I am recommending Quad Graphics as a long investment with what I believe is a compelling risk/reward profile.  In short, notwithstanding that Quad competes in a secularly unattractive industry over the long term, it is simply too cheap at 3.9x EV/EBITDA and offering a FCF yield of over 50% (no, that is not a typo).  I contend that Quad’s stock price already reflects a substantial amount of bad news.  However, the risk of permanent impairment of capital is low given the Company’s very substantial free cash flow and a secure balance sheet with less than 2.5x Debt/EBITDA, ample liquidity and no near term debt maturities.  Unlike many supposed deep value situations in structurally challenged industries, Quad brings company-specific catalysts, a material stock repurchase program, insider buying and a juicy 6.8% dividend yield while patient holders wait for value to be realized. 

Company Background

Quad is a leading global provider of print and related services that are designed to provide complete solutions to a broad base of customers. The Company's print products primarily include catalogs, consumer magazines, special interest publications, direct mail and other commercial specialty printed products, retail inserts, books and directories.  Quad/Graphics' print-related services include digital imaging and photography, binding, mailing and distribution, and logistics, data optimization and analytics services.  Magazines, catalogs, and retail inserts account for approximately two-thirds of revenue, well over 80% of which is U.S.-based. 

Quad was founded in Pewaukee, Wisconsin in 1971 by Harry Quadracci, the company’s now-deceased patriarch (his son Joel is now CEO) who established a very distinct culture marked by strong growth, mostly organic until quite recently, and industry-leading efficiency and profitability.  Today, Quad is #2 behind R.R. Donnelley (“RRD) in the still-fragmented printing market with some 25,000 employees in the United States, Canada, Latin America, and Europe, serving a diverse base of more than 7,400 customers from 142 facilities located in 21 countries, though the vast majority of revenue and profit is still U.S.-based.

Quad has contractual relationships with leading magazine publishers such as Condé Nast, Hearst Magazines, and Meredith Corporation, and prints well-known magazines such as Architectural Digest, GQ, InStyle, People, Sports Illustrated, Time, and Vogue. Quad prints retail newspaper inserts for J.C. Penney and Target among others; catalogs for industry leading marketers such as Cabela's, J.Crew, L.L. Bean, Limited (Victoria's Secret), and Williams-Sonoma; and direct mail products for Publishers Clearing House,  and Weight Watchers.

From scratch, Harry Quadracci built Quad into the largest private printing company in the U.S., with two particularly distinctive elements engrained in the Company’s culture.  First, he was both egalitarian and way ahead of his time in treating employees like partners.  For example, executives and plant employees alike wear blue Quad uniforms, and Quad provided an ESOP, profit-sharing and benefits such as on-site daycare and healthcare services long before they were in vogue.  In return, Quad enjoyed a loyal and highly efficient non-union workforce without any of the difficulties that have plagued unionized print companies.  Second, Quad has always been committed to technological innovation and reinvesting in its business for the mutual benefit of the Company and its customer base. 

Quad has had a relentless focus on minimizing its customers’ total cost of print production while maximizing the revenue derived from their print spending.  Quad has consistently been among the industry leaders in increasing its own productivity and reducing its customers' mailing and distribution costs through the integration of data analytics, finishing technology and logistics operations.  Because manufacturing accounts for only 20% of the total cost for catalogs and magazines, large firms like Quad have been taking share from smaller players due to their ability to reduce procurement (e.g. paper) and distribution costs.  To give you a sense of the scale involved, consider that Quad expects to co-mail nearly five billion pieces in 2011.  Although magazines and catalogs are by no means growth businesses, and in fact face longer term secular challenges, by capturing share, Quad should be able to grow at low single digit rates for at least the next several years (subject of course to the economic cycle).  For those desirous of additional information on these points, a good place to start is the investor presentations by Quad and RRD on their websites.

Today, Quad likely has the most efficient and modern manufacturing platform in the industry, which in turn has produced industry-leading margins and returns on capital.  For example, in 2009—an absolutely horrific year for the printing industry as one might imagine—Quad managed to hold EBITDA margins at over 17% despite a 21% drop in revenues while the much-larger RRD suffered over 200 basis points of EBITDA margin compression to 13.1% on a smaller decline in sales (RRD is larger, more diversified and more global than Quad).

For those who take a close look at Quad, I believe it is fair to conclude that they have established themselves as the best operators in an admittedly difficult industry, but until 18 months ago, Quad remained a private company.  Because of Quad’s strong management and historic aversion to undue leverage, it was able to survive the Great Recession despite a nearly 30% decline in EBITDA between 2007 and 2009.  Its highly leveraged competitor, World Color Press, however, succumbed to bankruptcy in January 2008, even before the brunt of the downturn. 

World Color Press Merger

By way of background, World Color Press had been a KKR-backed build-up of printing companies before going public and ultimately selling out to Canadian-based Quebecor, thereby forming the second largest global printing company behind RRD.  The combined company (renamed Quebecor World), which was publicly traded in Canada, suffered from a fragmented, outdated and under-sized manufacturing footprint, reflecting the fact that the business had been built by acquisition.  In the six years preceding its bankruptcy filing, Quebecor World spent some $1 billion in capex to upgrade its facilities and equipment, including over $300 million in 2007.  Quebecor World was also burdened with expensive pension plans (more on this later) and a workforce that was one-third unionized.  Finally, the company suffered severe losses from its European business, which it later sold in bankruptcy.

In July 2009, Quebecor World emerged from its joint Canadian/U.S. bankruptcy (and changed its name to World Color Press) having shed much of its debt and cost structure, with former creditors and well-known distressed debt players such as Avenue Capital, Centerbridge and Angelo Gordon emerging with large equity stakes in the newly reorganized and public company.  For all of 2009, World Color Press generated $3.1 billion of revenues and $329 million of EBITDA.

In January 2010, Quad and World Color announced a merger, which was really a mostly stock-based acquisition of World Color by Quad inasmuch as Quad management would run the combined company and Quad shareholders (essentially the Quadracci family and Company management and employees) would hold 60% of the combined company’s shares.  We should note that, even without a majority of the economic interest in Quad, the Quadracci family would continue to control the combined company through super-voting shares.  By virtue of the merger and registration of its shares, Quad came public when the merger deal closed in mid-2010.

When the deal was announced in January 2010, Quad disclosed the following metrics (financial data is LTM and in millions):

The appeal of the deal to Quad was pretty clear as it allowed the smaller, more efficient Quad to migrate much of World Color’s volume into Quad’s larger, lower-cost plants while removing substantial capacity from an industry burdened by overcapacity.  The Company estimated that it could achieve $225 million of annual synergies by the second anniversary of the deal with one-time costs to achieve such synergies of $195-240 million.

Quad closed at $48/share on its first day of trading in July 2010 with a market cap and total enterprise value (TEV) of $2.25 billion and $4.05 billion, respectively.  When Quad held its first earnings call as a public company in August 2010, it reported LTM EBITDA on a pro forma basis without and with synergies of $721 million and $946 million, respectively, representing an increase of $74 million in each figure since the previous disclosure in January 2010.  With the stock then trading at around $43, the market was pricing Quad at about 4.1x pro forma EBITDA with synergies, basically in line with where RRD was trading.

Recent Events

I will provide more detail below on what led to a 70% decline in Quad shares in the 18 months since its first earnings call, but at a high level, it is clear with the benefit of hindsight that Quad management made some rookie mistakes as a newly public company in communicating with analysts and shareholders, essentially overpromising and under-delivering.  Perhaps the Company’s most serious mistake was one of omission.  Although management did provide guidance on the one-time costs of integration ($195-240 million), they neglected to inform investors up front that there were material additional costs associated with the very substantial plant consolidation they were about to undertake.  The Company has called these costs “frictional costs” and they essentially represent the temporary inefficiencies associated with moving volumes from a plant to be closed into another facility.  Quad’s CFO explained these costs on the earnings call for the third quarter of 2010:

Looking at the plants receiving the work, in Phase I, before any work transfers, the plant begins preparing its customer support functions and infrastructure for the new work and begins hiring the skilled workforce. Recognize these costs are incremental and temporary but exist nonetheless in duplication. In Phases 2 and 3, both production and admin infrastructure increased to support the total volume of work to be transferred. By Phase 4, the receiving plant is efficiently producing the transferred work. Remember, our plants are complex job shops, and it takes a period of time to onboard any new customer, learn and meet their production expectations and efficiently produce their work.  Correspondingly, at the plant that is being closed down, as the work is transferred, which again is not a light-switch process, the revenues decrease faster than the production or infrastructure admin costs can be reduced. Thus, the same jobs in the same plant become temporarily less profitable on a fully loaded basis due to the incremental costs we are still carrying. And when the production is complete until the plant is sold, there are still some admin and infrastructure costs. These frictional costs are normal and fully expected. It is not practical to accurately quantify these frictional costs, and thus they flow through operating expenses versus restructuring charges, even though they are nonrecurring. I would like to point out that as period costs, these are not part of our expected costs to achieve of $195 million to $240 million, but they were clearly expected. This should help everyone understand what we mean by frictional costs as we consolidate our platform.

These frictional costs are quite substantial though difficult to quantify.  To put the magnitude of this effort into perspective, consider that in its first five quarters after acquiring World Color, Quad undertook the consolidation and closure of 12 plants with some 5 million square feet resulting in a gross reduction of over 5,000 employees and a net reduction of 3,400.  Basically, Quad had to terminate 5,000 mostly World Color employees and hire well over 1,000 new employees at the Quad facilities that would be accepting volume from the shuttered World Color facilities. 

As an editorial aside, I should mention that it is not uncommon for management teams to underestimate the cost, time and complexity of an integration of this scale.  I saw it repeatedly in my prior life as a private equity investor.  Indeed, in setting investor expectations, Quad management should have heeded what its CEO said in the same earnings call referenced above:  “Keep in mind that what we are doing has never been done on this scale in our industry.  It is the biggest restructuring of a platform of which I know.”  He was on the mark with those comments, but he should have accounted for this challenge by providing more margin for error in setting investor expectations.

There are two other issues that have been headwinds for Quad.  First, though the Company has not said so, it appears that World Color was perhaps more broken than Quad management appreciated.  World Color itself was not particularly well managed and, having been built by acquisition, it was operated on a decentralized basis and was not tightly integrated in any fashion (e.g., according to Quad, World Color had 94 post-retirement healthcare programs vs. one for Quad).  The other fundamental issue for Quad since it closed the transaction has been a weakening industry environment.  On a pro forma basis, EBITDA was down in the second half of 2010 due to pricing and volume pressure as well as the aforementioned frictional costs.

Despite these challenges, Quad consistently traded above $40 through Spring 2011, aided no doubt by an ebullient equity market.  In addition, the Company made considerable progress in reducing debt and the pension liability it assumed with the World Color transaction, including the agreed exit from a multi-employer pension plan (more on this later).  Finally, by the fourth quarter 2010 earnings call in March 2011, Quad management was confident enough in the integration to indicate their confidence in exceeding the $225 million annual synergy target by the second anniversary of the transaction in mid-2012.

In that same earnings call, Quad also provided its first forward EBITDA guidance, which heretofore it had declined to do.  In providing 2011 EBITDA guidance of $700 million, the Company noted:  “We are in the midst of a complex integration with many moving pieces.  In addition, the company we acquired was in a downward trajectory as a result of its bankruptcy.  Given these facts, we are making an exception to our limited guidance policy and will provide adjusted EBITDA guidance for 2011.”  This certainly smells like a newly public management team relenting to analyst and investor pressure to provide forward guidance, a step once taken that cannot be reversed and that management likely came to rue.

Over the next several months, Quad announced the initiation of a $0.20 quarterly dividend, a sign of confidence in the sustainability of earnings and cash flow.  In addition, Quad announced the swap of its break-even legacy World Color business in Canada for the printing assets of Transcontinental in Mexico, a more strategic location for Quad. 

In May 2011, Quad reported first quarter 2011 EBITDA was flat year-over-year, with realized synergies basically offset by frictional costs and volume and pricing weakness.  On the earnings call in May 2011, Quad reaffirmed its $700 million EBITDA guidance for the full year.  At $42.52 (Quad’s stock price the day following its first quarter earnings call), it was trading at a total enterprise value of 5.2x its 2011 EBITDA guidance.

Readers may recall that May 2011 began a stretch of five consecutive months in which all major equity indices declined, with the Russell 2000 falling some 25% over this time period.  Quad’s stock suffered even more than the market, falling over 30% to finish July at $33.66.  The stock then plunged a further 40+% to under $20 over the next eight trading days (ah, remember how much “fun” early August 2011 was for investors!) when Quad reported second quarter earnings on August 10.  Reported EBITDA was down almost 15%, with the culprits for such underperformance being continued frictional costs, and pricing and volume pressure across the business, but especially in the book segment, which accounted for only 7% of revenues but was hit especially hard following the Borders bankruptcy. 

For the first time, management provided an estimate of frictional costs incurred in the second quarter of $20-25 million, which offset most of the realized synergies in the quarter of $34 million.  Industry pricing pressure shaved a further $16 million from EBITDA while books detracted $5 million, with another $10-15 million hit from miscellaneous other issues.  LTM Adjusted EBITDA through the second quarter was $651 million.  With this poor performance and continued challenging industry and economic conditions, Quad lowered its EBITDA guidance for 2011 to a range of $660-700 million, which the Company indicated would provide “recurring free cash flow” (defined as operating cash flow, including frictional costs, minus capex but adding back one-time restructuring costs incurred in the integration) of approximately $260-300 million.

In early September 2011, Quad announced a $100 million stock repurchase program, a substantial buyback level for a company with a market cap at the time of less than $900 million.  With the exception of early October when U.S. markets hit their low for the year, Quad traded in a rough range between $18 and $21 over the next few months until it reported third quarter earnings on November 10.  Although Quad increased EBITDA year-over-year, the uplift was below expectations for this seasonally important time of the year, and there was no abatement of the industry headwinds management previously identified.  Consequently, management again lowered their full year EBITDA guidance, with the new range of $610-625 million (down from $660-700 million), representing a 9% decline in full year guidance at the midpoint of each range, but obviously implying a very difficult fourth quarter relative to expectations of only a few months previous.  (As an aside, RRD reinforced the weak industry conditions when it recently preannounced disappointing sales and earnings for the fourth quarter.)  Quad did leave intact its full year recurring cash flow guidance of $260-300 million, with expected working capital management improvements and reductions to capex offsetting the decline in core business performance. 

On the same call, Quad introduced preliminary 2012 EBITDA guidance, saying:  “While we are still in the process of developing our 2012 plan, we believe both economic and industry uncertainty and volatility will continue for the foreseeable future and will continue to impact our results. Our very early look at 2012 indicates that our adjusted EBITDA may be flat or lower than 2011 due to a projected slow economy and continued competitive industry pressures due to excess capacity. Offsetting these pressures are the synergies we are achieving.  Despite the challenging economic environment, we believe that 2012 recurring free cash flow will be at similar levels to 2011.”

Valuation

The market reacted to this most recent news as you would expect, taking Quad shares down 30% to under $13 from the day preceding the announcement to the day after.  Since then, the stock has been in a trading range between roughly $11 and $16.  At its closing price on January 30, Quad has the following valuation levels:

I have included in the calculation of total enterprise value above an estimated $100 million for the cost of exiting the legacy World Color Press multi-employer pension plans (“MEPP”), which will occur in 2012 (i.e. I essentially have added this one-time cost to debt as though the payment had occurred already).  Escaping these underfunded MEPPs in favor of defined contribution plans obviously makes a lot of business sense.  Quad will still have an underfunded (but frozen) Company-sponsored pension plan, which it also inherited from World Color.  At September 30, that plan was $324 million underfunded, an amount which I assume is now below $300 million based on the strong performance of equities in the fourth quarter as well as additional Company cash payments.  I have further assumed (and I believe this is quite conservative) that this underfunded plan will cost Quad $50 million of cash annually; with any kind of decent plan performance, the actual figures should be lower and perhaps much lower.

I have set forth below my estimate of recurring free cash flow for 2012, which is based on achieving $600 million of EBITDA and is consistent with Company guidance.  Please note that these figures include frictional costs, which should be substantially lower in 2012, but they exclude any remaining one-time restructuring costs/charges in 2012 relating to the World Color integration or the recently acquired Transcontinental Mexican assets.  I believe that, barring a U.S. recession, Quad should be able to generate $300 million or more of recurring free cash flow for the foreseeable future.

Based on these assumptions, Quad is trading with the following valuation metrics:

Quad is an under-followed, relatively new public company that has been left for dead after serially missing its own guidance.  It is cheap for some good reasons, but in my judgment, it is just too cheap.  To put these valuation figures into context, RRD currently trades at 4.5x 2012 estimated EBITDA according to Capital IQ, a multiple that if applied to Quad would produce a $20 stock price, up some 70% from current trading levels.  Recall that RRD has seen a substantial decline in its stock price due to weak industry conditions; in recent years, RRD has traded at or above 5x EBITDA so a 4.5x multiple itself potentially provides some upside.  Quad’s most recent balance sheet also has $50 million in prepaid expenses, representing a cash deposit in respect of the Mexican assets Quad acquired from Transcontinental pending regulatory approval to complete the Canadian divestiture to Transcontinental.  Once Quad delivers its Canadian assets to Transcontinental at closing, it should receive most or all of its $50 million deposit back, which will increase cash and reduce net debt. 

Although at these levels of undervaluation, I am content to be patient, I believe there are a few potential catalysts that could cause a re-rating of the stock.  First, in the next twelve months, Quad should complete the World Color integration and gradually remove the noise from its reported numbers, including returning to GAAP net income profitability.  Most importantly, I expect this management team, which has a long track record of operational excellence, to increase productivity in its plants as frictional costs abate.  In addition, I expect the Company will aggressively repurchase stock at current levels and perhaps even raise the dividend.  I do not assume any material improvement in industry or general economic conditions, but any such improvement could also be an upside catalyst. In any event, I believe holders are amply rewarded for being patient as Quad’s substantial cash flow continues to accrue to the benefit of equity holders.