Leading on from last time, when I caught up with Quarto, the small-cap illustrated and non-fiction publishers, today I’m looking more at the figures. My previous efforts were somewhat diverted by a rather interesting set of boardroom antics and the voting out of the long-standing CEO and founder, Laurence Orbach. So while much of the top structure of the company has changed in the period since I last looked at the company, one thing has been fairly constant – the share price. That’s hovered at around 150p since more or less the end of 2010. My not buying then is fairly irrelevant to me from a potential investor perspective – I think I’m shrewder than I was, and it never hurts to give a company – particularly a cheap looking one – a second look.
I’ll try to leave aside the management change issues, but in reality I suspect they permeate quite deeply. A company under the rather conservative control of a founder-CEO for so long surely expects some wobbling and wavering post his departure – particularly given the manner that it happened. So while we’ve seen an impressive track record of normality (barring 2008’s exceptionals) it’d likely be foolish to expect more of the same – particularly as the new driving forces want to more quickly pay down debt and ‘improve shareholder returns’. It’s clear that historically investors weren’t excited by this stock; it’s been trading on a lowly valuation ever since the financial crisis – so I think much of the future price performance will depend on how exactly the new board go about carving up the business and rearranging the capital structure.
Crucially, though, what they have to work with seems good. Assets inside the business have earnt decent returns on capital going back as far as I can see (mid double digit), though this has hasn’t returned to pre-crisis levels. I wonder if investors are sceptical of whether that will happen; the most clear knee-jerk reaction to seeing a company that produces books is that the internet/e-readers/the 21st century will destroy its business. I think Quarto’s business model is substantially more resilient than one might expect though, with their diversification and so on. The way the business is structured – something I mentioned last time, referring to the way all investment is essentially in intangibles – also gives them a pretty good degree of flexibility. They are able to fairly easily move to new markets by simply producing new and different books if old ones dry up. In that way, the only way Quarto really loses is if paper books as a medium around the world die. As I also mentioned before, I think their niche approach gives them a more resilient product. Enormous, homogeneous, mass-market products are replicable and subject to the constant visscitudes of competition. Focusing on very small markets means, among other things, your consumers are pre-selected to be (essentially) price inelastic.
Clearly, while the fate of the printed book in the west attracts much negative attention, there’s also places around the world where the book is very much a growing medium. Quarto are trying to spread their wings a little, given that revenues are still dominated by US and Europe, which is an obvious avenue of growth. Whether it comes off is clearly uncertain – new markets bring new challenges – but there’s likely to be some sort of intangible value in a business like Quarto which has been doing the same sort of thing for so long. As I touched on above, though, fixed costs and investment requirements are fairly low – if you capitalise operating leases and add them to property, plant & equipment, you get a figure of roughly $30m. Compare this to a working capital figure of over $100m. Those figures together – operating capital – have stayed roughly the same for the last 6 years. It’s fair to say that the business is functionally about as big as it was, which may explain some of the institutional investor anguish.
There looks to be things that Quarto can do to mitigate any potential problems then, and there look to be growth opportunities, too. There is a bit of a millstone around their neck, though; a substantial debt pile. Net debt sits at $81m, and interest cover is just over 3x (based on pre-exceptional operating profit). Having said that, I wonder how much of a problem this really is – given that intangible pre-publication costs on their balance sheet are essentially just cash-to-be over the next 3 years – but I guess it’s perception that matters more than anything. The new chairman has indicated a focus on debt reduction, but that process will be painfully slow barring some asset disposals or by allowing the company to essentially run-down its ‘stock’ of intangibles by under-investing. The latter of those, I think, would be a mistake and a detriment to the business, since it means the operations are being impeded by capital structure considerations. The former isn’t a problem is the right bit of the business is identified – and I don’t know anything about that!
I think I like the balance of risks Quarto presents, and I’m also quite curious about the impact Harwood Capital will have. Perhaps they’ll take a shorter-term timeframe to realise their investment, which is certainly possible – but given that I think the business is fundamentally sound, I’m not hugely worried if they don’t. While it probably is overleveraged from an outsider’s point of view, I’m reminded that Harwood Capital tried to buy Quarto in the past. By my calculations, if you strip out capital structure considerations, it’s an attractive proposition. It is cash generative, and there is a form of asset backing. This makes it attractive from an outright purchase point of view.
The situation is quite unusual, but I’m tempted.