GuruFocus Premium Membership

Serving Intelligent Investors since 2004. Only 96 cents a day.

Free Trial

Free 7-day Trial
All Articles and Columns »

Value Idea Contest Submission - Quadracci

April 29, 2013 | About:
"You don’t make money selling, you don’t even make money buying, you make money waiting." — Charlie Munger

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 (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.

Competitive Advantages

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.

35024_1367228420TZG4.png

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.

35024_1367225584Zca6.png

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.

Value

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.

Specific Risk

  • 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.


Management

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.

Read more

10-k

Drop-shipping mail.

USPS rates.

Cost of printing a magazine.

Free printing.

USPS strategy.

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 as usual.

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 (14 votes)

Comments

swnyc2
Swnyc2 - 1 year ago
Batbeer2,

Another excellent article -- as usual!

I wish I had paid attention to your first article in April, given that the stock has appreciated >60% since then.

How do you come up with such great ideas?

Between QUAD and OSTK, you're on quire a roll.

You make a good case for QUAD still being a good value, but having missed it in the low teens, I have to admit it's tough for me to pay $21 a share for it now - especially when not much has changed with regard to the intrinsic value of the company.

I know it shouldn't matter -- missing a buying opportunity in the past -- but it does.

In the meantime, it's definitely a stock worth watching, in case it drops in price along the way...


batbeer2
Batbeer2 premium member - 1 year ago
Hi Swnyc2,

Thanks for the kind words.

A stock is not cheap now because it cost more (or less) last week, last minute or last year. It is cheap because you are getting more than you're paying for.

In other words, ignore the graph. That is much tougher than it sounds though.


>> especially when not much has changed with regard to the intrinsic value of the company.

The acquisition of Vertis should increase revenue by 20% or so. There's a fair chance, owner earnings for this year or the next come in at $300m-$400m for a yield of 30%.

You wouldn't believe how ugly this stock looked last year. The company had been reporting losses ever since it had become publicly traded. Since then, the stock has come up a bit but the business has come up a lot.
varunfriend
Varunfriend premium member - 1 year ago
Hi Batbeer2,

Great article as usual .. You didnt answer Swnyc2's question though :) - how do you come up with ideas like that ? Perhaps you can share your process ..

I took a small position since apparently I cant do focussed research until I have some skin in the game. Iam reading through everything you posted and anything else I can find ... all signs point to this being a "fat pitch" ... will probably end up taking a substantial position on this.

Thanks again and keep up the good work.

batbeer2
Batbeer2 premium member - 1 year ago
Hi Varunfriend,

Thanks for the kind words.

>> since apparently I cant do focussed research until I have some skin in the game.

Yes. I know the feeling.

>> how do you come up with ideas like that ?

About half my ideas come from checking out the quarterly letters of Southeastern and Third Avenue.

Another 25% come from tracking interesting board members. The guy who started Staples is also at Carmart and Petsmart.... that's worth a look. Olsen (Tolles Munger and Olsen) is also at WPO and if memory serves he was at LVLT too....

Some of the ideas, I've stolen from VIC and gurufocus.com. I do my own research though. Often, there is some store of value that the original author ignored or overlooked. There's value in thoroughly checking such stuff out. An example would be Solitron. At one time it was a pretty popular value stock. It was discussed on many forums. It was net-cash. No one had taken a good hard look at the liabilities though. I did some work on that and it became clear to me that their liabilities were overstated. So not only did the cash exceed the nominal value of the liabilities, the liabilities were clearly overstated by 30% or so.

One or two come from the fact that I always check out the competition. I was looking at Goodyear and it struck me that Michelin was consistently more profitable.... so I switch to the better company and work on that one instead.

Apart from the "guru bargains" and "consensus picks" I don't use any screeners.

If I try to define this in terms of a process, I use two filters.

1) Can I possibly understand this company and any competitive advantages it may have?

2) Is it cheap?

In that order.

I am a strong believer in putting the most selective filter first. The first filter eliminates 95% of the companies I look at within a minute. I'm either dumb and honest or modest. Either way, it leaves me lots of time to focus on filter #2. The really good news is that any effort in stage 2 is never lost. A stock that is expensive today may become cheap tomorrow.

In short, I don't spend a lot of time finding interesting stocks. I do spend more time than most on the stocks that I find interesting. (Michelin, SIAL, CRMT, LVB, MTD, QUAD, BRS, INTC, SPLS....) are in essence pretty simple businesses. Also, they don't change much over time. I spend lots of time on stocks like that. Even if they are expensive, the work is not lost. They may become cheap at some point.
longleaf
Longleaf premium member - 1 year ago
Nice job! "Investing is where you find a few great companies and then sit on your ass." I am WAITING now. Thank you so much.
ecotycoon
Ecotycoon premium member - 1 year ago
Great quote thanks for sharing :)

"
You don’t make money selling, you don’t even make money buying, you make money waiting." — Charlie Munger
batbeer2
Batbeer2 premium member - 11 months ago
Talk about mistiming the market......

1) I have submitted this one for the value idea contest twice now.

2) In a year it has doubled.

Just not within a year of me writing about it ;o(


FWIW I think QUAD is still cheap. Just not absurdly so.
varunfriend
Varunfriend premium member - 8 months ago
What happened there? The stock just got crushed for what didnt look like that bad a news. Did I miss something?
batbeer2
Batbeer2 premium member - 8 months ago
Yeah....

IMHO the news isn't that bad. I guess the market was expecting better news.

Having said that, the per-share GAAP loss for the trailing nine months comes in at $0.60.

FWIW, I liked it at $12, I liked it at $36 and now I still like it at $29. The thesis still holds. QUAD is much better than its peers. Also, it's cheap.
varunfriend
Varunfriend premium member - 8 months ago
I agree.

I added to my position after the drop today ... doesnt seem like anything has changed. Original thesis is still valid and certainly not worth a 25% drop in price in a 2 days.
swnyc2
Swnyc2 - 8 months ago
Ditto. I substantially added to my position today as well.

Although it should be noted that one of the directors (Betty Ewens Quadracci) sold .2M worth of stock a few weeks ago at $32/share. It represented about a quarter of her holdings.....
chaoranhu
Chaoranhu premium member - 6 months ago
Thanks for sharing your thoughts on QUAD. They are great! Although I missed on your first post, I did add some after the recent drop. Depending on how you look at things, QUAD has anywhere from 4 to 6 dollars a share in current owner earnings. At the current price, that's 15 - 20+% in earnings yield. Being cheap is the main attraction. The downside is they are in a fragmented industry with over capacity and likely faces irrational competition often times. While interests of the board, management, and employees seem to line up well with outside shareholders, it's not as clear how well the management does capital allocation. With the business generating significant free cash flows, while it's prudent to pair down debt and pension liabilities, it seems they should also buy back shares. At the current price level, buying back shares is a much better use of cash than paying dividends. They have authorized a small $100mm buybacks, but have executed only a miniscule of that, even while their shares continue to trade at such depressed levels.Being a novice in accounting, I do have a question for you regarding maintenance CAPEX. In their 10-k, they state the following on page 77:"Property, plant and equipment—Property, plant and equipment are recorded at cost, and are depreciated over the estimated useful lives of the assets using the straight-line method for financial reporting purposes. Major improvements that extend the useful lives of existing assets are capitalized and charged to the asset accounts. Repairs and maintenance, which do not significantly improve or extend the useful lives of the respective assets, are expensed as incurred. Leasehold improvements are depreciated over the shorter of the lease term or the estimated useful life of the respective asset."They seem to imply that the amount marked as PPE purchases in their cash flow statement is more geared toward growth, since repairs and maintenance expenditures are expensed. We certainly don't have to take all that at face value. My question is, however, which item in their income statement accounts for maintenance CAPEX. I would appreciate it if you could help me understand that.
batbeer2
Batbeer2 premium member - 4 months ago

Hi Chaoranhu,

Sorry for the slow response. I just saw your question.

>> My question is, however, which item in their income statement accounts for maintenance CAPEX. I would appreciate it if you could help me understand that.

By no stretch of imagination am I an expert (or even very knowledgeable) in the field accounting. My best but incomplete answer to your question comes in two parts:

1) By definition, no item on the income statement accounts for maintenance (or for that matter growth) capex.

Capex is not reflected in the income statement because it's added to the balance sheet as PP&E (it's capitalized) and then that PP&E is depreciated over a number of years. It's these depreciation charges that are refleced on the income statement. If you buy a machine for $10m in year one and you capitalize that, then you will never find that $10m expense on the income statement. You'll find a recurring depreciation charge though (say $1m for 10 years).

Back to your question....

2) Without much knowledge of the printing business and how they tend to account for stuff, I would expect the maintenance expenses you're looking for to be in "operating expense". Maybe they stuff some of it into COGS.

If you replace the ink (cartridge) in the printer at you office and the new cartridge somehow improves the quailty of your printouts, what would you call that? It's probably an operating expense. However, if you happen to be in the business of selling those prints, that same expense could be accounted for as COGS.

But to be sure, no honest bookkeeper would agree to it being called Capex.

As for your assumption that QUAD's capex must be biassed towards growth because QUAD directly expenses some of its maintenance.....

I don't agree.

You can install an aircon in your shop and you could call that an improvement. You could capitalize that on the balance sheet and subsequently depreciate that over many years. But if all you competitiors are doing it, that aircon is not going to bring in more customers to your shop. It is not an investment for growth. QUAD can and probably does do that but it is a matter of opinion whether it's an investment for growth. I'd say no. At the end of the day its a matter of judgement. There are no rules for that. One company's aircon may be maintenance while at another company it is an investment for growth. Some may capitalize the machine and others won't. For those that don't, one could say they have a policy of depreciating their aircons within one year. In other words, the bookkeper values it at zero before it hits the balance sheet so it has been expensed.

What I can tell you for sure is that QUAD spends more on Capex than their competitors (Capex as a percentage of PP&E is higher). That to me is an indication that at least some of that capex is growth which implies FCF understates owner earnings. Alternatively, one could argue PP&E understates economic value. Either way, it's a good thing.

Hope any of this makes sense to you.

batbeer2
Batbeer2 premium member - 3 months ago

FWIW, I did a new estimate of the owner earnings of Quadracci based on the 2013 10k.

On page 75 it shows the company paid $55m in dividends and spent $292m on the acquisition of Vertis. Meanwhile they spent even more on Capex than they did the previous year.

They repaid a bit of long-term debt but borrowed a bit more from the bank (revolving facility). Net-net it cancels out. They didn't take on extra debt for the acquisition or the dividend.

On the pension side (page 111) the employer contributions to the fund almost matched the benefits paid and the return on the assets of the fund caused a big improvement of the funded status.

In short, my estimate of owner earnings for the year is roughly $350m (292+55).

That's $7 per share.

In this case, FCF as reported is a reasonable proxy for owner earnings.

Please leave your comment:


Get WordPress Plugins for easy affiliate links on Stock Tickers and Guru Names | Earn affiliate commissions by embedding GuruFocus Charts
GuruFocus Affiliate Program: Earn up to $400 per referral. ( Learn More)
Free 7-day Trial
FEEDBACK
Email Hide