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A Great Company at a Wonderful Price in a Terrible Industry - QUAD

April 16, 2012 | About:
Quad/Graphics (QUAD) treats its shareholders, customers, suppliers and employees with respect and trades at less than 2x owner earnings for 2011. The company has durable competitive advantages and is less leveraged than its peers.

"Ink is in our veins; ink is in our blood. It is our heritage, our mission and our business to be the very best at putting ink on paper."

Quad/Graphics prints such major U.S. magazines as Time, Newsweek, National Geographic, People, Black Enterprise and Popular Science as well as catalogs for mail order companies as L. L. Bean and Lands' End. The company also offers post-printing services such as distribution of finished pieces to newsstands. The company's shares trade on the NYSE at $12.50 for a market cap of $590 million (47 million shares outstanding).

1906 - The Quadracci family emigrates to the U.S. from Italy. The Quadraccis run a grocery store in Racine, Wis.

1930 - 16-year-old Harry R. Quadracci founds the Standard Printing Company behind the family store. A hobby. As the Depression worsens, the press becomes a source of extra income.

1934 - Quadracci sells his press to William A. Krueger, with whom he founds W. A. Krueger. The company becomes one of the largest printers in the U.S.

1962 - After graduating from Columbia Law School, Harry “Junior” Quadracci joins Krueger and works his way up to vice-president and general manager.

1970 - After a bitter three-month strike, Krueger's management gives in to the demands of its unionized work force. Harry junior, Krueger’s lead negotiator is disenchanted with the company's adversarial relationship with employees and leaves.

1971 – Harry junior takes a second mortgage on his home and launches Quad/Graphics. Harry sells a 30% stake in the new company. With the capital thus raised, he buys an abandoned factory in Pewaukee, Wisconsin. This becomes Quad/Graphics' first plant.

Quadracci convinces key production personnel from Krueger to join him at Quad/Graphics. Quadracci's disenchantment with the hostility between labor and management during his years at Krueger produce an egalitarian, non-hierarchical corporate culture. In return, Quad/Graphics enjoys a loyal and efficient non-union workforce.

In the early '70s, adult men's magazines (Penthouse & Playboy) account for nearly a third of Quad/Graphics' volume.

Quadracci repays investors' initial outlay within two years. The company treats shareholders with due respect.

1974 – Quadracci implements an employee stock ownership plan (ESOP). Over the years they buy back the warrants issued to the company's original investors. By 1997, Quad/Graphics' ESOP is the second largest shareholder of company stock after Quadracci himself.

1976 - Quadracci requires his delivery fleet to haul cargo during their empty return trips. When drivers ask him what kinds of loads they should haul, Quadracci replies, "How should I know?" The incident exemplified a key Quadracci management principle that came to be known as "Management by Walking Away."

1982 - Quad/Graphics forms its own ink manufacturing division, Chemical Research/Technology (CR/T). Today, CR/T produces more than 130 million pounds of ink annually. Offset ink in Wisconsin and gravure ink in Martinsburg, West Virginia.

1984 - The company is named as one of the "100 Best Companies to Work for in America".

1988 - QuadTech Europe established in Weesp, the Netherlands.

1991 - Employs more than 5,000 people. Annual sales are $509 million.

1997 - Purchases a substantial interest in Plural Editoria e Grafica, the commercial-printing arm of Sao Paolo, Brazil-based Folha Group.

2002 - CEO Harry “Junior” Quadracci, the founder, dies at 66. His brother and co-founder Thomas takes over.

2006 - Joel Quadracci (founders son) takes over as CEO.

2010 - Quad/Graphics merges with World Color (Quebecor). Quad management will run the combined company. Quad shareholders (family and employees) get 60% of the combined company’s shares. As a result of the merger, QUAD becomes publicly traded.

Receives Newsweek's Printer of the Year award for the 25th consecutive year.


Competition

The company competes with R. R. Donnelley (RRD), Cenveo (CVO) and Valasis (VCI). Quad/Graphics and R. R. Donnelley, combined, have a market share of roughly 15%.

Pre-merger, there were three players in the US capable of high volume publication gravure. Now, just two remain. Quad/Graphics and R. R. Donnelley. Rotogravure presses are expensive to fire-up but they can get you good quality on cheap paper. If you need to print lots of pages, the cost of paper can be significant (just look at COGS).

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At first glance, RRD seems to dominate the industry with superior OCF and FCF margins. Quadracci seems to be suffering from some indigestion after the acquisition of Quebecor World. On closer inspection, R. R. Donnelley’s pension liabilities are not only huge, they’re also growing and understated. The company assumes 8.5% return on pension assets. This alone probably explains why Donnelley's bonds yield over 8%.

Like bond holders, the GuruFocus community is not easily fooled. They'll have noticed Quad/Graphics:

Spends more on capex than the competition.

Has reduced its pension liabilities while its peers have increased theirs. Quad assumed multiple defined benefit pension plans as a part of the World Color Press merger.

Pays its suppliers (paper, ink, electricity) in time.

In short, Quad/Graphics treats its suppliers and employees with respect.

In the printing industry, good employee relations and good relations with your suppliers are durable competitive advantages. A strike or lack of paper will put you out of business in weeks. Unlike the competition, Quadracci has a non-unionized workforce. The company is less leveraged and as a result has lower interest expense.

Had R. R. Donnelley decided to fund its new pension liabilities, free cash flow would have been about half of what it now reports. Adjusting for the pension liabilities (I’ll ignore the fact that QUAD is clearly spending double on capex), in 2011, QUAD was twice as profitable as its peers.


Pension accounting

... can be complicated. In this case, M&A activity makes it worse. The $ 250 million of reduced pension liabilities I use come from page 95 of the most recent 10k. For the 2011 column, you can compare "Projected benefit obligation, beginning of year" versus "end of year". That's just the liabilities side.

You would have to add back the pension assets to get the net value. I use $412 million. There's a problem there. QUAD accounts for the assets at "fair value" using their own, less agressive, assumptions than Quebecor used. I use the 2011 "fair value" number for the assets. This is wrong but IMO conservative.

QUAD transferred some obligations to Transcontinental after funding those obligations with assets based on less aggressive assumptions than Quebecor used before. That is as fair as it can be to (former) employees but the bottom line takes a (nonrecurring) hit.


Financial strength

Summary: QUAD services its debt with ease.

The company paid an interest of about $ 100m on debt of $1500 million. The debt comes due in five years.

QUAD’s run-rate OCF (adjusting for lower pension contributions and debt) is roughly $400 million. At that rate, QUAD could conceivably retire its debt in four years (before it comes due) while spending more on capex than its competitors.

Taking care of the pension liabilities first is tax-efficient and smart from an owner's perspective. It does temporarily depress (operating) income.


Management

Joel Quadracci is paid about $1 million which is a bit less than the CEOs of CVO and RRD. Unlike them, Joel (along with his mom) have 200 times his annual salary tied up in common stock. His interests are aligned with the interests of minority shareholders.

QUAD's management could easily have issued some more debt and used the cash to retire all of the pension liabilities. This would have done wonders for (operating) income at the expense of higher taxes. This company is managed not like your average publicly traded company. It's managed like a family business.

Employees own about 20% of the company. Not only are the interests of management aligned with minority shareholders, the interest of employees is too.

Joel Quadracci and John Paulson have bought shares at higher prices.


Specific risk

1) The company's stock is divided into three classes: class A, class B and class C. The class B and class C stock have ten votes per share. "A" stock is entitled to one vote. All of the class B stock is owned by the Quadracci family.

2) The company continues to manage the bankruptcy claim settlement process for the Quebecor World bankruptcy proceedings in the U.S. and Canada.

3) Some of the industries that the company serves have been subject to consolidation, leading to a smaller number of potential customers. If smaller customers are consolidated with larger companies using other printing companies, the company could lose its customers to competing printing companies.

4) Some of the company's customers are highly leveraged. Any increase in the nonpayment or nonperformance by customers could adversely affect the company's results of operations and financial condition.

5) Changes in postal rates, postal regulations and postal services may adversely impact demand for Quad/Graphics' products and services.

6) Computers are becoming increasingly connected and portable. In the future, QUAD's services may no longer be required. No one will be putting ink on paper in creative and efficient ways. As it is, QUAD's (pre-merger) revenue quadrupled since 1991. I remember in 1991. Computers were becoming increasingly connected and portable. Many smart people were predicting the demise of the printing industry.


Owner earnings and fair value

In 2009, R. R. Donnelley bid $1.3 billion for Quebecor World (in bankruptcy!). That bid alone is twice what Quadracci currently trades for. That's absurd since pre-merger, Quad was worth more than Quebecor. $2 billion => $40 per share

I define owner earnings as the ability to reduce your liabilities, pay a dividend and buy back shares after paying your bills and maintaining your business. In 2011, QUAD spent more on capex than the competition and paid all its bills on time. Meanwhile:

QUAD reduced its pension liabilities by $250 million

Spent $30 million on dividends.

Reduced debt by more than $100 million.

From an owner's perspective, the company earned $380 million => oEPS of $7.50.

R. R. Donnelley recently paid $500 million for Bowne. Bowne, with $750 million of revenue could charitably be said to be worth 25% of Quad/Graphics. The transaction implies QUAD is worth $ 2 billion => $40 per share.

Quad/Graphics paid $ 25 million of income tax in 2011. This implies the IRS sees earnings of roughly $ 100 million after otherwise taxable pension fund contributions. The IRS says QUAD earned roughly $ 100 m in 2011. => iEPS of $2.50


Why is this cheap?

Quebecor World emerged from bankruptcy with distressed debt players such as Avenue Capital and Centerbridge owning significant stakes. These shareholders may now be selling their shares.

Reported earnings are depressed because QUAD "diverts" operating income to reduce its pension liabilities. This is a huge, temporary drag on GAAP earnings and FCF.

Some fear management treats employees well at the expense of shareholders. In this case, employees are significant shareholders. In fact, (former) employees cashing out now that the company is finally publicly traded may be a reason for the low price.


Catalysts

At some point, the pension funds won't require further funding. This should cause operating income to jump.

R. R. Donnelley is showing signs of distress (high bond yields, aggressive assumptions for the pension funds etc.). Should this giant run into trouble, Quad's revenue and margins will benefit.

The company raised its dividend 25% to $ 1 per share and may repeat that or buy back more shares.


Read more



recent 10k


Adjusting earnings for pension liabilities properly - If it's cheap enough, you don't have to do the calculations properly.

Donnelley's attempt to buy Quebecor World

Make it new

Bowne bought

Quadwatch - Former, disgruntled, emplyee.

Ready fire aim - Book about Harry Quadracci.

Decent overview of QUAD's 5-year numbers.


Disclosure

This is not a recommendation to buy or sell anything. At the time of writing, I had no position in any of the stocks mentioned. Any and all questions welcome.

About the author:

batbeer2
I define intrinsic value as the price I would gladly pay to own the business outright. With current management in place. For most stocks, that value is 0. As of September 2012, I'm the author of the monthly Buffett-Munger Best Bargains Newsletter. I can be reached at fvandenbroek AT gurufocus DOT com

Visit batbeer2's Website


Rating: 4.4/5 (34 votes)

Comments

tonyg34
Tonyg34 - 2 years ago
they also have negative earnings

you imply that this from funding the pension and the quebecor world acquisition. what is your outlook for normalized earnings? what has been the rate of decline in earnings?

buying anything below asset value is good, but not if the asset value shrinks (eventually the company will catch up to its stock price, instead of the other way around)

I just worry the company could go the way of standard register (SR),

random thought, this company reminds me of a previous GuruFocus discussion on Rimage (RIMG) - leader in loser category, good dividend and fcf, horrible roe/net margins, no real growth prospects
batbeer2
Batbeer2 premium member - 2 years ago
Hi Tonyg34

>> they also have negative earnings

IMHO they have positive earnings. The outright owner of QUAD would have been richer in december of 2011 than in january.

The IRS understands this, QUAD paid about $ 25m of income tax.

>> you imply that this from funding the pension and the quebecor world acquisition.

Yes.

I don't have an outlook for normalized earnings. I try not to predict. Having said that, I will delve into the GAAP earnings number and try to reconcile why it is so much different from (adjusted) FCF.

Who was the guy who famously said "earnings are an opinion, cash is a fact" :o)

QUAD reminds me more of Staples than of Rimage.


- EDIT -

Your questions were adressed by the company in this presentation. As I understand it, the company expects 2012 FCF of at least $ 300m. If they are right, 2012 GAAP earnings should come in at roughly $ 100 m. (FCF - D&A + Capex => $ 100m). In 2008, pre-merger, QUAD reported GAAP earnings of $ 100m on revenue of $ 2 B.

You may want to go to: http://investing.businessweek.com/research/stocks/financials/financials.asp?ticker=QUAD:US You'll get a feeling for the (pre-merger) numbers.

onthefringe
Onthefringe - 2 years ago
Wow. Thorough. Bookmarked.
benethridge
Benethridge - 2 years ago
Nice analysis. Very Phil Fisher-like.
Bob_in_Maryland
Bob_in_Maryland - 2 years ago
Why not make this a 5+ star article? You know? AND the price is right!

BUT. was it you who said said the industry is terrible?

That might cause the reader to feel (s)he was sent out on a misdirected play. ... Nothing wrong with that but there are a lot of associated "industries" playing the same game and - for sure - they are NOT in many specific portfolio's for just this reason.

Will continue with the DD but this story appears to be a truly awesome one. For anyone associated with journalism, libraries, computers, information dissemination, etc. this relates to a saga that more than deserves further publicity, understanding and/or appreciation. Seems as though QUAD has structured itself in a way that is truly visionary. You are entitled to a great debt of appreciation.

So cool! What a discovery!

- Bob
portfolio14
Portfolio14 - 2 years ago
This is an outstanding writeup.
batbeer2
Batbeer2 premium member - 2 years ago
Hi all,

Thanks for the kind words. Glad you like the article. It was fun to write.
kfh227
Kfh227 premium member - 2 years ago
nice to see someone use debt correctly. as an owner, you care about debt relative to FCF. it is also important to note interest rates on the debt.
shb600
Shb600 premium member - 2 years ago
Batbeer2,Any thoughts on this and current price of stock?

Quad/Graphics, Inc. (QUAD), announced today that it has reached a new, $900 million-plus agreement with Time Inc. that significantly extends and expands its magazine print work for the venerable New York publisher. Under the multi-year agreement, Quad/Graphics will handle more than 85% of the print work for 19 titles that are among the most popular magazines in America, including Time, People, Sports Illustrated, Entertainment Weekly, InStyle, Money, Real Simple, Fortune, Essence and Golf. The work represents a 35% increase in incremental Time Inc. print volume for Quad/Graphics over the term of the agreement, beginning in January 2014.
batbeer2
Batbeer2 premium member - 2 years ago
Hi Shb600,

I think the stock is still very cheap, just no longer absurdly so.

The news is good for Quadracci and bad for RR Donnelley. Rotogravure is all about volume, distribution and high quality on cheap paper. Anyone can print a decent glossy on ehm.... glossy paper. Printing a glossy on cheap paper is another matter. There are very few companies left with that capability.

If RRD dies, QUAD is a monopoly. No one else (excluding some newspapers) has nationwide rotogravure facilities.



RRD used to print almost all Time Inc.'s stuff.

Quadracci has now taken 80% of that business.

P.S.

< 3x sustainable owner earnings => absurdly cheap

3x - 7x sustainabe owner earnings => very cheap

7x - 10x sustainable owner earnings => cheap
baocheng
Baocheng - 2 years ago
mark
batbeer2
Batbeer2 premium member - 2 years ago
Vertis goes belly-up and is picked up by Quadracci for $ 260m. That's another $ 1B of incremental revenue. I wonder what the pension liabilities looked like at Vertis.
batbeer2
Batbeer2 premium member - 1 year ago


Some highlights of the full-year 2012 results:

  • Roughly $350 million of recurring Free Cash Flow

  • The Company retired $120 million in debt.

  • A $2 special dividend in december.

  • Regular 2013 quarterly dividend raised by 20% to $0.30 per share.

    In short, the profitability of Quadracci is beginning to show. This should start popping up on some stock screens now. At current prices, the yield on estimated run-rate owner earnings has dropped to 30%.

    The competition is not faring as well.
  • batbeer2
    Batbeer2 premium member - 1 year ago
    QUAD has doubled..... 14 months. Just my luck ;o(

    FWIW, I think it will double again; nomen est omen.

    The recent (slight) increase in interest rates has a big impact on the discount rate used for QUAD's pension liabilities. This reduces contributions and boosts reported earnings. We'll see.

    Please leave your comment:


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