26.1% between years, which were partially offset by a mix change toward lighter weight, lower-priced packages. Net sales for 2002 for package logistics were also impacted by our decision to cease serving several large mailers during 2001 because of price levels that proved unprofitable.

Financial Services’ 2002 net sales decreased 13.4% from a year ago, driven by lower net sales from both U.S. and international capital markets, primarily during the second and third quarters. During 2002, we derived 85.9% of our capital markets net sales from the U.S. For 2002, our U.S. and international capital markets net sales were down 18.4% and 24.3%, respectively. Within Financial Services, net sales for 2002 from customized communications solutions decreased 4.2% between years. 2002 net sales for RRD Direct were down 22.6% between years, due to lower prices, unfavorable work mix and more customer-furnished paper. 2002 net sales for International were down $28 million between years due to declines in Latin America driven by lower volumes and the effects of foreign currency devaluation, partially offset by increases in Europe and China.

Value-added revenue for the Donnelley Print Solutions segment decreased $179 million, or 8.4%, from 2001, primarily due to volume declines and price deterioration within the Magazines, Catalogs and Retail markets, as well as Premedia Technologies. Value-added revenue for Magazines, Catalogs and Retail and Premedia Technologies declined 14.1% and 14.5%, respectively, between years, consistent with the declines in net sales. Value-added revenue for Book Publishing Services increased 2.3% compared with 2001 due to increases in the consumer and educational markets, partially offset by declines in the religious and specialty markets. Value-added revenue for Telecommunications decreased 1.9% between years, which was less than the percentage decline in net sales due to higher customer-furnished paper during 2002 and improved material yield.

Value-added revenue for the Logistics Services segment increased $19 million, or 11.3%, from 2001. Value-added revenue for package logistics increased 21.2% between years, driven by increased postage discounts due to deeper penetration of the postal system (closer to the final destination) and lower per unit transportation costs. Results for package logistics in 2001 were hurt by a higher relative level of large mailers at price levels that proved to be unprofitable. Actions taken throughout 2001 to raise prices and adjust work mix had a positive impact on package logistics’ value-added revenue in 2002. Value-added revenue for print logistics was flat between years, primarily due to a reduction in per unit transportation costs driven by operational efficiencies and improved vendor management, which offset volume declines.

Value-added revenue for Financial Services decreased 12.8% from 2001, driven by the net sales decline noted above, slightly offset by a reduction in material costs due to a shift to more composition and fulfillment work. The decrease in value-added revenue in 2002 for both RRD Direct and International was attributable to the declines in net sales noted above.

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Earnings from operations for the Donnelley Print Solutions segment increased $36 million, or 13.5% from 2001. Earnings from operations included $55 million and $97 million in restructuring and impairment charges for 2002 and 2001, respectively. Earnings from operations continued to be negatively affected by the slowdown in the U.S. economy, particularly in Magazines, Catalogs and Retail. During 2001, we announced actions to better align our cost structure that included the closing of four print facilities within Donnelley Print Solutions. All four of these print facilities, along with our Berea, Ohio printing facility, were closed by the end of the second quarter of 2002 (see discussion under the caption “Restructuring, Impairment and Other Items,” below). The 2002 impact of productivity initiatives and savings from actions we have taken to restructure our operations have largely offset the effects of volume declines and price erosion on earnings from operations. Also included in earnings from operations in 2002 were lower corporate assessments ($10 million) and lower selling and administrative expenses ($7 million), due to a decrease in management incentive compensation and reduced volume-based selling incentives.

Earnings from operations for 2002 for the Logistics Services segment were $11 million compared with a loss from operations of $5 million a year ago. This improved performance was driven by higher value-added revenue from the package logistics business due to the factors noted above, along with lower goodwill amortization of $8 million. Earnings from operations for the print logistics business increased between years as a result of transportation cost savings noted above, and improved margins in 2002 following start-up problems in a distribution center in the Northeast during the fourth quarter of 2000 that continued into early 2001. Earnings from operations in 2002 also benefited from the shutdown of package logistics’ former headquarters in Minneapolis, Minnesota in mid-2001.

Loss from operations for the Other segment was $61 million in 2002 compared with a loss of $168 million in 2001. Of the $107 million improvement in operating results between years, $78 million related to lower restructuring and impairment charges and $21 million for lower spending on complementary businesses. Spending on complementary businesses in 2001 related primarily to Red Rover Digital (Red Rover), a provider of Internet web site design services, which was shut down during the fourth quarter of 2001. Financial Services’ loss from operations increased between years due to the severity of the capital markets decline and additional restructuring and impairment charges in 2002. RRD Direct’s loss from operations decreased between years due to lower restructuring and impairment charges, lower goodwill amortization, savings from previous restructuring actions and higher productivity that more than offset the impact of lower net sales. International’s loss from operations decreased in 2002 primarily due to lower restructuring and impairment charges and related cost savings in Latin America, partially offset by higher start-up costs for our facility in Shanghai, China ($6 million).

Loss from operations for the Corporate segment was $10 million in 2002 compared with earnings from operations of $51 million in 2001. The change between years of $61 million in the Corporate segment was due to the following: higher restructuring and impairment charges ($12 million); additional provision for litigation ($16 million); lower benefit plan earnings (excluding service costs allocated to the segments) ($11 million); higher corporate staff expenses ($9 million); lower corporate expense allocations ($19 million) and higher miscellaneous expenses ($2 million), partially offset by a lower LIFO provision ($8 million).

For a reconciliation of earnings from operations to earnings before income taxes by segment, see Note 18 “Industry Segment Information,” to the consolidated financial statements.

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Items Affecting Comparability of 2001 with 2000

The following significant items affect comparability of the consolidated statements of income and segment operating results:

Restructuring and impairment:  Operating results for 2001 were affected by the following restructuring and impairment items:

For a further description of restructuring activities and cumulative activity since inception of the restructuring plans, see Note 4, “Restructuring and Impairment,” to the consolidated financial statements.

Provision for plant closures:  2000 included a pretax charge of $9 million to close two manufacturing facilities (an RRD Direct facility and a Financial Services printing plant, both included in the Other segment).

Gain on sale of businesses and investments:  2001 included a pretax gain of $7 million related to the sale of our remaining interest in Stream, and was included in the Other segment.

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Affordable housing write-downs:  2001 included a pretax charge of $8 million to writedown the carrying value of our investments in affordable housing compared with a pretax charge of $4 million in 2000. The write-downs reflected declines in the underlying estimated fair value of our affordable housing investments and were included in the Corporate segment; see Note 3, “Acquisitions and Investments,” to the consolidated financial statements for further discussion.

Other investment write-downs:  2001 included a pretax loss of $19 million on the write-down of several Internet technology-related investments and was included in the Other segment; see discussion under the caption “Restructuring and Impairment and Other Items,” below.

Gain from demutualization:  2000 included a pretax gain of $13 million related to the sale of shares received from the demutualization of our basic life insurance carrier and was included in the Corporate segment.

Results of Operations—2001 compared with 2000

Net sales decreased $467 million, or 8.1%, to $5.3 billion compared with $5.8 billion in 2000. Acquisitions contributed an increase of $104 million in net sales between years, which was more than offset by lower volumes within the Donnelley Print Solutions, Logistics Services and Other segments.

Consolidated value-added revenue decreased $305 million, or 9.2%, to $3.0 billion compared with $3.3 billion in 2000. Acquisitions contributed an increase of $35 million in value-added revenue between years. Value-added revenue is affected by the price of scrap (by-product) paper we sell. Income from the sale of by-products is recorded as a reduction in our cost of materials. During 2001, we recognized a reduction in our cost of materials of $41 million from by-product revenues compared with $66 million in 2000, a decrease of 37.8%.

Gross profit as a percentage of net sales (gross margin) declined to 17.2% in 2001 compared with 19.1% in 2000, primarily due to lower margins within the Donnelley Print Solutions segment and our Financial Services operations within the Other segment. Gross margin was affected negatively in 2001 by lower volumes and relatively high fixed costs across most of the Donnelley Print Solutions segment, primarily within Magazines, Catalogs and Retail, as well as within Financial Services. Our Logistics Services segment, which has a lower gross margin than our Donnelley Print Solutions segment, also represented a higher proportion of net sales in 2001 (15% versus 12% in 2000).

Selling and administrative expenses decreased $30 million, or 5.1%, to $568 million compared with $598 million in 2000. Reductions in volume-related costs, including incentive compensation and sales commissions, savings resulting from our elimination of approximately 250 administrative positions company-wide ($10 million) and general cost containment were partially offset by increased bad debt expense ($16 million). The increase in bad debt expense during 2001 reflected a deterioration in collections during the year, particularly due to retail bankruptcies. Selling and administrative expenses as a percentage of net sales was 10.7% in 2001 compared with 10.4% in 2000.

Net interest expense decreased 20.6% to $71 million in 2001, due to lower average debt levels, and lower average short-term borrowing rates. Other expense, net, in 2001 was $1 million compared with other income, net, of $23 million in 2000. The primary components of other expense, net, in 2001 were as follows: other investment write-downs ($19 million); affordable housing write-downs ($8 million) and foreign currency transaction losses, net ($5 million), partially offset by gain on sale of businesses and investments ($7 million) and other miscellaneous income ($24 million). The primary components of other income, net, in 2000 were as follows: gain from demutualization ($13 million) and other miscellaneous income ($16 million), partially offset by affordable housing write-downs ($4 million) and foreign currency transaction losses, net ($2 million).

Earnings before income taxes decreased $359 million, or 82.7%, to $75 million compared with $434 million in 2000. Earnings before income taxes in 2001 included restructuring and impairment charges of $196 million

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and the other significant items affecting comparability as noted above. The effective tax rate in 2001 was 66.6% compared with 38.5% in 2000. See Note 10, “Income Taxes,” to the consolidated financial statements for a reconciliation of the effective tax rate between years as certain of the significant items affecting comparability did not have an associated income tax provision or benefit as shown in the table above. Net income decreased $242 million, or 90.6%, to $25 million compared with $267 million in 2000. Diluted earnings per share decreased 90.3% to $0.21 in 2001 from $2.17 in 2000. The rate of decrease was slightly lower on a per-share basis due to fewer average shares outstanding in 2001.

The following table shows the trends in net sales and value-added revenue by end market:

Operating Results by Business Segment—2001 Compared with 2000

Net sales of our Donnelley Print Solutions segment decreased $343 million in 2001, or 8.9%, from 2000. The incremental impact of acquisitions on net sales between years was not significant. First half net sales of the Donnelley Print Solutions segment were down 6.8% between years. The impact of the economic slowdown worsened in the second half of 2001 as second half net sales decreased by 10.9% between years. Net sales for Magazines, Catalogs and Retail decreased 12.2% between years, which reflected volume decreases across all major markets. Increased retail bankruptcies, as well as lower magazine and retail insert advertising spending, and lower catalog page counts drove the majority of volume declines. Net sales for Book Publishing Services were down 9.2% from 2000 driven by lower volumes in the consumer and religious markets. Net sales for Telecommunications decreased 3.2% between years primarily due to volume shortfalls in the domestic directory market.

Net sales of our Logistics Services segment increased $84 million in 2001, or 12.2%, from 2000. We acquired package logistics in February 2000, which contributed an incremental $104 million in net sales between years. Unit volumes for package logistics were up 21.9% between years, partially due to an additional five weeks of activity in 2001. In addition, package logistics benefited from higher pricing in 2001, including a more profitable customer mix. Net sales of our print logistics business were down 6.0% between years, driven primarily by lower freight services volume and, to a lesser extent, reduced expedited services volume.

Net sales for Financial Services decreased 22.7% compared with 2000, driven primarily by the slowdown in both U.S. and international capital markets. Capital markets volume was particularly impacted by the events and

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aftermath of September 11. During 2001, we derived 85.0% of our capital markets sales from the U.S.; our U.S. capital markets sales were down 20.9% from 2000. Due to weakness in the international capital markets during 2001, our international capital markets sales were down 58.6% from 2000. Within Financial Services, net sales for 2001 from customized communications solutions decreased 4.9% between years. Net sales for RRD Direct in 2001 were down 9.5% between years, as work performed in 2000 for the U.S. census was only partially offset by improved price and work mix in 2001. Net sales for International decreased 9.6% between years, primarily due to lower net sales in Latin America from lower volumes and foreign currency devaluation.

Value-added revenue for the Donnelley Print Solutions segment decreased $199 million, or 8.5%, from 2000, resulting from volume declines across all major markets. The incremental impact of acquisitions on value- added revenue between years was not significant. Value-added revenue for Magazines, Catalogs and Retail declined 12.4% between years, driven primarily by lower volumes as noted above. By-products revenues in the Donnelley Print Solutions segment were down $23 million between years.

Value-added revenue for the Logistics Services segment increased $45 million, or 36.9%, from 2000. Package logistics contributed an incremental $35 million in value-added revenue between years, up 59.1%. During 2000, package logistics was affected negatively by low price levels in response to competition and low-margin work for a number of large mailers. In 2001, package logistics benefited from higher net sales, and higher postage discounts due to deeper penetration of the postal system (closer to the final destination), which more than offset increased transportation and handling costs. Value-added revenue for 2001 in our print logistics business increased 16.3% from 2000, despite the drop in net sales between years, driven by lower transportation costs. The decline in transportation costs related to better cost management and non-recurring start-up costs of a new distribution facility in the Northeast during the fourth quarter of 2000.

Financial Services’ 2001 value-added revenue decreased 23.0% from 2000, driven by the slowed U.S. and international capital markets. The declines from 2000 in value-added revenue for RRD Direct and International were consistent with the declines in net sales.

Earnings from operations for the Donnelley Print Solutions segment declined $213 million, or 44.2%, from 2000. Earnings from operations included $97 million in restructuring and impairment charges in 2001. Earnings from operations within Magazines, Catalogs and Retail in particular were hurt by the severity of the volume declines, particularly during the second half of 2001. During 2001, we announced actions to better align our cost structures that included the closing of four print facilities. Two of these facilities were closed in 2001, while the two largest (Des Moines, Iowa and Old Saybrook, Connecticut) ceased operations in the second quarter of 2002.

Our Logistics Services segment incurred a loss from operations of $5 million including a $1 million charge for restructuring and impairment compared with a loss of $14 million in 2000. This improved operating performance in 2001 was driven by package logistics, and the positive factors affecting value-added revenue noted above. Logistics Services also benefited from reduced expenses in 2001 related to the shutdown of package logistics’ former headquarters in Minneapolis, Minnesota during the year. Our print logistics business incurred a loss from operations in 2001, driven by lower freight services volume, as well as lower expedited services volume related to the declines in Financial Services. Within print logistics, the distribution center start-up problems in the fourth quarter of 2000, as noted above, were resolved in early 2001, partially offset by additional facility expansion costs during 2001.

The loss from operations within the Other segment was $168 million in 2001, compared with income of $8 million in 2000. Of the $176 million decline in operating results between years, $94 million related to higher restructuring and impairment charges in 2001. The loss from operations for both years included expenses of $22 million and $28 million in 2001 and 2000, respectively, to grow complementary busineses, including Red Rover, which was shut down during the fourth quarter of 2001. 2000 included an additional operating loss of $2 million for our Louisville distribution center through June 2000, the date of disposition. Earnings from operations within Financial Services were negatively affected in 2001 by the capital markets slowdown, resulting

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in a net loss from operations in 2001. RRD Direct incurred volume shortfalls during 2001 and experienced operational issues at its Newark, Ohio facility, following the consolidation of another direct mail facility into Newark in 2000. The loss from operations in 2000 included a pretax charge of $9 million to close two plants (an RRD Direct facility and a Financial Services printing plant). The International loss from operations increased in 2001 primarily due to additional restructuring and impairment charges, and volume declines and currency devaluation in Latin America.

Earnings from operations for the Corporate segment were $51 million in 2001 compared with $26 million in 2000. This increase was driven by higher benefit plan earnings (excluding service costs) ($9 million); lower provision for LIFO inventories ($4 million) and lower corporate administrative and other unallocated expenses ($16 million), partially offset by higher restructuring and impairment charges ($4 million).

For a reconciliation of earnings from operations to earnings before income taxes by segment, see Note 18 “Industry Segment Information,” to the consolidated financial statements.

Other expense, net, for the Other segment in 2001 included a pretax loss of $5 million on our investment in Argentina related to the impact of the devaluation of the Argentine peso, which is the functional currency of our operations in Argentina. While the devaluation was formally announced in January 2002, the currency impact of translating non-peso denominated assets and liabilities into U.S. dollars was recorded in 2001.

Restructuring and Impairment and Other Items

The following discussion should be read in conjunction with Note 4, “Restructuring and Impairment,” to the consolidated financial statements.

During 2002, we recorded pretax restructuring and impairment charges of $89 million ($54 million after-tax, or $0.47 per diluted share). The 2002 pretax charge included $15 million related to the shutdown of our Berea, Ohio plant which produced short-run specialty magazines and was included within the Donnelley Print Solutions segment. The total 2002 pretax charge was comprised of the following: employee termination benefits related to additional workforce reductions ($37 million); a curtailment loss related to postretirement benefit plans ($8 million); exit costs related to closed facilities ($6 million); relocation costs for defined exit activities which were expensed as incurred ($22 million) and asset impairments to reduce the carrying values of assets held for disposal to fair value ($16 million). 2002 total pretax restructuring and impairment charges by segment were: Donnelley Print Solutions: $55 million; Logistics Services: $2 million; Other: $16 million and Corporate: $16 million. The pretax charge was included as restructuring and impairment charges in the consolidated statements of income on page F-2.

During 2001, we recorded pretax restructuring and impairment charges of $196 million ($137 million after-tax, or $1.15 per diluted share). Of the total $196 million pretax charge, $106 million related to various restructuring actions announced during 2001, and $90 million related to write-downs to adjust the carrying values of certain businesses to fair value. The 2001 pretax restructuring and impairment charges of $106 million by business segment were: Donnelley Print Solutions: $86 million; Logistics Services: $1 million; Other: $15 million; and Corporate: $4 million. The pretax charge was included as restructuring and impairment charges in the consolidated statements of income on page F-2.

As part of our efforts to build a more effective print platform, we continually assess each plant’s scale of operations and geographic location relative to our entire print platform. In 2001, we announced the closure of the following five U.S. manufacturing facilities: St. Petersburg and South Daytona, Florida; Des Moines, Iowa; Old Saybrook, Connecticut; and print production only at a Financial Services sales center in Houston, Texas. Each of these print facilities lacked the necessary scale and geographic location to remain competitive. All customer work produced at these facilities was transferred to other company facilities once necessary expansions to accommodate the new work were complete.

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As of December 31, 2002, all five U.S. manufacturing facilities (both Florida facilities; Des Moines, Iowa; Old Saybrook, Connecticut and Berea, Ohio) had ceased operations and were considered held for disposal. In addition to the five U.S. manufacturing facilities, we closed two additional facilities in 2001 outside of the U.S. due to sales shortfalls from acquisition plans and to streamline costs: Ediciones Eclipse S.A. de C.V. (Eclipse) in Mexico and Hamburg Gráfica Editora in Brazil. Eclipse was sold in December 2002 at net book value; the Brazilian facility has also ceased production and was considered held for disposal at December 31, 2002. The net book value of assets held for disposal at December 31, 2002 was $15 million, and included the following breakdown by segment: Donnelley Print Solutions: $14 million and Other: $1 million.

During 2001, in accordance with SFAS No. 121, Accounting for the Impairment of Long-Lived Assets to Be Disposed Of, we recorded a pretax impairment charge of $90 million to adjust the carrying values of certain of our businesses to fair value. This included write-downs with respect to the Donnelley Print Solutions segment: (Berea, Ohio: $11 million) and the Other segment: RRD Direct (Newark, Ohio: $37 million), and International including Argentina (Atlántida Cochrane: $19 million); Brazil (Circulo do Livro and Hamburg Gráfica Editora: $11 million); and Mexico (Eclipse: $12 million). The pretax impairment charge of $90 million reduced goodwill by $36 million and property and equipment by $54 million. The write-downs were primarily the result of the deterioration in net sales from the original acquisition plans, such that the carrying values of the entities were not considered to be recoverable.

We regularly assess our manufacturing platforms to assure that they are efficient, flexible and aligned properly with our customers’ needs. In March 2001, we announced a $300 million upgrade of our print platform, approximately one-third of which related to restructuring costs. This upgrade program included the purchase of seven new presses and two associated binding lines, of which four presses and two binding lines were placed into service as of December 31, 2002. As of December 31, 2002, cumulative capital expenditures related to this upgrade program were $179 million, and we expect to spend an additional $44 million in 2003 to complete the program.

As a result of all restructuring actions and impairment write-downs since 2000, we realized cost savings in 2002, net of incremental costs associated with the platform upgrade, of approximately $126 million compared with our 2000 cost structure. Of these total savings, $121 million represented the cash component and consisted primarily of salary and employee benefit-related savings from workforce reductions of $116 million. The non-cash component of $5 million consisted of lower depreciation expense of $13 million, partially offset by incremental depreciation expense related to the platform upgrades of $8 million. Based on restructuring actions announced as of the end of 2001, we expected to realize cost savings of approximately $90 million in 2002 compared with 2000, which included $86 million in projected cost savings due to workforce reductions, and $4 million of lower depreciation expense. During 2002, we substantially completed all restructuring actions announced in 2001, which included all expected workforce reductions and related plant closures, with no significant changes in actual savings from our earlier estimates. The additional incremental savings in 2002 of  $36 million related to 2002 announced actions.

During 2002, we announced several restructuring actions that included an additional plant closure (Berea, Ohio) and various workforce reductions across the company, resulting in additional cost savings in 2002 of approximately $36 million. These additional cost savings in 2002 consisted of lower salary and employee-related benefits due to workforce reductions of $30 million, lower depreciation expense of $1 million, and other miscellaneous expense reductions of $5 million.

The two largest plant closures announced in 2001 (Old Saybrook, Connecticut and Des Moines, Iowa) did not cease operations until the second quarter of 2002. Accordingly, 2002 savings discussed above do not reflect a full year of benefits as a result of these plant closures or from the additional restructuring actions announced during 2002. We, therefore, expect to realize additional annualized savings in 2003 of approximately $40 million consisting primarily of lower salary expense and related employee benefits of $34 million.

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The above reductions in our cost structure for 2002 were offset by the impact of volume reductions and pricing pressures during the year. We expect to drive gains in throughput, productivity and capacity utilization once volume activity levels recover.

During 2001, we recorded a pretax charge of $19 million ($19 million after-tax, or $0.16 per diluted share) to write down the values of several of our Internet-related technology investments. The largest such investment was a minority interest in an Internet communications services company that we acquired in 2000 for $14 million for which no publicly-traded market data was available. During the fourth quarter of 2001, this Internet communications services company entered into an equity transaction with a third party, which provided a basis for a revised valuation and an impairment of our minority interest. The total $19 million pretax charge was included in other income (expense) as investment write-downs in the consolidated statements of income on page F-2.

Financial Condition, Liquidity and Capital Resources

Because of our scale, manufacturing experience and strong customer base, we continue to generate strong cash flows from our printing businesses. We plan to use these cash flows to continue our transformation in several key areas and invest in future growth to create value for our shareholders. This includes upgrading our print platform to enable us to better serve our customers in a more cost-effective, flexible and efficient manner. Further, it includes building value-added services upstream toward our customers and downstream toward the consumer. In addition, we will continue to invest in programs that provide the foundational support underlying these transformation efforts, including continuous improvement, business process redesign and cultural change. If we do not have investment opportunities that generate returns above our cost of capital, our philosophy is to return excess cash to shareholders through share repurchase and/or dividends, while maintaining our targeted capital structure.

The working capital deficiency of $88 million at December 31, 2002, did not affect our ability to operate our business or to meet any of our obligations. From time to time we may operate with a working capital deficiency, but without negative impact on the business due to the timing and availability of other sources of funds.

Commercial paper is our primary source of domestic short-term financing. On December 31, 2002, we had $21 million outstanding in domestic commercial paper borrowings. In October 2002, we replaced our existing domestic revolving credit facilities with two new revolving credit facilities. The new facilities consist of a short-term facility that matures in October 2003 and provides for borrowings of up to $175 million and a long-term facility that matures in October 2007 and also provides for borrowings of up to $175 million. The company pays an annual commitment fee on the total unused portion of the credit facilities of 0.07% for the short-term facility and 0.09% for the long-term facility. The facilities bear interest at variable rates based on the current LIBOR rate and the company’s credit rating. As of December 31, 2002, there have been no borrowings under these credit facilities. These facilities provide support for issuing commercial paper and other credit needs. We also maintain various other credit facilities, which are generally uncommitted, to support the financing needs of our non-U.S. operating units. Management believes that cash flow and borrowing capability are sufficient to fund operations and planned capital expenditures of the company for the forseeable future.

We address certain financial exposures through a controlled program of risk management that includes the limited use of derivative financial instruments. We enter into interest rate swaps to manage our interest costs and exposure to changes in interest rates. In addition, from time to time we enter into forward and option contracts to minimize potential exchange risk and transaction losses in non-U.S. entities with non-functional currency denominated borrowings, sales, purchases or expenses. We do not use derivatives for trading or speculative purposes and we are not a party to leveraged derivatives.

During 2001, we entered into interest rate swap agreements to exchange fixed rate for floating rate payments periodically over the life of certain outstanding debt instruments. These swaps have been designated as fair value

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hedges and were highly effective as of December 31, 2002. During 2002 and 2001 we also entered into various interest rate swap agreements to exchange floating rate for fixed rate payments. See Note 11, “Debt Financing and Interest Expense,” to the consolidated financial statements for details.

As of December 31, 2002, our only off-balance sheet financing activities were non-cancelable operating lease commitments described in Note 8, “Commitments and Contingencies,” to the consolidated financial statements.

Cash Flows from Operating Activities

Cash flow from operations in 2002 was $409 million, a decrease of $139 million from 2001. This decrease was primarily due to the payment of approximately $130 million related to the COLI settlement (see Note 10, “Income Taxes,” to the consolidated financial statements) and lower net income excluding non-cash charges in 2002, partially offset by a 2001 payment of $62 million related to COLI. Our cash conversion cycle (days’ sales outstanding plus days’ inventory on hand minus days’ payable outstanding) improved to 40 days in 2002 from 48 days in 2001. The ratio of operating working capital* to sales has continued to improve to 2.2% in 2002 from 5.2% in 2001 and 5.8% in 2000.

Cash flows from operations decreased by $192 million in 2001, primarily due to the receipt in 2000 of a tax refund of $77 million related to the carryback of tax losses following the sales of certain subsidiaries, a 2001 tax payment of $62 million for COLI tax liabilities as a result of the settlement of a federal tax audit, and weaker operating performance in 2001.

* The operating working capital to sales ratio is defined as a 13-month average of net receivables, net inventories and prepaid expenses minus accounts payable, accrued compensation and other accrued liabilities, divided by a 12-month rolling average of net sales.

Cash Flows From Investing Activities

Our principal investing activities are capital expenditures to improve the productivity of operations. In 2002, capital expenditures totaled $242 million, a $31 million decrease compared with 2001 spending of $273 million. 2002 spending included investments to create a more efficient print platform to serve our magazine, catalog and retail customers and the opening of a printing plant in China. The reduction in capital spending from 2001 is due to lower spending on our new platform and the 2001 openings of a printing plant in Poland and several facilities within our Premedia Technologies group. We expect to continue to fund capital expenditures primarily through cash provided by operations. We expect 2003 capital spending to be below $250 million.

Acquisitions

We made no business acquisitions in 2002 or 2001.

Divestitures

In June 2002, we recorded a pretax gain of $6 million ($6 million after-tax, or $0.06 per diluted share) upon collection of a note receivable that had been previously reserved in connection with the sale of MMI in 1999.

In November 2001, we sold our remaining investment in the common stock of Stream for approximately $10 million in cash. We recognized a pretax gain of $7 million ($7 million after-tax, or $0.05 per diluted share) from this transaction.

In June 2000, we sold our 100% interest in R.R. Donnelley (India) Ltd. and our 25.37%-owned subsidiary, Tata Donnelley Limited, to Tata Sons Limited for approximately $13 million in cash; there was no gain or loss recognized from this transaction.

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Cash Flows From Financing Activities

Financing activities include net borrowings, share repurchases and dividend payments. As of December 31, 2002, total net borrowings decreased $64 million from December 31, 2001, compared with an increase of $57 million for the same period a year ago. This lower level of incremental borrowing in 2002 ($121 million) is primarily due to the expiration of the company’s share repurchase program in 2002, partially offset by the company’s payment of approximately $130 million related to the COLI settlement.

Share Repurchases

We acquired 0.5 million, 8.8 million and 2.5 million shares of our stock in 2002, 2001 and 2000, respectively, for $15 million, $248 million and $63 million, respectively, in privately negotiated or open-market transactions. Since 1996, we have spent approximately $1.5 billion to repurchase stock and reduced the number of shares outstanding by approximately 29%.

In January 2001, the Board of Directors authorized a share repurchase program for up to $300 million of the company’s common stock in privately negotiated or open-market transactions. From February 1, 2001 through the expiration date (January 31, 2002), we purchased approximately 8.1 million shares at an aggregate cost of approximately $230 million under this program.

Net cash used to repurchase common stock, defined as cash used for share repurchases net of proceeds from stock options exercised, was $3 million in 2002; $250 million in 2001; and $22 million in 2000.

A summary of the shares outstanding is presented below:

Dividends

Dividends to shareholders totaled $111 million in 2002 and $110 million in each of 2001 and 2000. In 2002, we increased our dividend by 4%, representing our 32nd consecutive annual dividend increase. We have consistently paid a dividend since becoming a public company in 1956.

Financial Condition

Our financial position remains strong as evidenced by our year-end balance sheet. Our total assets in 2002 were $3.2 billion compared with $3.4 billion at the end of 2001. Average invested capital (total debt and equity, computed on a 13-month average) was $1.9 billion in 2002, compared with $2.3 billion at the end of 2001. The return on average invested capital increased to 9.4% in 2002 from 3.1% in 2001. The return on average invested capital, excluding the significant items in Item 6 on page 11, increased to 10.4% from 10.0% a year ago.

At December 31, 2002, the debt-to-capital ratio decreased to 52% from 54% in 2001 and year-end debt-to-total market value* was 29% compared with 24% in 2001.

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Contractual Cash Obligations and Other Commitments and Contingencies

The following table quantifies our future contractual obligations as of December 31, 2002: