Tying Theory to Practice
Quarto Group seem like a logical stock to take a look at after my post last week (somewhat tangentially related!) on media stocks and their book metrics. While they’re not really in the stable of business I analysed there, they do share a lot of the same characteristics – which we’ll come on to later. Importantly from my point of view, they’re small in market cap terms, and earn consistently good profits bar an exceptional dip in ’08. That’s a nice base from which to start any investigation, as those two factors – small enough to induce some sort of pricing inefficiencies and cheap enough (on P/E terms) to offer good long-term returns, on average, strike a chord with my methods. That’s the logic behind the very first step, so it’s from there that I go into more detail.
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. Revenue, as we see from the graph, is more resilient than one might perhaps expect through a recession; I was particularly impressed that none of their books brought in more than 1% of their revenue. That’s no mean feat, and is diversification any investor would be proud of!
They’re hardly priced for success, either, on a forward and historic P/E of ~5, but recent results suggest that if a downturn is coming, it’s certainly not starting yet. Their October IMS reported revenues up 5%, operating profits up 3%, and PBT up 9%. While those aren’t astonishing growth figures, when you’re rated at the wrong end of single-digit P/E ratios a simple maintenance of your profits would see investors rewarded. It hasn’t taken long to identify my potential difference of opinion with the market then; I wonder if Quarto is simply hit by sector bearishness by investors who fear for the survival of books in the future. While the industry is indeed undergoing a shakeup, Quarto’s unusual position may make them better positioned than most to survive and profit out of it. There are, of course, some pitfalls to my optimistic call; as I alluded to in the first couple of paragraphs, being in media means that you’ll naturally be light on the tangible assets, and heavy on the less quantifiable stuff.
That’s explained the only way I know how below – with a graph. Unfortunately using a pie became a little convoluted, so I’ve divided a bar chart into three segments, hopefully obvious as assets, liabilities and aggregates. Key factors to consider are the predominance of intangible assets in their book value makeup, and the relatively high level of debt (£73.8m) relative to most other metrics; yearly profit, assets, cash flows etc. If we include the value of these intangibles in our valuation of the business, the book value reported comes very close to the market cap of the company. If we don’t, tangible book value is £30m to the negative.
Echoing my sentiments in the previous post, though; is sticking to tangible book value as I so rigidly do really fair when considering a firm whose whole business is based around, more or less, selling intangibles? A lot of this will hinge on how you treat the business’s sizable pre-publication costs balance of £33m. This has remained remarkably flat over the last 3 years and, as far as I can discern, seems to be a perfectly reasonable thing to account for. Much like Barratt have a big wedge of ‘work in progress’ on their balance sheet, Quarto spend money on developing future cashflows. Since they will generate cash – just like a house will – why discriminate simply because the work done here isn’t in bricks and mortar? This depends on how conservatively you want to treat the accounts, I suppose, but unless you see a good reason that the cashflows won’t be realised – like a ceasing of trading – they seem a fairly reasonable thing to include. Obviously in a liquidation scenario all bets are off, but I never really approach this sort of company from that angle anyway – some business which work with physical assets can reasonably be expected to hold said asset, and as such their accounts should be waterproof. I don’t think Quarto fall into that category.
Since we’ve discussed their balance sheet and earnings, though, we’re left with one other statement – cashflows – and in many ways, this is the final piece in jigsaw, the unifying argument. I’ve discussed how difficult it is to place a value on different assets, tangible and intangible, and how measuring worth from book value is equally slippery. Really, though, there is one factor that transcends the tangible/intangible border; and that factor is simply the ease of conversion to cash. When you think about it, it’s the ease of conversion to cash that we really care about when looking at a going concern. Sure, tangible/intangible is a useful proxy for this – property is very easy, goodwill is almost impossible, but there are evidently exceptions.
Quarto’s is very obvious. The fact is, those pre-publication costs we just discussed are effectively converted into cash every year – as if we were to strip the amortisation out of the income statement, Quarto would be earning £12m more per year. The reason pre-publication costs (as a balance sheet item) stay roughly the same is that the opposite happens on the other end – £12m is then pumped in to future publications. Intangible this may be, but don’t be fooled by thinking this is a useless construction. If the company were to simply stop pre-publication expenses and wind down their operations, the asset would be converted into cash at a 1:1 ratio, assuming no accounting hiccups. You don’t get that with many others. A rather long digression around the more arcane points of accounting maybe, but I think it wraps up rather nicely my discussion last week. The bottom line, for me, is that PTBV and PBV are useful guides to the makeup of assets – and I will continue to screen on them for convenience reasons – but nothing beats really understanding the flow of cash and where things come in and go out.
As for Quarto? Well, if I take the discussion above, all I’ve really arrived at is that they’re not really overvalued. That’s certainly not much of a conclusion! It’s a fascinating business, and the Annual Report is a great read – the Chairman’s Statement is fantastic and wide-ranging, and tempts me to invest simply as I buy into his mantra – “the next lasting thing”, not “the next big thing”. His letter is filled with other equally calm and long-term viewpoints, which is what I love to see, and he has his money where his mouth is in terms of significant share ownership. Alas, I know very little about the wider macro issues surrounding publishing – something which I think is rather important if you’re planning to invest in a sector so widely believed to be heading down the pan in the digital revolution. I may well do a sectoral on publishing, as it makes sense to look at the whole range of cheap looking stocks – buying a stock which is so heavily impacted by sectoral bearishness without looking at the rest of the sector seems like madness to me. We’ll see!