Image Shown: Shares of Quad/Graphics Inc (QUAD) have tumbled over the past year due to concerns regarding the secular decline in the printing business and its now terminated all-stock deal to acquire LCS Communications Inc (LKSD). On July 31, shares of QUAD leaped higher after reporting second quarter 2019 earnings on July 30.
By Callum Turcan
Quad/Graphics Inc (QUAD) is a printing company seeking to shift towards advertising & marketing offerings that are better suited for the digital age. Most of Quad/Graphics’ revenue is generated in the US. The company mentions in its 2018 10-K filing that “the printing industry… is in secular decline” while the US advertising is expected to grow by 4% CAGR from 2018 – 2022 according to a third-party research service cited in Quad/Graphics’ annual report. The company reported second quarter 2019 earnings on July 30 after the market closed. Please note that the Quadracci family, through the Quad Voting Trust, controlled 72% of the company’s voting power as of early-2019.
We mentioned back in March 2019 (article here) that we weren’t fans of Quad/Graphics’ $1.4 billion all-stock deal to acquire LCS Communications Inc (LKSD) as the move did little to change the structural problems facing the printing business. Scale alone doesn’t mitigate such powerful headwinds, which is why we are very supportive of management dropping the deal due to opposition from the US DOJ. The deal was terminated on July 23, with Quad/Graphics agreeing to pay a $45 million termination fee to LCS Communications.
Shares of QUAD yield 10.6% as of this writing, more a function of a declining stock price than strong underlying fundamentals, and that’s after shares rallied by over 31% on July 31. Refinancing Term Loan B with Term Loan A is expected to save Quad/Graphics $12 million per year on annualized interest expenses, a product of the LCS Communications deal falling through, which may have provided a nice tailwind to shares of QUAD.
Second Quarter Earnings
Part of the July 31 rally can be attributed to Quad/Graphics’ adjusted earnings beating guidance and its revenue falling in-line with consensus analyst estimates during the second quarter, along with management maintaining the firm’s very generous $0.30/share quarterly dividend. The firm posted $1.0 billion in net sales, down marginally from last year’s levels, while its EPS flipped to negative at $0.30/share during the quarter.
Management reiterated that Quad/Graphics would meet 2019 guidance during the second quarter, reassuring investors that recent decisions will have a stabilizing effect on its business. Quad/Graphics expects its 2019 sales would come in at $4.05 billion-$4.25 billion, down from $4.2 billion in 2018 at the midpoint. The firm’s adjusted EBITDA is expected at $360 million-$400 million (down from $415 million in 2018) while management forecasted $145 million-$185 million in free cash flow, which is marginally up at the midpoint versus 2018 levels of $164 million. Reiterating 2019 guidance was likely viewed as a very welcome sign by the market.
Quad/Graphics bought Periscope, not the company purchased by Twitter Inc (TWTR) in 2015, but a creative advertising agency last year. That transaction was first announced in November 2018 and involved Quad/Graphics spending $133 million in cash to gain a greater foothold in the advertising space. Note this deal came on the heels of Quad/Graphics’ European division acquiring Peppermint Warszawa through a transaction announced in September 2018, which is another creative advertising agency. These deals were pursued to bulk up Quad/Graphics’ advertising and digital marketing offerings and enable multi-channel marketing strategies that weren’t possible through its printing business alone.
All of these transactions are part of what management refers to as Quad 3.0, or the next phase of the business model where Quad/Graphics becomes “a comprehensive marketing solutions partner for its clients” instead of simply offering mass printing services (the kind of mail that a large retail company or healthcare provider might send to mailboxes all over the country i.e. “magazines” highlighting the latest deals or a pamphlet covering a new product or service launch). This is essential to its long-term survival, and we appreciate the moves being made in this arena, but a lot more work needs to be done first.
More Improvement Needed
The firm’s net sales declined by 3% from 2016 to 2018, while its GAAP operating income was cut in half, leading to Quad/Graphics’ GAAP diluted EPS dropping to $0.16 in 2018 from $0.90 in 2016. Net operating cash flows are down 26% during this period while capital expenditures moved lower by 9%. Quad/Graphics’ free cash flows moved down from $248 million in 2016 to $164 million last year. Cash dividends consumed $63 million in 2018, while another $37 million was allocated towards share buybacks. Quad/Graphics’ free cash flows are in decline and that could eventually put a lot of pressure on its balance sheet, but for now if things stabilize, the situation isn’t as dire as once thought.
Its acquisitive streak led Quad/Graphics to build up a $1.1 billion net debt load (inclusive of short-term debt) by the end of June 2019. The company’s leverage ratio (debt to adjusted EBITDA) climbed from 2.1x at the end of 2018 to almost 3.1x as of the end of the second quarter, largely due to acquisitions. Management noted that the goal is to bring that down to 2.8x by the end of 2019, and the firm retained its long-term leverage ratio target of 2.0x-2.5x. We caution that Quad/Graphics remains highly levered, which puts its dividend at risk over a longer time horizon if things don’t change. Payout increases are highly unlikely, especially as the company pursues deleveraging efforts and in light of its shrinking free cash flows (which may stabilize this year).
Concluding Thoughts
We aren’t interested in Quad/Graphics but appreciate management’s decision to throw in the towel on the LCS Communications deal. Quad/Graphics is a company that doesn’t need more scale in the printing business; it needs to fundamentally change the services and products that it offers. The firm teamed up with dtx company (“dtx,” all lower-case) on July 10 to grow its presence in the direct-to-consumer advertising/marketing business, a sign that management plans to keep the balling rolling in the right direction. Please note that Quad/Graphics’ net debt load remains onerous and its dividend is supported by free cash flows from a dying business, making its strategic shift essential to preserving its payout. We will continue monitoring events as they unfold at Quad/Graphics.
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Callum Turcan does not own shares in any of the securities mentioned above. Some of the companies written about in this article may be included in Valuentum’s simulated newsletter portfolios. Contact Valuentum for more information about its editorial policies.