Disclosure: I have an interest in Quarto shares
Forgive me for the Churchill reference – but it does have some relevance for my illustrated book publishing friends at Quarto. That’s because, along with their 17th March final results announcement, Quarto noted that the two activists still on their board – after almost four years of involvement – will be standing down at the next AGM. The group has successfully passed through a phase of reassessment and considerable uncertainty, as the long-time CEO and founder of the company stepped aside on the activists’ behest and made way for a new leadership team.
Quarto has reduced debt, sold off non-core assets, started several innovative new imprints and improved financial results. It was, I imagine, something of a tight-rope walk.
The group still trades at less than 7.5x my run-rate cash flow estimate. I think they can generate around 13% of their market cap in freely available cash each year, with which management can choose to either pay down debt, distribute a dividend, or invest in acquisitions.
My opinion here has not changed – this is too high a free cash flow yield for a high quality company. The market gives it little credit for the resilience of its business model and places undue emphasis on financial risks from a relatively high (though now substantially improved) debt position.
Despite continued strong momentum in the shares over the last few years, the rating remains little changed – the improvement in price has mirrored underlying improvement in the company. There is further to go, and the slight loosening of the one-track strategy of debt reduction heralds, for me, the next chapter of the investment.
Results were good, as they were flagged to be. They were more or less in-line with my expectations last August, which were (at the time) some distance ahead of the analyst consensus. Adjusted EBIT came in around the middle of my $15.6-17.5MM estimate. Net profit came in above, despite a slightly higher tax rate than I had anticipated.
One disappointment is the restatement of the prior year accounts; something that now looks worryingly like a trend. I never have any issues with the particular restatements being made, but continual restatements just don’t look good. In Quarto’s case, the fact they generate substantially more than their reported profit in cash might lead one to believe that the cause is relatively benign.
For a much more detailed walkthrough of the results, the company helpfully provides a presentation (click image to access):
Two things stand out as being of particular significance to me:
Firstly, progress in the publishing business generally is excellent. The group has two ‘non-publishing’ businesses – a Hong Kong based print broker and an Australian/New Zealand direct marketing business. The latter of these is a difficult business at the moment, made particularly painful in consolidated accounts when brought in with a deep currency devaluation. The former is a perfectly fine business sourcing print services, and a service provider to the group. But it is for the publishing businesses that one invests in the story, and it is publishing businesses which are intrinsically higher quality. Of particular note in the year were adult colouring books; one in particular, Color me Calm, contributed $3.6MM to group sales – an enormous sum compared to Quarto’s historical best-sellers. A Minecraft book contributed almost a million dollars. Quarto, as ever, seem swift to capitalise on trends.
Children’s publishing is a particular focus of management and has been growing quickly. Notably, along with the ~40% rise in revenues, a Quarto book won last night’s Waterstones Children’s Book Prize for best illustrated book – David Litchfield’s The Bear and the Piano.
Secondly, and more specifically, the group’s intellectual property spend seems to be more directly translating into sales. This is extremely important, because the ‘machine’ on which the business is built is the continual churning out of new books, with which the group pounds the streets on the first year and which then provide the backlog revenues that shore up future years. Here is a chart of ‘product efficiency’, taken from the presentation, which shows how the prior year’s development spend is converting into this year’s sales:
Even if you strip out the three excellent colouring books, you end up somewhere in line with last year on this metric. The group’s gross margin is also improving. Putting two and two together, I would suggest the return on the group’s development spending continues to improve, and that this also gives more confidence they are creating a resilient base of intellectual property. The group’s off-balance sheet asset – its back catalogue of books – continues to grow.
Things seem to be continuing merrily along in the right direction.
The outlook statement touts management confidence in delivering ‘continued earnings growth in 2016’. Given how good this year was in the context of currency devaluation and big declines in the non-core businesses, I am surprised by this; I would have thought they would strike more of a ‘hopeful we can maintain’ tone. That said, I am optimistic they can continue to find cost to cut out of the business and cash that can be released.
For what it’s worth, here’s how the market may well be pricing the stock at its current levels:
The market, I suspect, has doubts about the longevity of the business; this is captured in the expectation that $8.5MM is the ‘run-rate’ cash flow, less than that which they managed this year, despite this year having $1.6MM of acquisition spending, above normal capex, and significantly above historical investment in new product. The market also continues to perceive the group as being unduly risky due to the debt pile. 15% is a high rate of return to require. It is substantially above that implied in most small-cap stocks.
This price-of-risk concept presents an important question: what is the problem with debt? The problem with debt is that it reduces flexibility for companies. The problem with debt is that it magnifies downside deviations, by exacerbating the impact of a downturn in trading.
I don’t disagree with this, but I care about risk holistically. Many businesses with no debt go bankrupt – some businesses with plenty survive. It is the stability and predictability of cash flows that differentiate those two groups. This year marks Quarto’s 16th consecutive year of net profit. That stability of profitability and cash flow come because they provide an enormously diverse range of product (if you’ll permit me that – they are all books!) to a very diverse supplier base – from Amazon, to hairdressers, to DIY shops, to bookstores, direct distributors and their own online shop. The products are remarkably resilient, something that can be directly verified by looking at historical numbers and by considering the scale of consumer deferment on the purchase of 1001 Movies To See Before You Die or Square Foot Gardening. They’re not exactly Ferraris or new houses. Perhaps people hark back to simple pleasures when times get tough.
I am not blasé about debt – it is there, and it is a claim before me in the capital structure. What it doesn’t do is massively increase my perceived risk.
I view the business more like this:
I think the group’s run-rate cash flows sit at something like $9.5MM were they to lighten up on growth spending. This year, they managed $8.7MM by my measure – but, as I mentioned above, this includes significant acquisition and above-trend new product spending that I hope will drive more than a 3% growth in publishing revenues.
I also think a 12% rate of return fairly compensates me for the risk I am taking in Quarto shares. You can have a discussion on cost of equity until you are blue in the face – suffice to say that, in my opinion, 12% is substantially above the implied cost of equity in more or less any developed market you can find, even small-cap ones, and that I think Quarto is moderately less risky than the average security through the cycle.
If you’re uncomfortable with this way of looking at things, consider that £3.70/share corresponds to something like 10x this year’s earnings. I am not trying to justify some NASDAQ valuation here.
The past and the future
I have held Quarto shares personally for almost three years now. It has been an interesting and instructive journey. Most telling, I find, is sitting and analysing what I was most worried about at any point in time; because as the narrative changes, the risks change with it. Looking at what made me nervous says a lot more than looking at what I was hoping for.
When I first looked at the company I was worried about two things – I was worried about the debt pile, which was substantially larger back then on a smaller base of earnings, and I was worried about the threat of e-books and digital life generally. It is easy to scoff at now, but there was a point where commentators were proclaiming the impending death of the phyiscal book – or, at least, pretty steep volume declines. Debt is no fun in combination with declining volumes, and the market priced the stock as such.
As it happens, physical books have done very well in the last few years. E-books seem to be complementary or, at the very least, not too damaging to the tangible world. On top of that, Quarto’s illustrated book niche seems to make them pretty difficult to replicate or replace – something that was part of the theory all along.
Hence, around a year ago, my worry changed. The company was executing the turnaround successfully, debt was being repaid, earnings were increasing and the world seemed to have accepted that physical books were not going away. Now my fear was strategic – the improvement was not being reflected in the stock price, and the board consisted of some extremely shrewd investors who were looking at the same positive trends that I was. As has happened before, my worry was being taken out of the investment at a 30% premium – hardly, I felt, fair recompense for my time and risk given that the business was doing well.
With the reorganisation of the share register, that risk has now reduced significantly. But investors always find something to be worried about, so what for the future?
My fear now is one of a wider range of outcomes. Three years ago, the board and the company had a clear, defined and obvious path – it would repay debt, it would sell off non-core assets, and it would attempt to make the organisation leaner and more profitable. It was heads-down, inward looking operational time. Now, the group’s lower burden gives it the flexibility to do more things. The CEO seems excited about the future of the business and the many directions it could take. His case is bolstered by the excellent performance of the Ivy Press acquisition last year, but the presentation seems to hint at bigger propositions than small tuck-ins.
That is a worry for me, particularly given the fact that any large transaction would invariably require some equity ticket. As I noted above, my perception is that the market is pricing Quarto with a 15% cost of equity. My assertion is that this is far too high a price for the quality of the business. Given my valuation of the shares at substantially more than their current price, I do not want to be diluted! Nonetheless, I have seen everywhere, in every company, the organisational imperative for growth and change. My spreadsheet fantasy of three more years of debt pay-down, followed by a nice tender repurchase of the shares if the market continues to misunderstand the company, seems a vanishingly small probability. A much more likely outcome seems to me that the company continues on a growth path; larger, with more money, more liquidity, and more excited brokers. And at that point another question becomes paramount; we have seen that management are good operators. Are they equally good capital allocators?
I hope Quarto gets a more fulsome valuation before the right deal comes along. I suspect the deal itself might well start to fix some of the problems participants have with the share – low liquidity, small size, difficult to benchmark. Momentum is good, people seem to be getting on board with the story, and the stock is cheap. Quarto continues to be a core holding of mine.