Buy-and-hold investing is not a goal or even a strategy; it is the result of buying stocks at 20% or less of their intrinsic value. Case in point: Quad/Graphics. Reading back what I wrote about QUAD last year, I believe I failed to explain why the fundamentals of the business are better than meets the eye. With good reason. At the time, it hadn’t dawned on me that Quad/Graphics is a company with sustainable competitive advantages.
Quad/Graphics, named after late founder Harry V. Quadracci, provides commercial printing and distribution services. The company is the second largest commercial printer by revenue, second only to R.R. Donnelley & Sons (NYSE:RRD). After Quad/Graphics' recent acquisition of Vertis, the company is also the largest commercial printer in South America.
The U.S. print advertising business of approximately $45 billion is highly fragmented. Quad/graphics and R.R. Donnelley, the two largest companies, take 30% while the next 400 competitors take just 20%. Ever since Quad/Graphics was founded, the company has been gradually and profitably taking market share. Today, Quad/Graphics has a national distribution network for catalogs, magazines and letters. Only R.R. Donneley has a similar network. World Color used to be the rotten apple in the barrel, creating pricing wars. World color has been taken out now, leaving a duopoly of R.R. Donnelley and Quad/Graphics. R.R. Donnelley is in trouble though, choking on its pension obligations.
So what's the moat?
In short: It much is cheaper to transport bits and bytes than it is to move paper.
The traditional print workflow encompasses processes from prepress through physical distribution of product. The entire print run is produced at a single location. Following print and binding, printed materials are delivered to the final destination. This could be a store, a customer distribution center or the U.S. postal service. This workflow is known as print-and-distribute
Quad/Graphics, as one of the few companies with a nation-wide network of high-volume (rotogravure) presses, inverts this process. This workflow of electronically distributing a job and then physically printing the end product near the point of final delivery is known as distribute-and-print.
That’s nice in theory, but does this work in practice?
Well….. the cost of printing a magazine like Playboy is roughly 50 cents. Of that, 35 cents are the cost of the paper itself and 5 cents are for ink. The printer gets a dime for applying the ink to the paper.
In other words, you could double the efficiency of your printing facility and you would shave off 5 cents (10%) of the cost to the customer. That's tough! It's also precisely what most print shops are trying to do.
Or... after printing, you could drop off the finished magazine at the USPS's Sectional Center Facility (SCF) nearest to its final destination. This shaves off roughly 50 cents from USPS’s standard rate. Mail entered into the USPS’s system further downstream, gets a postage discount.
Wow! I’ve saved my client the entire cost of printing the magazine! I’m printing it for free. What’s more, my client is now able to track every single order all the way to one of the 250 USPS distribution centers. That’s hard to compete with.
That is why Quad/Graphics operates a network of high-volume rotogravure presses. The network enables the company to get the final product to its destination in the most timely and cost-effective way possible. They send the bits and bytes over the Internet and do the actual printing near to where the final product needs to be. Any increase of postal rates, fuel costs and freight costs will increase the pricing power of Quad/Graphics’ network.
So what is a rotogravure press?
A rotogravure press is an expensive machine that enables you to get a high quality result on cheap paper. With a rotogravure press, the only liquid that touches the paper is ink. On an offset press, the non-printing area is covered with a water-based film, keeping the non-printing areas ink-free. This excess water turns cheap paper into mush. What’s worse, you need to apply heat to dry the paper quickly after printing.
The paper itself of course is a major cost. Also, the ability to use cheaper (lighter) paper again reduces distribution costs. The only drawback of a rotogravure press is that it is relatively difficult to set up for short runs.
Owner earnings is the amount of cash a company could pay out to shareholders or use to retire debt.
In 2012, Quadracci paid out dividends of roughly $140 million ($3 dollars per share). They didn’t take on extra debt to do it. In fact, the company spent another $140 million or so reducing debt. That's after:
a) Spending $85 million on interest expense and
b) The acquisition of Vertis. Though the deal closed in 2013, QUAD lent Vertis some money in 2012.
QUAD generates more than enough cash to service its debt which matures in 2017. Compare that to R.R. Donnelley. That company is spending more on interest expense each year. They are now spending $250 million per annum. That's roughly half their FCF.
I like using round numbers so I’ll call it owner earnings of $5 per share.
$5 per share is what they used to reduce debt plus the amount they returned to shareholders as dividends.
With shares trading at $21, that’s a 24% yield on owner earnings (P/E of 4).
Last year, there was some uncertainty if the company would ever report positive earnings. This year one could rightly wonder why earnings as reported understate cash earnings.
One reason is that the discount rate used for pension liabilities was lowered from 4.7% to 3.9%. Just as some investors value an asset with a discounted cash flow model, companies estimate the present value of their future pension obligations with a DCF model. Quad/Graphics has lowered the discount rate used in that model. This has caused the pension liabilities to be marked up to the tune of $75 million. Even then, by making some meaningful cash contributions, the company managed to reduce their pension liabilities. In any case, without the effect of lowering the discount rate, reported earnings would have come in almost 60% higher. Going forward, the discount rate may go up, down or sideways. Unless is goes down, reported earnings will be meaningfully higher.
- The industry is changing. These changes are both cyclical and structural. Cyclical changes come from trends in the economy, such as ad spending, paper prices and interest rates. Structural change is a result of the ever changing ways in which people communicate.
- The USPS closes distribution centers near printing facilities.
- The Quadracci family owns supervoting shares.
- The cost of transporting printed matter to the distribution centers rises faster than USPS rates.
- The Vertis acquisition triggers some write-offs.
For many decades, the Quadracci family has run the business for the benefit of shareholders. A lot of these shareholders were and are (former) employees. The current CEO, Joel Quadracci, is paid less than his peers. Unlike his peers he has many times his annual income tied up in stock. Importantly, so have his family and friends.
Cost of printing a magazine.
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 as usual.