Quarto: Déjà vu all over again

Disclosure: I have an interest in Quarto shares

Quarto reported results today. For those wanting some background, I’ll requote what I first said when I looked at the company:

Quarto are in publishing, but with a few key differences from firms that may immediately spring to mind. The most important one is probably the type of books they are producing. Instead of focusing on fiction, a rather hit & miss affair that hopes to churn out a few bestsellers every year to compensate for some of the flops, Quarto have a varied portfolio of books with very narrow remits and niche audiences. Perhaps I could best illustrate this with their best selling book in 2010: ‘Complete Guide to Wiring’. By focusing on books for such small groups of people and keeping such a wide portfolio, Quarto remain fairly insulated from the more brutal swings in consumer spending.

Over two thirds of the group’s sales come from backlist – titles published in prior years. No title accounts for more than 1% of group revenues in any given year; last year, the biggest was around 0.6%, the second around 0.4%, and the tail develops after that. I repeat those facts as a sort of mantra when people ask about Quarto, because when I tell them it’s a book publishing company I always get the same blank stare. Investors remember Quercus, which blew up after over-stretching itself after the success of Stieg Larsson. Investors remember Bloomsbury, which saw its revenues double and then drop by 33% in consecutive years thanks to Harry Potter. 

I think it’s undeniable that Quarto are fundamentally different. 

QRT_RevEBIT

It’s difficult to find any business which exhibits this sort of stability. To be fair, I should note that the EBIT figure above is the famous ‘underlying’ EBIT figure – and the group did book fairly significant restructuring charges in the recession, as well as the odd exceptional in prior years.

Trading update

The trading update today should have surprised no-one; the group had telegraphed twice in their announcements that the year would be more second half weighted than prior years. Some scepticism is always warranted with the claim, but you can always feel more comfortable when it’s pre-warned rather than announced on the day as an excuse for poor performance. The company’s explanation, namely currency factors and ongoing ‘retail trends’  – a slow shift toward customers tending to stockpile less inventory as Amazon and co. muscle their way through and create a more just-in-time approach to stock holding, which will naturally flow through to Quarto (their end-sales are heavily Christmas weighted, after all) – make sense. I also see little incentive for management to puff their feathers by deferring a profit warning, particularly when their business model gives them a great deal of visibility over the remainder of the year.

The progress on debt reduction was a bit disappointing, but the whole event itself is a bit of a damp squib. H1 is a much smaller half than H2, and this one, we are told, particularly so.

What we do get, though, is a reignition of the debate on the group’s debt. Given that I bought the shares two years ago – when the net debt was substantially higher – it should be clear that I’m not terrified. Why?

Firstly, as I noted above, the group is resilient to macroeconomic shocks and supposed secular shifts. In the 2007 – 2012 period Quarto faced both a collapse in consumer confidence and a widespread opinion that printed book sales were about to imminently dive as we all started to read cookbooks and the like on our Kindles. In that period, Quarto never had a revenue decline of more than 7% – pure noise to most companies – and, in fact, continued to spend increasing amounts investing in new books. They rode through that period with a more challenging debt pile than they do now. They can get away with this because the group generates a reliable stream of free cash flow. They can even more easily get away with this because they generate a large amount of cash from books which are already backlisted, requiring minimal investment to keep fresh.

The group has generated an average of $12.6MM of unlevered free cash flow over the last three years. This is the money the company has ‘available’ to make its interest payments and dividends and then either pay down debt or make acquisitions. Their current interest bill is looking likely to come in at something like $2.7MM for the year. The group is operating well within the covenants on its (newly refinanced) debt, which stretches through to 2019. It would take a significant impairment to cashflow and EBIT for the group to test the limits of this facility. Even better, the heavy backlist weighting gives the group flexibility on cashflows if and when they need it. They can lighten up on investment in new books without hurting near-term, and turn into more of a ‘harvester’ of their previous investments than a sower of new seed.

I don’t want to over-egg the pudding – and this next sentence will seem like sacrilege to many – but I find it bizarre why people are comfortable with property groups running with absurdly high levels of leverage and uncomfortable with Quarto’s debt pile. The answer is predictable – ‘the difference is that the REIT has lots of hard assets as safety and ‘downside protection”. But Quarto has downside protection too – a backlist catalogue built up over decades, generating over $100MM of revenues at a 35%+ gross profit margin, with minimal investment requirements. The difference between the two assets I’ve just described is that only one of those two cases demonstrably sees a savage fall in cashflows and residual values when you care most – a recession!

I get the concern, but I think the debt is a bit of a red herring.

In fact, if I was management – or a private equity firm – I’d be tempted to look at buying the whole thing and leveraging it up. Why not?

Valuation

The second half will be more weighted than last year, when it pulled in 62% of the full year’s figures. 64 or 65% might be a reasonable assumption for this year given management’s repeated comment. Naturally, you need to trust them on this – they have visibility on the order books, but we do not. Management’s actions in the past – plus their repeated delivery of the targets they express – give me no reason to doubt them.

Applying a 36/64 split to the H1 revenues gets us to a revenue figure of around $184MM.

Sliced another way, I’m looking for a $12MM revenue increase from last year. Most of that is covered by acquisition. The rest should be covered by the work-through of increased investment in books in the last couple of years, as well as better payback periods on those investments as the group has made a point of squeezing dimes internally. There is a significant, unknowable variable in the movement of exchange rates in the last 6 months of the year. C’est la vie. That will be swings and roundabouts in the longer term.

There were a couple of margin-affecting adjustments in the first half of the year, but I’m comfortable with them excluding the amortisation of acquired intangibles and some expensed costs related to the acquisition. On an underlying basis, margins will likely remain in their recent range of 8.5 – 9.5%. Scale and restructuring, as well as better paybacks from recent books point towards improvement in margin, as does an improving macro environment and consumers more loose with cash. Prudence suggests one should assume the lower until proven otherwise.

That gives us an EBIT range of $15.6MM – $17.5MM.

As I mentioned before, finance costs have been reduced by both the lower debt pile and, I assume, the interest rate due to the refinancing. I assume the ramp up and down in capital requirements is fairly symmetrical in the year around the mid-point, now. $2.7MM for the full year assumes a slow deleveraging and, perhaps, a slightly improved rate.

The group’s tax rate is a bit messy given the different jurisdictions in which it operates – each with different corporate tax rates – and the usual ambiguities of global tax in any international organisation. The past few years have probably been too low, on average. Something like 25 – 30%, for a 27.5% midpoint, is my working assumption.

This gives us a net profit range of $9.4MM – $10.7MM, against a market cap of £40m/$63m.

The group is still investing slightly ahead of its rate of amortisation, so cash flows will lag this net profit figure even on an organic basis. If you have faith in management – and you shouldn’t be investing if you don’t – they will keep up their recent trend of improving sales rates on new titles, which should translate into pretty attractive RoIs on this growth spending. You should also not forget to include some provision for the minority interests, which eat a few percentage points of the year’s profit.

A P/E of 6 still strikes me as too low for a business with growth prospects and defensive characteristics. The debt is the issue that creates the opportunity – and, neatly for shareholders, it’s a self-remedying issue as the group generates substantial cash with which to pull down to a more market-friendly level, both by direct repayments and by investing in the books which will ensure trading profits continue to grow.

The blue sky

I like sweeteners on my investments, and I think there are two sweeteners with Quarto. At the current valuation they’re nothing more than a glint in management’s eye, but being involved with the professional world of the city you get an appreciation for how important story is to the whole sell-side mechanism (brokers, researchers and so on). The current story is one of cheapness and debt reduction. If I am right, this should drive re-rating in the next couple of years.

After that, though, there are two angles. I don’t know how big they will be or how relevant they will be to the share price – they are sweeteners, after all – but it’s a fun game to try and predict the next sentiment shift ahead of time.

Firstly, the group continues to look (and find!) ways to monetise its IP. A good example of this is This Is Your Cookbook – a great present, by the way, so it comes recommended. The group’s model sees it paying fixed fees for books they publish (no rights issues or tails of royalties), and the sheer volume of content they’ve produced in relation to their back catalogue is enormous. So why not, in this case, take a database of recipes the group owns the rights to – in combination with their experience in printing – and allow customers to create personalised cookbooks? It’s a cute idea. I have no idea how big the market for this is, but the principle is interesting. On a less out-of-the-box front, the group unified its imprints under one brand identity on Quarto Knows. This will serve as a platform for the direct selling of books. I’m unsure to what extent this will prove an actual profit centre in itself – clearly the margins are attractive when you take out the retailer, but I can’t envisage much in sales running through the platform. Still, it’s all a step in the right direction, and a string to management’s bow.

Secondly, the group has signalled its intention to engage in accretive acquisitions. The purchase of Ivy Press last year for £1.5MM was said to be ‘earnings enhancing’ which, assuming there’s not too much fiddling of the figures going on (you can justify any number with acquisitions..!) means they must have bought it pretty cheap, given their own multiple. Both trading updates since the acquisition have noted that Ivy Press is outperforming expectations, and given that the group expected to realise significant synergies on the acquisition, the cash-on-cash return profile for the transaction must look attractive. The fragmentation of the market, Quarto’s market leading position, and the structure of the business’s the group would likely target – small teams, probably owner-operated – reminds me a bit of Judges Scientific. There is real scope for a management team to add value by getting rid of the substantial overheads related in running a small publishing business, and Quarto seem a logical consolidator given their dominance in the field.

That said, I’m not comfortable attributing any value to the potential here. The Ivy Press acquisition was a purchase of a business which had separated from Quarto in the first place, and I find the purchase of intrinsically people-based businesses to be a particularly tough way to add value. There is probably an argument that Quarto would be going for backlist heavy publishers – so less people based, more product – but I also see from Quarto’s pre-recession past that there was a period of acquisitive growth. My roughshod analysis makes it look like capital invested at what turned out to be a pretty low rate of return, which is at least in-line with my expectations. The vast majority of companies pursuing acquisitive growth add no discernible value or, indeed, destroy it, and the subsumption in to the group as a whole is an inherently messy, difficult to track and hard to measure process for an external investor. That’s why I want the evidence of value-add to slap me in the face for me to buy an acquisitive growth strategy.


But that’s all for the future! For now, the rating will continue to be driven by debt-reduction and operational improvements. I have, clearly, drunk the potion, and I have a strong bias towards sticking with the stories as they deliver. Barring any unforeseen change to my expectations as laid out here, we’re still a long way from where I’d be willing to sell.

 

2 Replies to “Quarto: Déjà vu all over again”

  1. red

    “In fact, if I was management – or a private equity firm – I’d be tempted to look at buying the whole thing and leveraging it up. Why not?”

    Quite right, Lewis. I’d buy this whole. The challenge with owning it as a passive minority shareholder is that one can’t be as sure that they will pay out an approriate share of cash flows rather than reinvesting it so that the FCF yield can seem a little too abstract. After all, every penny paid out would raise the market value of the company by 2p which is far in excess of the ROI on any acquisitions.

    In the end, one is relying on not quite a greater fool but something close to it to take it off one’s hands — which is not such a bad bet in the UK market — but I’m not sure it is a value investment as much as it is a speculative trade.

    • Lewis

      Curious about your logic on the divi raising the market value – is your inference simply that the cost of capital the market is attributing the company (implicitly high) is ~2x their current return on capital?

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