R.R. Donnelley Logistics Services (Donnelley Logistics) represents the company’s logistics and distribution services operation for its print customers and other mailers. Donnelley Logistics serves its customers by consolidating and delivering printed product and parcelspackages to the U.S. Postal Service closer to the final destination, thereby resulting in reduced postage costs and improved delivery performance. Following the company’s acquisition of certain net assets of CTC Distribution Services LLCL.L.C. (CTC) in February 2000, the combined operations of Donnelley Logistics and CTC have been included within the reportable segment “Logistics Services” for the three and nine months ended September 30, 2000. Prior year amounts have been restated to reflect the current year presentation.Services.” Refer to Note 9 to the condensed consolidated financial statements for additional informationmore details regarding the acquisition of CTC.

        The company has disclosed earnings (loss) from operations as the primary measure of segment earnings (loss). This is the measure of profitability used by the company’s chief operating decision-maker that is most consistent with the presentation of profitability reported within the consolidated financial statements. The accounting policies of the business segments reported are the same as those described in the “Summary of Significant Accounting Policies” (F-6footnote on page F-6 in the 19992000 Annual Report on Form 10-K).10-K.

        In twothree federal trial court decisions involving different corporate taxpayers, the courts disallowed deductions for loans against those taxpayers’ COLI programs. A trial involving a taxpayer in another court is imminent, and appealsAppeals from the first twothese decisions have been or are expected to be taken. While the company believes its COLI program differs from those involved in the earlier litigation, should the reasoning of these cases be upheld and applied to others, in addition to payments already made, the company could lose an additional maximum of $152up to $155 million in federal and state tax benefits for periods from 1993 through 1998. In addition, should all or a portion1998 plus interest of the company’s COLI deductions ultimately be disallowed, the company would be liable for interest on those amounts. The company’s maximum exposure for interest should all prior COLI deductions be disallowed is approximately $62$50 million after-tax through September 30, 2000 .March 31, 2001.

        The company will continue to examine its COLI position with respect to the final resolution of pending cases. During the fourth quarter of 1999, the company recorded an additional tax provision of $51 million ($0.40 per diluted share) related to COLI. The ultimate resolution of thesethe company’s COLI issues may have a material impact on the company’s results of operations and financial condition.

        In accordance with the provisions of SFAS No. 133, the company recorded a transition adjustment upon adoption of the standard to recognize its derivative instruments at fair value, to recognize the ineffective portion of transactions accounted for as cash flow hedges at transition and to recognize the difference (attributable to the hedged risks) between the carrying values and fair values of related hedged assets and liabilities. The effect of this transition adjustment decreased reported net income in the quarter by an immaterial amount. The company also recorded an immaterial transition adjustment in Accumulated Other Comprehensive Loss to recognize previously deferred net gains on those derivatives considered cash flow hedges at transition. The company will reclassify into earnings during the next five months the transition adjustment that was recorded in Accumulated Other Comprehensive Loss as of January 1, 2001.

        The company formally documents its hedge relationships, including identification of the hedging instruments and the hedged items, as well as its risk management objectives and strategies for undertaking the hedge transaction. Derivatives are recorded in the Condensed Consolidated Balance Sheets at fair value in other assets and other liabilities. This process includes linking derivatives that are designated as hedges of specific assets, liabilities, firm commitments or forecasted transactions. The company formally assesses both at inception and at least quarterly (atthereafter, whether the derivatives that are used in hedging transactions are highly effective in offsetting changes in either the fair value or cash flows of the hedged item. The assessment of effectiveness for option contracts is based on changes in the intrinsic value of the option due to changes in the spot exchange rate. Changes in the time value of option contracts are reported currently in earnings. When it is determined that a minimum) markedderivative ceases to be a highly effective hedge, the company discontinues hedge accounting.

        At facilities that are being closed, assets being disposed of were written down to their fair market values, less estimated costs to sell. Fair market value through earningsof land, buildings and other comprehensive income. This statementsignificant pieces of equipment was based upon external appraisals. Impairment recognized in the first quarter of 2001 relating to buildings and equipment to be disposed of was $6 million. The net book value of assets to be disposed of at March 31, 2001 was $28 million.

        The company expects to complete restructuring activities initiated in the first quarter of 2001 by the end of the first quarter of 2002, with the possible exception of the sale of land and buildings. Though the properties are currently being actively marketed and production has been subsequently amendedeither ceased or is expected to cease by SFAS 137 (which moved the effective dateend of the second quarter 2001, sales may not close within one year, due to fiscal years beginning after June 15, 2000)real estate market conditions. Additional charges related to this restructuring are expected to range from $8 million to $10 million, with the majority anticipated to be recognized by the second quarter of 2001, and SFAS 138. These rules become effective forprimarily relate to equipment and employee relocation.

        During the first quarter of 2001, the company on January 1, 2001.recognized an impairment charge for $2 million to write down the carrying values of two Internet-related technology investments recorded using the cost method of accounting. Both investments related to entities that had experienced significant solvency issues during the first quarter of 2001, such that the company believed it was probable that the carrying values would not be recovered.

        R.R. Donnelley & Sons Company is a leading commercial printer,(NYSE:DNY) provides comprehensive, integrated communications services that efficiently and logistics company.effectively produce, manage and deliver our customers’ content, regardless of the communications medium. While our superior 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 137-year history as a printing industry leader positions us well for the future. The printing industry is projected to grow along with the communications industry. Print advertising is expected to remain among the most cost-effective ways for our customers communicate more efficientlyto deliver their messages and effectivelygenerate revenue as they use words and images to inform, educate, entertain and sell. In each of our businesses, we use our distinctive capabilitiessell to manage and distribute words and images in ways that provide the greatest value to every customer. Our common stock (NYSE: DNY) has been publicly traded since 1956. At the end of September 2000, we had approximately 34,000 employees on four continents. We offer a full range of integrated service solutions to serve our customers’ needs from over 100 manufacturing, service and logistics locations. While we have extended our core competencies into selected international markets, 89% of our revenue is currently generated in the United States.

        We are first or second in annual revenue in all five of our primary end-markets:

        We operate primarily in the commercial print portion of the printing industry, with related service offerings. Our related services,offerings designed to offer our customers complete solutions for communicating their messages to target audiences regardless of the means of distribution, include:

        For the third quarter, net income from continuing operations was $92 million in 2000, or $0.75 per diluted share, compared with $86 million in 1999, or $0.67 per diluted share. Third quarter 2000 results included a one-time non-operating pretax gain of $13 million ($8 million after-tax, or $0.06 per diluted share) related to the sale of shares received from the demutualization of our basic life insurance carrier. Excluding the effect of this one-time gain, earnings per diluted share from continuing operations for the third quarter of 2000 were $0.69, up 3% from a year ago, reflecting lower average shares outstanding. Earnings per diluted share from continuing operations of $0.67 in the third quarter of 1999 included a $0.01 favorable impact from Stream International (Stream) (refer to “Divestitures”).

        For the third quarter of 2000,Consolidated value-added revenue decreased 3% from a year ago; excluding Stream in 1999, value-added revenue increased 4% from a year ago. This 4% increase was primarily due$29 million, or 3.9%, to acquisitions.

        Gross profit for the first nine months of 2000 fell by 1% to $817 million, compared with $824 million a year ago. Gross profit rose 6% for the first nine months of 2000, excluding the impact of Stream in 1999.        Gross profit as a percentage of net sales fell to 19.6% from 21.2% a year ago, primarily due to less profitable work mix within Financial Services andwas 15.3% in the expansionfirst quarter of our lower margin2001 compared with 17.8% in the first quarter of 2000. Our Logistics Services segment, which has lower gross margins than our Commercial Print segment, represented a higher proportion of consolidated net sales in the first nine monthsquarter of 2000 (11%2001 (14.3% versus 5%11.1% in the first quarter of 2000), primarily as a year ago). This decreaseresult of the expansion into package logistics through the acquisition of CTC in February 2000. Commercial Print’s gross margin was partially offset by margin improvements in our core Commercial Print operations (Long-Run Magazines, Catalogs and Insertsdecreased between years primarily due to lower Financial Services’ volume as a result of depressed capital markets, as well as Book Publishing Services) due to productivity improvementsescalating energy and higher by-products pricing. The sale of by-products reduced our cost of materials by $50 million in the first nine months of 2000, up $25 million from the first nine months of 1999.healthcare costs.

        Selling and administrative expenses for the third quarter of 2000 were $150decreased $7 million, or 4.5%, to $138 million compared with $164$144 million a year ago. This represented 10.4%in the first quarter of net sales compared with 11.7% a year ago. Spending reductions and cost containment of $13 million coupled with the elimination of Stream expenses ($16 million) and lower Year 2000-related expenses ($7 million), were partially offset by increased spending to expand into complementary businesses ($10 million), higher investment in information systems infrastructure ($6 million) and recent acquisitions ($6 million).

        InterestNet interest expense fordecreased 20.4% to $18 million in the thirdfirst quarter of 2000 was approximately $23 million, down $0.3 million from a year ago, primarily2001, due to lower debt levels, lower interest rates on commercial paper, and as a result of the suspensionrefinancing $200 million of our share repurchase activity.matured long-term bonds with commercial paper in December 2000, which carries a lower interest rate. Other income, net, decreased $2 million between years primarily due to non-recurring gains on sale of assets in 2000 ($5 million), partially offset by increased miscellaneous expenses in 2000 ($3 million).

        OtherExcluding restructuring and impairment charges of $22 million in the first quarter of 2001 (see Note 11 to the condensed consolidated financial statements for additional information), net income net, forof $28 million in the thirdfirst quarter of 2001 decreased 40.3% from $47 million in the first quarter of 2000, while diluted earnings per share decreased 39.5% to $0.23. Including restructuring and impairment charges, net income decreased 68.9% while diluted earnings per share decreased 68.4%. The effective tax rate for the first quarter in both years was $1638.5%.

        Net sales of our Commercial Print segment, which includes materials such as paper and ink, decreased $75 million in the first quarter of 2001, or 6.3%, from a year ago. The volume of pass-through material sales impacts the level of net sales, particularly for Long-run Magazines, Catalogs and Inserts. First quarter net sales for Long-run Magazines, Catalogs and Inserts decreased 1.9% between years, which reflected volume decreases across all major markets, as well as a lower volume of pass-through material sales. The first quarter 2001 economic slowdown resulted in volume decreases driven by lower magazine and retail insert advertising spending, as well as lower catalog page counts. Paper prices employed within Long-run Magazines, Catalogs and Inserts were up $11 million5% from the same period a year ago.

        First quarter loss from operations for the Logistics Services segment was $4.6 million, or an additional $4 million loss between years. The first quarter loss from operations for print logistics was $5.7 million unfavorable to the prior year first quarter. This increasedecline in print logistics was driven by higher transportation costs, primarily due to increased carrier and fuel costs in excess of price increases, and consolidation center expansion costs. The improved first quarter performance of package logistics between years reflected a higher-margin customer mix, increased volume, and deeper penetration of the postal system (closer to the final destination). During the fourth quarter of 2000, package logistics had been affected negatively by low prices in response to competition, low margin work and facility start-up costs. Actions taken to-date in 2001 to raise prices and adjust work mix have begun to have a positive impact on package logistics’ results.

        Cash used in operating activities totaled $25 million in 2001, compared with cash provided by operating activities of $56 million in 2000. The decrease in 2001 was primarily due to a pretax gainhigher investment in operating working capital, a payment related to the settlement of $13 million froma federal tax audit (see Note 7 to the sale of shares received from the demutualization of John Hancock Mutual Life Insurance Company, our basic life insurance carrier.

        Capital expenditures during the first nine months of 2000 totaled $181 million compared with $198 millionOur cash conversion cycle (days’ sales outstanding plus days’ inventory on hand minus days’ payable outstanding) continued to improve to 42 days from 44 days a year ago. Spending was directed principallyThe ratio of operating working capital to investmentssales also has continued to improve to 6.2% in 2001 from 6.7% in 2000.

        Our principal recurring investing activities are capital expenditures to improve the productivity and international expansion. Full-year 2000of operations. In the first quarter, capital expenditures totaled $33 million, a $24 million decrease from a year ago. We expect capital spending is expected to be underbetween $300 million and $350 million in support2001. Over the next 24 months, we plan to invest up to $300 million to improve the efficiency and flexibility of selected opportunities, including expansion ofthe long-run printing and binding operations serving our Poland operationsmagazine, catalog and a new directory plant in Flaxby, England, as well asretail customers. We will make investments to standardizeupgrade plants with fewer, yet wider and upgrade systems company wide. Management believes thatfaster, presses and related equipment to offer customers more flexibility and improved distribution efficiencies with virtually no change to the company’s cash flow and borrowing capacity are sufficient to fund current operations and growth.capacity.

        In February 2000, we purchased CTC, which approximately doubled the sizemade acquisitions and investments to extend our geographic reach and expand our range of our Logistics Services business and expanded our distribution capabilities (refer to Note 9). During the first nine months of 2000, we also acquired Dallas-based Omega Studios, known for producing high-quality digital photography, turnkey creative concept, layout design and desktop publishing services; the Florida financial printer EVACO; the Seattle-based premedia provider Iridio, Inc.; and a leading Brazilian book printer Circulo do Livro. In addition, we invested in Noosh, Inc., a business-to-business Internet-based service designed to improve the process of buying, selling and managing print.capabilities.

        In March 1999, we purchased the financial printing unit of Cadmus Communications. The purchase included the assets and operations of five service centersAcquisitions completed in Baltimore, Charlotte, Raleigh, Richmond and New York, as well as a print-on-demand and fulfillment facility in Charlotte and selected software products. In April 1999, we purchased the net assets of the Communicolor division of the Standard Register Company. During the first nine monthsquarter of 1999, we also purchased the net assets of the Brazilian book printer Hamburg Gráfica Editora; the net assets of a California-based transportation company, Freight Systems Inc.; and a 30% equity investment in an Internet website design firm, Multimedia Live.2000 included:

        Net cash providedFinancing activities include net borrowings, dividend payments and share repurchases. Our net borrowings decreased by borrowings during$70 million year over year, primarily due to acquisition activity in the first nine monthsquarter of 2000 decreased $316 million over the same period from a year ago due to lower share repurchase activity in 2000, as well as higher cash flows from operations. At September 30, 2000,2000. See Acquisitions above.

        Commercial Paper is our primary source of short-term financing. On March 31, 2001, we had an$385 million outstanding in commercial paper borrowing. In addition, at March 31, 2001, we had $438 million unused revolving credit facility of $425 million with a number of banks. This credit facility provides support for the issuance ofissuing commercial paper and other credit needs. Management believes our cash flow and borrowing capability are sufficient to fund operations.

        Process controlWe purchased 3.1 million and information systems are increasingly important to the effective management of the company. The upgrade and standardization0.9 million shares of our systems is necessarystock in the first quarter of 2001 and 2000, respectively, for us to succeed$88 million and $21 million, respectively, in using information technology to our strategic advantage. In 1999, we focused our efforts on ensuring that processes and systems were Year 2000 compliant. In addition, we began ongoing initiatives to upgrade and standardize our information technology infrastructure. In 1999, we deferred a number of other infrastructure and systems initiatives that would support continuous productivity improvements and enhance service capabilities, while we completed our Year 2000 efforts.privately negotiated or open-market transactions.

        During the transition from 1999 to 2000, all operations were fully supported by trained personnel. Key efforts were focused on four business-critical factors: safety of employees, continuity of production, environmental compliance and reporting, and continuity of systems to support the ability of personnel to continue working (such as the availability of utilities or operation of payroll systems). At the end of the transition, no Year 2000 issues affecting any business-critical factors were reported by any operation. To the extent that date-related issues were reported, they were limited to instances where personnel available at the site were able to promptly correct the issue without disruption to our operations.

        In December 1999, the U.S. Environmental Protection Agency, Region 5 (U.S. EPA) issued a Notice of Violation against us, pursuant to section 113 of the Clean Air Act (the Act). The notice alleges that our facility in Willard, Ohio, violated the Act and Ohio’s State Implementation Plan in installing and operating certain equipment without appropriate air permits. While the notice does not specify the remedy sought, upon final determination of a violation, the U.S. EPA may issue an administrative order requiring the installation of air pollution control equipment, assess penalties, or commence civil or criminal action against us. We responded to U.S. EPA on March 10, 2000. We do not believe that any unfavorable resultthe resolution of this proceedingmatter, even if unfavorable to us, will have a materialnot materially impact on our financial position or results of operations.

        In addition, we are 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.

        We are a large user of paper, bought by us or supplied to us by our customers.customers or bought by us. The cost and supply of certain paper grades used in the manufacturing process will continue to affect our financial results. However, management currently does not see any disruptive conditions affecting prices and supply of paper in 2000.2001.

        Postal costs are a significant component of our customers’ cost structures. Changes in postal rates whichwent into effect in January 2001 and are anticipated earlyexpected to increase again in 2001, mayJuly 2001. These increases are not expected to negatively affect the demand for our core print capabilities, but the proposedcompany. In fact, postal rate increases will enhance the value of Donnelley Logistics Services to our customers, as we are able to improve the cost efficiency of mail processing and distribution. This ability to deliver mail on a more precise schedule and at a lower relative cost should enhance our position in the marketplace.

        In addition, to paper and postage costs, consumer confidence and economic growth are key drivers of print demand. Ademand for our services and a significant change in the economic outlook could affect us. The slowdown experienced in U.S. capital markets in the fourth quarter of 2000 has continued into 2001, negatively affecting our Financial Services business. However, growth in demand for customized communications solutions for investment management, banking, insurance, managed care and pharmaceutical companies provides opportunities for our products, as evidenced byFinancial Services business to partially offset the recent slowdown in domestic Capital Markets which we expect to continue through the end of the year.U.S. capital markets slowdown.

        In the longer term, technological changes, including the electronic distribution of information, present both risks and opportunities for the company. Many of our new business initiatives are designed to leverage our distinctive capabilities to participate in the rapid growth in electronic communications. Our goal remains to manage and distribute words and images, regardless of the means of distribution, to help our customers succeed by delivering effective and targeted communications in informing, educating, entertaining and selling.the right format to the right audience at the right time. We believe that with our competitive strengths, including our comprehensive service offerings, technology leadership, depth of management experience, customer relationships and economies of scale, we can develop the most valuable solutions for our customers, which should result in increased shareholder value.

        We areThe company is exposed to market risk from changes in interest rates and foreign exchange rates. However, wethe company generally maintainmaintains more than half of ourits debt at fixed rates (approximately 64%62% at September 30, 2000)March 31, 2001), and ourtherefore its exposure to short-term interest rate fluctuations is not materialimmaterial to the consolidated financial statements of the company as a whole. OurThe company’s exposure to adverse changes in foreign exchange rates also is immaterial to ourthe consolidated financial statements of the company as a whole, and wethe company occasionally useuses financial instruments to hedge exposures to foreign exchange rate changes. We doThe company does not use financial instruments for trading purposes and areis not a party to any leveraged derivatives. FurtherFor further disclosure relating to financial instruments issee the “Debt Financing and Interest Expense” footnote to the consolidated financial statements included in the Debt Financing and Interest Expense note in the Notes to Consolidated Financial Statements included in our 1999company’s 2000 Annual Report on Form 10-K.

        On each of November 25, 1996, and June 30, 1998, purported class actions were brought against the company alleging racial discrimination and seeking actual, compensatory, consequential and punitive damages in an amount not less than $500 million. On December 18, 1995, a class action was brought against the company alleging age discrimination in connection with the 1993 closing of the company’s Chicago catalog operations, and violation of the Employee Retirement Income Security Act.Act (ERISA). On December 28, 2000, a purported class action was brought against the company alleging failure to calculate pension benefits for former employees of the company’s Chicago catalog operations in accordance with plan documents and ERISA. These actions are described in Part I of this quarterly report on Form 10-Q.

        Certain statements in this filing, including the discussions of management expectations for 2000,2001, constitute “ forward-looking“forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. Such forward-looking statements involve known and unknown risks, uncertainties and other factors that may cause actual results to differ materially from the future results expressed or implied by those statements. Refer to Part I, Item 1 of the company’s 19992000 Annual Report on Form 10-K for a description of such factors.

        (b) No current report on Form 8-K was filed during the thirdfirst quarter of 2000.2001.