Description

QUAD/Graphics (QUAD) is one of two major printers (the other being LKSD, a spin out of RRD) in the US.  For a more detailed history, you can refer to Arturo’s long writeup from May 2017.  This is an opportunistic short writeup given the outperformance post earnings this week.

Printing is a secularly declining business as newspapers/magazines/catalogues/books continue to lose to the Internet.  Nothing new, and it’s showed up in the Company’s organic revenue declines.  

The stock has increased over 30% in the last two days.  In my opinion, this is largely due to the guidance of flat top line growth and rising EBITDA margins.  Below, I’ll detail how the flat top line growth is really just due to an acquisition, and how I don’t believe this Company will be able to hit their rising EBITDA margin guidance.  I expect the multiple to revert back over the year as actual results come in below guidance.

What helps make this a better short than just missing numbers are some qualitative flags that I will highlight as well.

Sales

Sales growth in FY2017 was -4.6%, which was comprised of -3.5% organic growth and -1.1% paper pricing declines.  Guidance for FY2018 was $4.0-4.2b, implying slightly down at the midpoint.  However $150mm of the guidance was from an acquisition of Ivie, which was announced concurrently with results.  Backing this out, it seems the Company is assuming -1% to -5% organic growth.  

EBITDA

The Company has a history of including in EBITDA many one-time benefits that mask the true deterioration in margins.  Besides including non-cash pension income in EBITDA historically (they were forced to back it out starting in FY2018), the major benefit in FY2017 was a $19.4mm benefit due to a change in vacation policy.

Backing out the one-time items going back to FY2013 (which is the year they purchased Vertis, their last large acquisition), it shows a steady decline of margin from 12% down to 10.3% in FY2017.  This is despite an annual average of $94mm of below-the-EBITDA-line restructuring expense ($56mm of cash outlay annually) during that time (literally every quarter has a charge).  The one year they increased margin was FY2016, which was after they cut employees by 7% in FY2015 as part of an aggressive cost cutting campaign (as highlighted by restructuring expense being $165mm that year).  The decline has accelerated through FY2017, and 4Q17 vs 4Q16 adjusted EBITDA margins were down 92 bps as the benefit of the cost cutting campaign is overwhelmed by the negative operating leverage in a declining organic growth environment.

Yet, backing out Ivie, it seems the Company is guiding core EBITDA margins to go up from 10.3% to 10.6% at the midpoint of guidance.  Given FY2017 had the least amount of restructuring expenses in the past five years, I don’t think that there’s another round of cost savings that will offset the negative operating leverage.  Below are historicals compared to guidance given this week and my downside case used in valuation later.

Flags

1. Constant restructuring - allows for management teams to hide potential ongoing costs

2. 4Q15 writeoff of vendor receivable and subsequent 1Q16 reversal moves $10mm of EBITDA from FY2015 to FY2016

1. While I don’t know the exact requirements needed to show auditors proof that a receivable should be written off, the fact that it was reversed the next quarter is a bit suspect, and the fact that it bridged fiscal years makes it even worse.

2. Per the proxies, FY2015 Adjusted EBITDA target was $525mm for determining the annual cash incentive compensation.  The actual result reported in the proxy was $462mm (I know this doesn’t foot with Company reported EBITDA for FY2015, but it’s the number they cite in the proxy), so even with the $10mm extra EBITDA they would’ve missed it.  The FY2016 target was $440mm, while actual was $480mm.  By moving the $10mm from FY2015 to FY2016, they i) lowered the FY2016 target due to missing the prior year target by so much, and ii) gave them a nice boost to make sure they would blow away the lowered FY2016 target.

3. How meaningful was this?  In FY2015, the CEO could earn a range of $585k-$1,950k under the annual cash incentive program.  He earned $597k.  In FY2016, because of the lowered EBITDA target and the extra $10mm, he earned the maximum $1,990k.  

4. Would the EBITDA target have been as low as it was ($440mm after $525mm the year before) and would the Company have exceeded it so much that gave the board justification to award the max bonus possible?  I may be reaching, but it seems like awfully questionable timing.

3. Board makeup

1. The board is primarily comprised of insiders or industry guys - John Shiely has been on since 1996, Kathryn Quadracci Flores is the CEO’s sister, Chris Harned is brother-in-law to both the CEO and Flores, John Fowler has been with the Company since 1980, Mark Angelson came on board in 2010 with the World Color Press acquisition, Doug Buth is an industry guy and a former vendor to the Company.  

2. Of the 9 board members, it seems only 2 are truly independent, and they aren’t on any of the committees.

4. Corporate plane for private use - the CEO gets to use the corporate plane for personal use, which has resulted in $100-200k a year of expenses.  

Valuation

I decline core revenues by 4% organically for the next two years, grow Ivie by 10% in FY2019, and reduce core margins by 50 bps each year.  My 2018 EBITDA is well below guidance given my margin assumptions.  I apply a 5x multiple and give them credit for cash generated and get 37% downside. At 4.5x which is closer to where the shares have traded historically, it’s 49% downside.  LKSD trades at 3.7x 2017 EBITDA.

Risks

Merger with LKSD, though there may be anti-trust issues there

Better than expected organic results and margin improvement

Successful evolution from a printing company into a “marketing solutions partner"

Catalyst

Margin deterioration as organic volumes continue to decline resulting in EBITDA below guidance