UPDATED: Quarto - Financial noose chokes good operational advances in publishing

Update (original note below this text):

Trading update for 2017 should come out in next week or so.

No sign of a rights issue so my hypothesis is incorrect so far. Based on H1 2017 results and H2 trading update the company appears to have diminished earnings power at least near term, so likely reduced cash generation therefore unlikely to have been able to pay down debt. Of course, late part of 2017 and Christmas trading may contain positive surprise. When things go their way the company can have excellent cash production potential.

There have been 2 interesting purchasers of stock: 1) Chuk Kin Lau who now owns 20% (from zero at beginning of H1 2017) and 2) Dr Laurence Orbach has boosted holding to near 18% from 15%. Orbach is founder of Quarto who was kicked out in shareholder revolt back in 2012.  Chuk Kin Lau is CEO of Lion Rock Group (previously 1010 Prining Group)...I haven't checked out but I think he has had business dealings with Quarto (bought their HK business?).

I note that this stock stressed its banking covenants at the end of 2016. It complied with them H1 17 but I don't think that there has been any information on repositioning those covenants to be more favourable to business seasonality.  A lack of that in FY 17 results would suggest nervy banks.

So, the path from here seems to be either a surprising strong and cash productive end of 2017 meaning no crisis....and then this could lead to fight for control from two big shareholders (willing to take on high debt as they believe they see the cash flow potential) and/or an orderly rights issue. Alternatively, earnings and more importantly cash flows disappoint and this triggers a crisis in the stock which at this late stage in terms of managing debt overhang quite probably leads to a private take-out (by one or both of the big stock holders)...if they are going to take on the company in those circumstances they will want to pay nothing for equity and get themselves  some elbow leverage on debt discussions with banks.

Conclusion is that an exciting few months looks to be in the offing. Place your bets. (FYI: I don't hold, did in the past).

Original early 2017 text below:

Based on a thorough review of my position and look through current and past annual reports I came to the conclusion I should sell my holding in Quarto Inc (LON:QRT). There's probably a rights issue, acquisition overfunded with equity issue or lowball private equity takeout coming.

I have made positive Quarto comments in the past so thought I'd give my change of mind. Its a hard company to analyse so I welcome alternate views and analysis.

I made a previous comment (http://www.stockopedia.com/content/quarto-good-stock-dumb-management-173243/) that can be summarised as decent company, bad management. I have decided that was precisely wrong and should be turned around. A bad company is far more worrying than bad management. Operationally there is much that is good due to the heavy lifting over recent years by senior management but financially the company is stretched, lacking flexibility and somewhat cornered by a combined high indebtedness and high annual requirement for pre-publication investment (nearly $40m) to retain current revenue levels.

Summary of why I am negative:

1) Negative earnings and cashflow surprise coming (recent reports from Stockdale and Liberum contain simple analytical errors and overestimate both).

2) Potential for goodwill writedowns. Although these do not have precipitate cash impact exceptionals through income statement and balance sheet will be very hard for Quarto Inc (LON:QRT) to publicly wear from here.

3) Close to maximum use of borrowing facilities.

4) High need for ongoing capital investment (pre-publication costs near ¼ of annual revenue)

5) Whilst there is clear indication that pre-publication investment is bringing in improved results for the ‘frontlist’ (first year of sales of book) there is convincing indication that that the ‘backlist’ is not performing. Accumulated backlist IP is the driver of profits and cashflow.

More in-depth discussion:

Capital investment is fighting to standstill

Is pre-publication investment working? Does it bring a high return on capital invested? The company present a metric called “product efficiency” that shows they have improved returns for the frontlist by 50% over the last 4 years (and I estimate that should have a $4.5m operating profit impact). However, there is a lack of evidence that this is flowing through to aggregate backlist performance (as seen by the greater weighting of frontlist on revenue in recent years). The improvement in frontlist returns is nearly enough to compensate for losses to operating profit from BGD since its peak 2012 contribution but it comes with a high capital cost. However, we do not see this frontlist investment flow to greater backlist revenues yet (which is where the profit and cash juice is!). This hints at deterioration in the backlist elsewhere (and/or a greater emphasis on titles that have short lifespans).

Tired assets?

Financial frailties combined with what I think are indications of some tired assets in some of their imprints severely curtails management choice. In 2017 Quarto Inc (LON:QRT) needs to have a stellar performance in terms of organic growth to just standstill relative to 2016 results (ex the huge BGD driven exceptional items). It’s possible but it’s a high hurdle and the analysis and comment out there on the company doesn’t recognise this and implies that the company will just have a fairly regular year, produce the earnings and cash, pay down some debt and look cheap on approx 6.5 PER. I see the company on 9 PER, unable to pay down debt and at risk of goodwill write-downs (the latter point is more speculative and less important).

Broker forecasts too optimistic and missing essential info

Broker forecasts are overly optimistic on PBT by $3-6m as they assume the 50% gain in profit from the Co-editions unit is retained rather than a one-off (everything points to it mainly being a one-off gain) and they don’t adjust for the fact that timing of becker&meyer acquisition was done at a seasonally positive time (so $1.9m gain rather than $1m loss for a full year, see notes to accounts). On the positive side I think they have not accounted for $2.2m share based expense that will not reoccur at such a high level as CEO was granted large stock award in 2016 financial year.

There could also be losses arising from the NZ business of BGD that is being held for sale and still trading under Quarto. It is somewhat surprising that this disposal has not happened yet and there is a chance that the business is not salvageable and needs to be wound down by Quarto. The assets are already written down but there would still be some earnings and cash impact from bad trading and shutdown costs (unlikely to be huge but zero visibility at the moment).

Cash earnings are overstated by $5-6m as brokers do not account for the 2017 payments due on 2016 becker&meyer and Harvard Press acquisitions. In the Liberum note the cash error is even more egregious as they assume that company has a net $7m cash gain from sale of Regent in HK rather than net $4.5m adjusting for cash on Regent balance sheet. Once corrected both Stockdale and Liberum notes are saying Quarto will be cash-flow negative in 2017. My estimate is +$1m...however, I accept a wide margin of error.

CEO has has some success 

IMO the CEO has done a good job in reorienting the company since taking over from the founder in 2012 during an activist kerfuffle. Operationally he has improved the publishing business. The legacy bequeathed him was high indebtedness and an antipodean trading business (Books and Gifts Direct) that was just about to turn sour and over the course of his tenure turn from operating profit of $4.5m in 2012 to turning negative at -$2m in 2016 (excluding exceptionals of -$14.2m that is!). For a business that has tended to report OP ex exceptionals of $16m in 2012 to 2016 that’s a significant hit to take. The story of BGD decline is significantly to do with Australia and NZ’s end of commodity boom but it must also be a story of lack of senior management oversight and good judgement on this non-core business. 

That Quarto Inc (LON:QRT) has managed to hold onto to this OP level despite BGD decline illustrates that the CEO has been successful in improving the operational performance in core publishing (which has come with significant increase in pre-publication investment too). With perfect foresight the CEO should have offloaded non-core BGD when he took over. In the real world very few people would have had such foresight. CEO Leaver was relatively young and inexperienced when he took over and I view it as a failure of the activists and the chairman they sponsored who precipitated the CEO change at the time (who, coincidentally, had himself awarded a rather astounding share incentive plan and a 3 year tenure!).

Whatever the excuses (decent as they are), the rot set in and they didn’t get in front of things leading to the messy eruption in 2016 as BGD went over the cliff. As well as lack of foresight there is story about how management share based incentive schemes can act as disincentive to necessary corporate surgery as both the old Chairman and the CEO had generous packages for the 2012-16 period and overly radical corporate surgery to BGD and other areas would’ve endangered attaining the awards.

Dllution coming

Quarto has put itself in a position whereby it could attract a new band of activists or, more extreme, a private equity backer willing to step in and provide the financial fixes that the public market is unwilling to do if core assets are cheap enough. The only way to save itself from this (bar an exceptional operational pick up) is a rights issue to pay down debt. My preference is for a straight rights issue and for it not to be tied in with a large and “transformative” acquisition. On a clean rights issue with some write-down of goodwill if necessary or even restructuring/closures there could be a really great entry point in this stock. I see a good business waiting to breakthrough that is currently getting outrun by financial and previous acquisition legacy.

I see enough in the company that means even with a dilutive issue of equity I would have been okay holding on to the shares given their good to decent value (even accounting for broker analytical errors) and good ongoing performance from publishing and changes made over the years. In that scenario there’s a clearer earnings picture, less debt and a stock that should move to more reasonable teens PER.

However, I doubt the market will have the stomach for a rights issue at a decent price so management will need to tie in an acquisition for positive narrative. That makes what’s going on noisy and very poor visibility so a more risky hold for me.

The nightmare scenario is a takeout of equity by private equity at distressed prices. This could be catalysed through earnings/cash degradation, debt covenant trouble and/or banks reluctant to renew and write-downs of goodwill. In this scenario the public market can clam up, particularly for a complex and hard to understand company like Quarto with a history of exceptionals, and just turn a cold shoulder. Manna from heaven for private equity as they get some pretty decent operational assets at next to nothing (as long as they see the debt as supportable).

I am not predicting the nightmare of private equity distressed takeout at zero for equity holders but the probability is sufficiently above zero now (and would be aggravated by tougher market etc) to mean it must be part of the consideration and I should sell.

Why might I be wrong?

1) International Co-Editions make another stellar performance in 2017 and add $3m above normal contribution as they did in 2016. If this were expected I think that the annual report would have made more of this likelihood and talked a quantum shift in performance. Note, Quarto have changed their reporting for 2017 so will not report Co-Editions separately.

2) New blockbuster titles. This would have to be quite considerable and remarkable, probably more so than what they benefited from in the adult colouring craze.

3) The improved frontlist product efficiency coupled with the growth in pre-publication costs feeds through to backlist revenue (so great free cash flow and earnings boost)

4) Big shift in last 4 years to significant children's publishing and perhaps this reaches a critical mass in 2017 that is surprisingly impactful.

5) Perhaps there is an astounding and transformative acquisition to be done.

6) Trade (i.e. not private equity) takeover of Quarto (likely needs to get cheaper still though...and not obvious who that would be)