Small Cap Value Report (13 Aug 2015) - QRT, SDM, CNIC

Thursday, Aug 13 2015 by

Good morning!

Quarto Inc (LON:QRT)

Share price: 210p (down 10.6% today)
No. shares: 19.7m
Market cap: £41.4m

I last reported on this "leading global illustrated book publisher and distribution group" on 9 Feb 2015 on renewal of the company's bank facilities.

Prior to that, I reported on 2 Feb 2015 covering the 2014 trading update. Those two articles are still relevant, so I won't repeat all the same detail below.

Interim results to 30 Jun 2015 - Quarto has made nearly all its profit in H2 in recent years, so the interims are not a good guide to full year performance. Accordingly today's fall in adjusted operating profit from $0.6m to $0.2m is not of enormous concern, although it would have been better to see profits improving.

Last year it made $0.6m adjusted operating profit in H1, and $14.8m in H2, so it's a very heavily H2-weighted seasonal trading pattern, which I presume is due to its illustrated books being popular items for gifts at Christmas.

Therefore it's a waste of time further analysing H1 trading, and more important to focus on the outlook comments for H2, which say;

We fully anticipate Quarto will have a strong second half of the year with good order book visibility.  Quarto will develop further as a business in 2015 and continue to expand our reach in channel, territory and format. We are well-positioned, as we have shown in recent years, to grow organically, capitalising on our strengths, making long-lasting, information-rich books and selling them in as many languages and channels as possible. We also intend to develop the business by making suitable acquisitions, as we have done, that are complementary to our existing businesses and provide financial and operational synergies, taking advantage of opportunities that support the long-term growth of our business around the world.

That sounds pretty emphatic to me, and the positive comments are backed up with "good order book visibility", meaning that it's more than just hoping H2 will be strong.

Valuation - the valuation graphics look very appealing, as do the quality scores too, so this initially looks a very good value share. Bear in mind that the graphics are based on last night's closing price, so with the shares down 10.6% today, the PER will now be nearer 6 than 7, and the dividend yield will have risen to about 3.4%.

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The Quarto Group, Inc. is an illustrated book publishing and distribution company. The Company is engaged in creating content and publishing books from a diverse portfolio of imprints. The Company operates through segments, including Quarto International Co-Editions Group; Quarto Publishing Group USA; Quarto Publishing Group UK, and Quarto HK. The Quarto International Co-Editions Group segment creates illustrated books that are licensed and printed for third-party publishers for publication under their own imprints. The Quarto Publishing Group USA segment creates and publishes illustrated books in North America and sells co-editions of them internationally. The Quarto Publishing Group UK segment creates and publishes general non-fiction and illustrated books in the United Kingdom market. The Company’s books are sold in approximately 50 countries and in 39 languages. more »

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Stadium Group plc is a provider of integrated electronic technologies. The Company operates through two divisions, including Technology Products, which incorporates wireless, interface and displays, power and stontronics, and integrated Electronic Manufacturing Services (iEMS) provided through design and manufacturing operations in the United Kingdom and Asia. It offers various services, such as design (electronic, mechanical and software), prototype, new product introduction (NPI), global procurement, in house tooling and molding, printed circuit board (PCB) assembly, box build and test, packaging and global logistics. It provides wireless machine-to-machine (M2M) connectivity solutions for original equipment manufacturer (OEM) devices in vehicle tracking, telematics, fleet management, smart metering, asset tracking, wearable technology, handheld devices, infotainment and security systems. It serves various manufacturers in the marine, aviation, medical and broadcast industries. more »

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CentralNic Group plc (CentralNic) is a holding company. The Company is engaged in the provision of independent global domain name registry services. The Company provides registry services and strategic consultancy, and it is the owner and registrant for a portfolio of domain names, which it uses as Second Level Domain extensions (SLD) for domains. CentralNic's registry services (wholesale) business provides high quality technical and operational services, through its domain registry, billing and cash collection platform. The platform enables retailers around the world to sell domains using a range of domain extensions, and supplies the core Internet infrastructure (DNS) that powers the domains that CentralNic distributes. The Company's platform supports all three categories of domain name extensions: generic Top-Level Domains (gTLDs, such, country code Top-Level Domains (ccTLDs, such as .uk), and SLDs, such as more »

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  Is LON:QRT fundamentally strong or weak? Find out More »

16 Comments on this Article show/hide all

Analysis 13th Aug '15 1 of 16

' surprised that the StockRanks gives a very high score of 97 to Quarto, but the system seems to more-or-less ignore balance sheet weakness, high debt (and pension deficits


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Ramridge 13th Aug '15 2 of 16

Hi Paul
Re. Quarto Inc (LON:QRT). I really like the way you look at high net debt and consider the impact on the financials if the debt were to be reduced to acceptable levels.
Your para. however lacks details. When you say "1 year's profits", is this OP?, PTP? or NP?
If it is Net Profit then your assumption of 1x Net Profit looks on the conservative side. My own rule of thumb is a max of 3.5x OP (borrowed from the Naked Trader). So a target 2x OP would be reasonable to me.
Regards, Ram

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rhomboid1 13th Aug '15 3 of 16

Hi Paul

Thanks for a very interesting take on Quarto , it makes me wonder how many other companies have undisclosed debt covenants that are based on a flawed understanding of the key drivers of the business concerned.

The only reason I ask is that I ran a business for a while where our lead bankers spent ages trying to get their heads around how to apply inappropriate covenants that they were used to using in other superficially similar circumstances. In so doing they ended up taking a much larger risk than I would have done in their shoes and doing so obliviously!

Every time we had a facility review the same credit analyst would attend and miss the wood for the trees in exactly the same way as in prior reviews , Quarto looks very similar and we are only discussing it as you've picked up on it and they've followed best practice by disclosing in detail their covenants.


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AlanJenkins2 13th Aug '15 4 of 16

To be fair,if you were to make an open offer large enough to completely satisfy demand from existing shareholders,wouldn't that reduce demand in the aftermarket ? If it did - even temporarily - that might cause the share price to weaken - upsetting shareholders who had just bought in the open offer even more !

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fek47 13th Aug '15 5 of 16

Wow, fantastic analysis today Paul on Quarto Inc (LON:QRT). Thanks for sharing your insights as always.

What I think is interesting to point out is that Quarto Inc (LON:QRT) is a favourite of Lord John Lee (I have heard him speak about the company more than once in the last year or so).  He's normally one for pretty strong balance sheets, so QRT is an unusual pick for him given its undeniably weak balance sheet.


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Paul Scott 13th Aug '15 6 of 16

In reply to post #104567

Hi Ramridge,

Re Quarto Inc (LON:QRT) , I was only trying to give a rough idea of how a more stable balance sheet might look, and demonstrate the point that the PER would then be much higher. It doesn't need to be worked out precisely to get the point across.

I would much rather invest in Bloomsbury Publishing (LON:BMY) for example, which actually has net cash, but is on a PER of 11.8. That seems to me a much better risk:reward play than the superficially cheap, but heavily indebted Quarto Inc (LON:QRT) .

Although I take your point that you would be happy with net debt of say 2x operating profit, which is fine - whatever suits you - there's no one correct answer!

Regards, Paul.

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pesquera 13th Aug '15 7 of 16

There's an excellent write-up on CNIC in your very own pub!

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Paul Scott 13th Aug '15 8 of 16

In reply to post #104569

Hi rhomboid1,

Brilliantly put! I totally agree. EBITDA-based covenants are currently fashionable with banks, but as you say, they can be completely inappropriate for some businesses, whilst being a good proxy for cashflow at other businesses. Yet some banks seem oblivious to this, and as you correctly state, are taking on much more risk than they realise. That's certainly my view of the banking position at Quarto Inc (LON:QRT) , and is a large risk which is currently dormant, but who knows what might happen in future?

I don't see the point in taking that risk, when the business isn't even particularly appealing.

Regards, Paul.

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AlanJenkins2 13th Aug '15 9 of 16

In reply to post #104584

Bloomsbury has excellent figures,but I'd guess that the Harry Potter money would start to tail off.

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Paul Scott 13th Aug '15 10 of 16

In reply to post #104574

Thanks Francis!

I spoke to Lord Lee about Quarto Inc (LON:QRT) a while ago, and his view is that the company has considerable intangible, but real value in the book catalogue. So he sees them as annuities which churn out profit for long periods. Therefore he seemed to consider the bank debt as acceptable, which surprised me too.

Regards, Paul.

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Kelvin Prescott 13th Aug '15 11 of 16

Hi Paul

great analysis as always. Re. your question about CentralNIC, my opinion is that the Google announcement is a distraction and doesn't affect (either positively or negatively) the potential revenues and profits that CentralNIC might generate.

Domain registration companies look, from the outside, like they print their own money. Customers have to pay for, .com, and other extensions in order to maintain their internet presence. In theory, every time a new extension (like .xyz) is created to provide additional capacity, customers would then have to pay additional fees to preserve and protect their internet identity.

However, it doesn't actually work like that, as distribution and registration is a business with pretty low barriers to entry, and the wider governance (largely open source/liberatarian) over the internet domain hierarchy means that even if new internet "real estate" is created, the price of the estate will tend to go down in proportion.

This kind of business is actually more like a regulated utility like National Grid than a digital/web business, in my opinion, and should be valued on a similar basis.

I'm ambivalent about whether its a good investment right now. The forecasts all look rosy, and the balance sheet isn't too bad (given that it has raised a lot of capital in the last couple of years). However, its a bit on the small side for me and I'm not convinced management are running it for the benefit of shareholders...

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MGinvestor 13th Aug '15 12 of 16

Hi Paul,

there is plenty of analysis done for CentralNic CentralNic (LON:CNIC) over at the TMF by GHF as pesquera noted above:

and also By Martin

One definitely worthy of research - In the high risk high reward category though

Edit: and if you Search Twitter for CentralNic - its had plenty of coverage today to

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Julianh 13th Aug '15 13 of 16

Thanks Paul
I hope this post makes some sense. I've been sitting at Gatwick airport for this last - ell it feels like the last few years. Flight is delayed due to thunderstorms this morning.
On balance sheet risk:
* the danger signs on Quarto are obvious in the stock report - Altman Z-score at close to distress level and net gearing at 141%
* it does seem strange that these obvious risks are not reflected in the stock ranks. I'd be happier with a stock rank system that reflected these risks. Maybe we can suggest this in the feedback and requests slot
* and sometimes it seems to work the other way round. I've seen stock reports with Altman Z-scores at distress levels even though the company had no debt and buckets full of cash.
Well no system is perfect. And this one is pretty good. So it makes sense that we need to do some work too.
Thanks again for illuminating analysis.

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TerryHancock 13th Aug '15 14 of 16

An interesting question is why Quarto has debt given that it's basic operating model should generate positive cash - that is the beauty of the co-edition model, you are only making books that will definitely sell and make a profit. Over many, many years Quarto has acquired a string of imprints financed almost entirely by debt, the shares are quite tightly held with a non- trivial % owned by the companies founders - that may explain the dividend policy and the oversize gearing. The core legacy problem appears to be that most acquisitions have not generated value or noticeably improved cashflow. Turnover has risen slowly and over 10 years has roughly doubled, but earnings have been much more uneven. This company also has a long track record of "exceptional adjustments" meaning reported figures can be quite opaque. In fairness the current management team seem to be making a decent fist of improving operating metrics but in balance sheet terms the old adage about " I would not start from here if I were you" definitely applies.

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Paul Scott 15th Aug '15 15 of 16

In reply to post #104632

Hi JulianH,

I agree that the Altman Z-score isn't much use. I've found its scores are rather erratic, and so I prefer to check the amount of, and terms of the debt position myself. Plus checking the balance sheet myself, in the context of a business's cash generation & outlook, is a critical part of my own due diligence.

That said, as no doubt Ed would say, the Altman Z-score is mathematically proven, to screen out nearly all companies which go bust in the next 12 months.

Another key point, is that near-zero interest rates are creating an artificial environment, where banks are happy to allow zombie companies to continue trading, as by charging them say 5% interest pa. but having a near-zero cost of funds, the banks are effectively seeing 4%+ of bad debts being recovered each year. So they're happy to run with that situation forever, and get back money that they otherwise would have lost. That's one of the main reasons for continued near-0% interest rates - it allows the banks to rebuild their balance sheets by diverting the interest receipts that savers would have got, onto banks balance sheets instead!

Therefore I feel that any system which does well in this environment will need a radical re-jig once interest rates normalise, as it could well be allowing far too much risk through inadvertently, in a benign environment. There's a good case for making hay whilst the sun shines, but I'm just flagging up balance sheet risk that will, at some point, resurface with a vengeance!

Regards, Paul.

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Julianh 16th Aug '15 16 of 16

Another thought! Maybe we can ask Ed to create a Paul Scott "Bargepole" short screen, picking up some of the balance sheet weaknesses that can be quantified and put into a screen. And even if he does I'll still be reading your column because there are is always more information in the fine print that can easily get missed in the headline numbers.
I'm not so sure we need to worry about a return to interest rate normality. We've been waiting for a return to normal interest rates for a few years now and almost nothing has happened. Can the central banks really return interest rates to normal without causing another crash? It's a bit like any bubble. Once the bubble has formed, pricking it will bring a big explosion. It always feels safer to avoid the bang by keeping on pumping in more air.
As always thanks

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About Paul Scott

Paul Scott

I trained as an accountant with a Top 5 firm, but that was so boring that I spent too much time in the 1990s being a disco bunny, and busting moves on the dancefloor, and chilling out with mates back at either my house or theirs, and having a lot of fun!Then spent 8 years as FD for a ladieswear retail chain called "Pilot", leaving on great terms in 2002 - having been a key player in growing the business 10 fold. If the truth be told, I partied pretty hard at the weekends too, so bank reconciliations on Monday mornings were more luck than judgement!! But they were always correct.I got bored with that and decided to become a professional small caps investor in 2002. I made millions, but got too cocky, and lost the lot in 2008, due to excessive gearing. A miserable, wilderness period occurred from 2008-2012.Since then, the sun has begun to shine again! I am now utterly briliant again, and immerse myself in small caps, and am a walking encyclopedia on the subject. I love writing a daily report for on most weekday mornings, constantly researching daily results & trading updates for small caps. Cheese! more »


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