At $12.50, QUAD/Graphics Inc. (QUAD, Financial) was first submitted for GuruFocus.com's value contest in 2012. It took 14 months for the stock to hit $25, so my younger self was denied the $1,000 prize. At the risk of appearing more obstinate than original, I am submitting QUAD a third time. The company has further improved its competitve position, and the stock is once again absurdly cheap.
Business and history
Quad/Graphics provides commercial printing and distribution services. This industry is highly fragmented with many thousands of companies and total revenue of $75 billion in the U.S. The four largest printing companies in the U.S. account for less than 15% of total revenue.
Since becoming publicly traded in 2010, QUAD has acquired former giants of the industry Quebecor and Vertis. It is currently in the process of acquiring LSC (formerly RR Donnelley). Cenveo, the other major competitor with similar scale, filed for bankruptcy a year ago. It has been a bloodbath since I first wrote about the industry. With its efficient network of printing facilities, Quad/Graphics has emerged as the clear winner and consolidator.
Competitive advantages
In a nutshell, it is cheaper to transport bytes than it is to transport tons of paper.
Anyone can buy the equipment to print and bind a magazine or book, which explains why the printing industry is so fragmented. The workflow of a typical printing company is known as print-and-distribute. With its network of facilities, Quad/Graphics can and does electronically distribute a given job and produces the printed matter as near as possible to the point of final delivery. This is known as distribute-and-print. It is both cheaper and faster for anyone who needs to have a book, magazine or insert distributed on a national scale.
On a unit level, the cost of printing a magazine like Better Homes and Gardens is roughly 50 cents. Of that, 35 cents are the cost of the paper and 5 cents are for ink. The printer gets 10 cents for his work and the cost of maintaining his equipment. For its part, the USPS charges between 20 cents and $1.00 for delivering that magazine. The price depends on how the magazine is delivered to the Sectional Center Facility (SCF).
A printer who delivers a pallet of correctly sorted printed matter directly at the SCF nearest to the destination saves the customer more on postage than the entire cost of production. Of course, the USPS would much prefer if that pallet carried all commercial printed matter stacked according to the mailman's route. With the pending merger of LSC communications and QUAD, the industry moves closer to making that happen.
Not only does QUAD have a network of facilities, the company has rotogravure presses. Rotogravure presses are expensive high-volume machines that can print high-quality images and text on cheap paper. On a rotogravure press, the only liquid that touches the paper is ink. On the more common offset press, the area not covered in ink is covered with a thin film of water. This water turns cheap paper into mush. QUADs ability to use cheaper and lighter paper reduces both production and distribution costs.
Valuation
One intelligent definition of the owner earnings of a business is the amount of excess cash that business can return to shareholders or use to pay down debt while maintaining its competitive position.
From 2012 to 2017, Quad/Graphics spent roughly $350 million on dividends and $1.5 billion retiring debt (average of $300 million per annum). That’s a significant amount of excess cash for a company with a market cap of $600 million. From the perspective of the outright owner, the shares offer a 50% annual yield (2x owner earnings).
From the perspective of an LBO artist, the company has an incremental debt capacity of $1.5 billion. One could theoretically acquire QUAD for $750 billion (that’s $15 per share) and saddle the company with $1.5 billion of incremental debt for a quick 100% profit.
In sum, the shares are absurdly cheap.
LSC merger and outlook
As mentioned, QUAD/Graphics is acquiring LSC communications. LSC is the former commercial printing business of RR Donnelley. LSC also has a significant publishing capability. Under the terms of the merger, five shares of LSC will be exchanged for three new shares of QUAD/Graphics. LSC generates roughly $150 million worth of free cash flow on $3 billion worth of revenue. Roughly speaking, the acquisition increases QUAD’s share count by 40% and its reported free cash flow by 60%.
Another way to put it is that the combined company has a proforma market cap of $900 million and reported free cash flow of $300 million. That is assuming management fails to find synergies. Though it is not critical to the thesis, it is almost certain that the merger of LSC and QUAD will come with a number of opportunities to reduce fixed and operational costs.
Financial strength
LSC and QUAD each have about $75 million of annual interest expense. That is manageable in light of the fact that as a pair, QUAD and LSC earn $300 worth of free cash flow. Assuming zero profit for LSC, QUAD alone can handle an extra $75 million worth of interest expense.
In sum, the company services its debt with ease.
Management
For decades, the Quadracci family has run Quad/Graphics for the benefit of shareholders. Many shareholders are (former) employees. Joel Quadracci is CEO and has been for a decade or so. He earns about $1 million, which is a bit less than the salary of Thomas Quinlan, the CEO of LSC and significantly less than the salary of Daniel R. Knotts, the CEO of RR Donnelley. Mr. Quadracci has roughly 12 times his annual salary tied up in stock. Quadracci has a balanced approach to capital allocation, with a focus on the reduction of the debt incurred in the various acquisitions and paying approximately 25% of free cash flow out as dividends. As debt is reduced, the dividend is increased.
Since 2010, QUAD has grown revenue by 30% while decreasing fixed assets by 40%. Employee count is also down 20%. Operationally speaking, a printing press worth $35,000 now generates $100,000 worth of annual revenue. This depreciation of redundant fixed assets is what has depressed reported GAAP earnings relative to free cash flow. The printing business is perceived to be a high fixed-cost business. If QUAD is a high-fixed cost business, then Amazon is a high fixed-cost business too. Amazon needs $30,000 worth of fixed assets to generate $100,000 worth of revenue.
In essence, Quadracci has acquired the revenue, relations and contracts of his former competitors and moved that workload to QUAD's existing network of plants, increasing asset utilization and efficiency in the process. One network is enough and as discussed in previous articles, QUAD has the most efficient network in the industry.
Specific risk
Of course, the commercial printing industry is in decline. It has been for decades and it is expected to decline even further. QUAD’s market share is still less than 10%, though, so there’s room to take market share as smaller competitors fail. As noted, Cenveo is struggling, as is the remainder of RR Donnelley.
Quad/Graphics is highly dependent on the United States Postal Service. Of course, the reverse is also true. Any disruptive change at the USPS could have a significant effect on QUAD’s business model.
Market risk: the integration of LSC and QUAD will cause some one-time frictional costs that might spook investors.
Disclosure
This is not a recommendation to buy or sell anything. This is an expression of my views about QUAD/Graphics with the intent of engaging in intelligent discussion about the company and its stock. At the time of writing, I owned stock of QUAD/Graphics and held no position in any other stock mentioned.
Read more
https://www.pubexec.com/article/5-ways-magazine-publishers-can-maximize-postal-savings/
https://www.targetmarketingmag.com/promo/WastingMoney.pdf
https://pe.usps.com/archive/html/dmmarchive20070315/243.htm
https://www.qg.com/blog/understanding-usps-delivery-performance
http://courierexpressandpostal.blogspot.com/2010/12/developing-flat-mail-distribution.html
P.S.
Enterprising investors might consider the stock of LSC. Assuming that company maintains its quarterly dividend until the deal closes, one is acquiring QUAD stock at a meaningfull discount to its already depressed current price.
