Quad/Graphics, Inc. — Q3 2018 Form 10-Q
Business context and reporting period. The filing covers the quarter and nine months ended September 30, 2018. Quad describes itself as a marketing-solutions provider built on a print and distribution platform. Its U.S. Print and Related Services segment generated about 91% of sales; International generated about 9%. Results include Ivie from its February acquisition and Rise after Quad obtained control in March. Comparisons are affected by those additions.
Financial performance
- Q3 revenue: $1,029.1 million, up 2.4% year over year. Product sales fell 3.5% to $826.7 million, while services rose 36.3% to $202.4 million, largely reflecting Ivie, Rise and higher logistics sales.
- Q3 earnings and margins: Operating income declined 13.2% to $40.6 million; operating margin fell to 3.9% from 4.7%. Net earnings attributable to common shareholders increased to $23.4 million from $19.8 million; diluted EPS was $0.46 versus $0.38. Non-GAAP EBITDA was $103.9 million (10.1% margin), down from $107.7 million (10.7%).
- Nine-month results: Revenue increased 1.5% to $3,012.1 million, but operating income fell 46.4% to $68.6 million and operating margin declined to 2.3% from 4.3%. Net earnings attributable to common shareholders fell to $29.3 million from $51.9 million; diluted EPS was $0.57 versus $1.01. Non-GAAP EBITDA decreased to $253.0 million (8.4% margin) from $307.8 million (10.4%).
- Cash flow and investment: Nine-month operating cash flow was $46.6 million, down from $179.7 million. Capital expenditures were $85.0 million, producing negative free cash flow of $38.4 million, versus positive $118.1 million in 2017. Management attributed the cash-flow decline mainly to a $107.5 million adverse change in operating assets and liabilities and lower cash from earnings. Investing cash outflow was $119.6 million, including $71.4 million for acquisitions.
- Liquidity and debt: September 30 cash was $6.3 million; unused revolving-credit capacity was $554.6 million, net of letters of credit. Debt was $1,058.2 million and capital leases brought total debt and lease obligations to $1,074.4 million, up from $964.8 million at year-end 2017. The non-GAAP Debt Leverage Ratio was 2.46x, versus 2.15x at year-end; management’s target range is 2.0x–2.5x. The company reported compliance with debt covenants, including total leverage of 2.39x against a 3.75x limit.
- Other metrics: Inventory increased to $354.5 million from $246.5 million at year-end. Dividends declared were $0.30 per share in Q3 and $0.90 for the first nine months.
Material changes and management commentary
- Traditional print revenue and pricing faced continuing declines and competitive pressure from industry overcapacity and digital substitution. For the first nine months, product sales declined $99.4 million; service sales grew $144.3 million, chiefly from acquisitions and logistics.
- Management cited cost-reduction initiatives and lower SG&A as offsets to print pressure, but nine-month EBITDA and operating margins declined. Nine-month results also included a $22.3 million non-cash ESOP contribution, increased restructuring and impairment charges, and a $13.3 million net benefit from property-insurance claims.
- Restructuring, impairment and transaction-related charges were $40.6 million for the first nine months, versus $22.5 million in 2017. The 2018 total included $16.0 million of impairments and $17.2 million of employee termination charges. Management expects additional restructuring and integration costs.
- Quarterly results and cash flows are seasonal: sales and operating income are generally higher in the third and fourth quarters, and operating cash flow typically peaks in Q4 as working capital needs ease.
Outlook, risks and contingencies
- The filing provides no specific earnings or revenue guidance. Management said it expects adequate liquidity from operating cash flows, available cash and revolver capacity to fund operations, integration, restructuring, investment, debt service and shareholder returns.
- On October 30, 2018, after quarter-end, Quad and LSC Communications approved a definitive agreement for an all-stock acquisition valued at approximately $1.4 billion, including refinancing LSC debt and assuming other obligations. Closing was expected in mid-2019, subject to customary conditions, regulatory approval and shareholder approval.
- Key stated risks include declining print demand, pricing pressure and excess capacity; postal-rate and service changes; paper, labor, energy and freight costs; customer contract and collection risks; acquisition integration; foreign-exchange exposure; and debt covenants. Quad noted the proposed tariffs on Canadian uncoated groundwood paper were rescinded by the ITC in August 2018.
- Quad is cooperating with the SEC, DOJ and OFAC on an investigation involving potential FCPA issues in Peru and China and transactions involving Cuba. The company said it did not anticipate a material adverse effect, but outcomes remain unresolved. Litigation with GCIU trustees over multiemployer pension withdrawal liability also continues; the recorded $20.4 million estimate may change with the outcome.
- Argentina was classified as highly inflationary effective June 30, 2018; the currency change resulted in $1.4 million of foreign-exchange losses during the first nine months. The company also reported a $9.9 million tax benefit from reducing its liability for unrecognized tax benefits and had not yet chosen an accounting policy for GILTI taxes.
Important facts for investors to verify
- Whether service growth and acquired businesses can offset ongoing declines in print volume and pricing, and how margins perform after integration.
- Why operating cash flow fell sharply, the extent to which working-capital outflows reverse seasonally in Q4, and the company’s ability to sustain positive free cash flow.
- Debt and liquidity implications of the proposed LSC transaction, including financing, refinancing, dilution, approvals and integration risks.
- Future restructuring and impairment costs, and the final amounts and timing of GCIU withdrawal liability and the regulatory investigations.
- Whether Quad maintains covenant headroom and its leverage target while funding capital spending, dividends and any share repurchases.