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

Wednesday, May 24 2017 by

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…

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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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7 Posts on this Thread show/hide all

aflash 24th May '17 1 of 7

Have not been able to post a copy of the chart.

It is of dubious value anyway because of lack of volume.

Nevertheless it is possible to trace a 5 Elliot Wave Up pattern from 2012. Three up, two counter trend. Third wave long and strong. 

Therefore the retreat from the Hi which is almost 61,8% would allow for an A,B,C, correction. B being countertrend and therefore Up because the trend is now Down. 

So from support at 245 there may be a bounce. After that it is down.

Since you have made such an exhaustive fundamental bottom-up analysis I wanted to acknowledge it, having sold today.

From the top-down the printed word may not have much future.

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mojomogoz 25th May '17 2 of 7

Hi aflash

I agree that there's a decent chance it goes up from around here. In fact, as I said in my note, the business may be in a position to surprise positively given refocusing work done over the years.

Optically Quarto looks very cheap today. Its not even expensive if my view on 2017 earnings are correct (9.1 PER). However, the world isn't fair and negative news will not be adequately cushioned by valuation. First half results tend to be weighed down with costs with second half being where the profits are made and pure publishing focus should accentuate that. Timing of acquisition and disposal cash is positive in H1 but that should be drowned out by pre-publication investment cycle.

My reason to sell is balance of risks based and the possibility of a dilutive equity raise. For a small company to have a couple of positive broker notes in succession may hint that the company is doing the rounds and action is imminent. Raising equity is a good thing for this stock and path to improving valuation rating and if it were that simple I would likely have held my position.

Best wishes

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mojomogoz 27th Sep '18 3 of 7

Hello! Anyone follow this share and have an idea why down 20% today with no news. Big volume obvs but why?

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rhomboid1 27th Sep '18 4 of 7

In reply to post #402724

Not following closely but it’s now at a fascinating point...if no lifeboat rights issue needed to get bank deal done then this is way oversold ...but as ever someone thinks they know something & has pressed the eject button..

On my watchlist

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dangersimpson 28th Sep '18 5 of 7

Been following the saga here just because it is an interesting one to look at. Given the debt situation you would think it is nailed on that it needs a rights issue to re-build the balance sheet. That said there is a couple of reasons why this may not be the case:

1. It is highly cash generative and has a strong back catalogue of titles that have a long tail of sales. The reason that the debt has increased has been their re-investment of all their OCF into more pre-production assets. If they really thought the debt was unmanageable they could just cut the pre-production investment for a couple of years and it would come down quickly.

2. I believe that they have not been particularly focused on G&A costs in the past and there is scope to reduce here.

3. They have a financially strong shareholder in CK Lau who would presumably be happy to put extra cash in/underwrite a rights issue if needed.

That said, my understanding is that the recent management upheavals haven't helped. Orbach getting himself voted in may have triggered change of control clauses and strengthened the banks' hand in how the business is run in the future with regard to capital structure. Orbach also may not have had a clear plan of how to fix things though, hence his arrival and then departure. The current management are capable of sorting the mess out given time - the question is whether they will be given that time by the banks.

Someone clearly wanted out at any price today to sell 144k @68p when the spread was 82-85 at 10:14. Presumably this was reported as a late trade or someone wouldn't have paid 85p for 5k half an hour later! I guess we should find out in the next few days if the seller was prescient or simply panicking.

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mojomogoz 28th Sep '18 6 of 7

In reply to post #402804

I'm interested in Quarto Inc (LON:QRT) as its a stock I bought 2015/16 ish somewhere mid to high 100s and then sold out in 2017 somewhere north of 250. It was a period when I went from informed but 'light' analysis to deep analysis and created a bespoke model for the company. Its not just been for Quarto either, its generally my path, as I'm a bit contrary and want to get into situations that people perceive as bad but where I think the downside is reasonably secured and I can hold a stock for a long time waiting for a better return and narrative to play out. Warning: Not a style that works well in 2018!...or I'm just a bit rubbish :)  

My recent successes have been selling stocks more than purchasing. For example, I recently sold Indivior (LON:INDV) near its high after picking up sub IPO price. Got to work more on the buys!!!

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

From my original note:

"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)."

The above is the key point. The back catalogue is the business. What's happening recently is that the company is cash flow flat to negative once pre-publication costs are accounted for. With that much debt this cannot be sustainable balance. The company is running very hard to stay afloat operationally and cannot find the spare cash to feed its capital structure. The big investment in new publications, with hindsight, looks a but sh1t or bust.

Why has cash from back catalogue deteriorated? Why is the heavy investment in front book not showing through to back catalogue?

An investor needs an answer to this IMO and not just the obvious refinancing with banks.

My guess is that the seller will be Intrepid from the USA. I've met them from a USA perspective (not their global fund) and in US equity they are good quality contrarian value guys that do their homework. I was surprised to see them on the Quarto shareholder list. It made me check back on my analysis when they appeared as I feared I must have it wrong...and so Quarto could be a cheap buy.

If I had an appetite to short sell I would have done it for this company and I would still do it from here. Quarto is likely a zero as that's the only way someone pays out the debt...however, I do even wonder whether Orbach or Lau will even do that now that they are on the inside as the strong hint from the cash flows is that there is something operationally sour too...

My guess is that some publication areas have died on them. That means they probably need to write down intangible assets too. The only thing that has value is the back catalogue but separated from Quarto that value will likely be very low.

I think that the next owner of Quarto will do so out of administration.

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mojomogoz 28th Sep '18 7 of 7

In addition to above. For anyone a bit geeky on Quarto Inc (LON:QRT) here are a couple of questions I asked management back in H1 2017:

3) Has the underlying publishing business mix changed in recent years in a way that means frontlist sales will be a higher proportion of revenues going forward? You have stated that higher ‘product efficiency’ is an indicator of likely higher backlist value. That doesn’t seem to be evidenced in results yet. That said, the significant continual YoY ramp up in product efficiency (from 1.01x in 2013 to 1.57x in 2016) may hide the backlist effect due to the growth impulse in frontlist. There is tentative but equivocal evidence of uplift in a metric like Publishing OP/Pre-publication costs which shows a 5.5% increase YoY since 2014 (2014 - 47.1%; 2015 - 53.0%; 2016 - 58.4%). However….

4) Carrying on from (3)...given that product efficiency for new titles has increased at c.16% YoY in the same 2014-2016 period (so, on simplistic logic translating to approx $4.5m pa to publishing OP) this suggests that there is significant deterioration in some areas of publishing. The problem could be, for example, older backlists not performing well or a meaningful minority of imprints not performing well and not being so actively funded to produce new titles? Discounted sales of backlist could also help to explain these performance stats.

I believe if you can answer the above then you can get answer to whether there is a sustaible net cash flow from Quarto and whether the course of action is long term upside at the expense of a bit of equity dilution or a zero out for equity to deal with the debt.

Quarto should have raised equity 1.5+ years ago. They missed their window.

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