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Quad/Graphics, Inc. (NYSE:QUAD)

Credit Suisse 15th Annual Global Services Conference

March 12, 2013 2:00 pm ET


John C. Fowler - Chief Financial Officer and Executive Vice President

David J. Honan - Chief Accounting Officer, Vice President and Controller


Colin Moore - Crédit Suisse AG, Research Division


Colin Moore - Crédit Suisse AG, Research Division

From Quad/Graphics, we have John Fowler, CFO; and then Dave Honan, Corporate Controller, with us. Thanks.

John C. Fowler

Thanks much and good morning. Just a -- we'll take a quick fly-through about Quad. A little bit of the overview, we're a printer-related channel solution to a Fortune 500 client base. With the recent acquisition of Vertis, we're approximately $5 billion in annual sales with 25,000 employees, second largest printer in the western hemisphere. We have 70 plants, 8 countries, we're the largest printer in Latin America that was a byproduct of some of our original investments, as well as our acquisition of Worldcolor 2.5 years ago, and we're headquartered just outside of Milwaukee.

We're really proud of the client base that we have, it's a Who's Who, whether you're looking at retailers, catalogers, magazine publishers, we're very proud of that, that's the tremendous amount of strength that we have as we look at how we grow our business long term in a very competitive industry.

We've got a great platform. I mean, you see in the United States, with the blue dots, we really cover all of the areas of the country, so we have the ability to handle both large runs that are going to be produced in a centralized location for maximum efficiencies, as well as distributed print. And you can see looking up in the upper right with Latin America, were in all the major countries in Latin America with a large coordinated continent strategy.

When you look at our revenue by product line and this has been pro forma-ed for Vertis, historically, the 3 major product lines that Quad has been strong in has been catalogs, magazines and retail inserts. With the acquisition of Vertis, which was about a $1.1 billion business, 2/3 of which was retail insert, 1/3 of which was direct mail, it made retail inserts our strongest individual product line, and it also increased direct marketing, direct mail, which we view as a product line that's got good growth legs.

We are primarily a US-based company. Europe is about 3% of our business. We operate out of Poland, so about 50% of our European sales are domestic in Poland. About 50% is export, basically the northern European countries, so we have not been impacted by the various challenges in Europe. And Latin America, here, it's a little bit understated because a couple of our investments are 50-50 joint ventures that we share control but we don't consolidate them.

As I said, we're in the commercial printing industry. It's about a $43 billion industry and we're very pleased with the position that we have as a second largest producer. It is very competitive. One of the things that has been the challenge in the printing industry has been the capacity utilization of the industry. It's listed at 64%, this comes out of bureau labor statistics. If you went back prerecession, you'd see a number that would be in the mid to upper 70s.

Clearly, we experienced the pressures that are the cyclical pressures, whether it's the economy, consumer confidence, what's happening in retail. And structurally, we know what's going on with digital media online content. Having said that, we really like where we're positioned. And as one investor who has made a lot of money said, John, I've created a lot of wealth for myself in investing in companies that are well-run, understand the realities that they're facing, and mature to declining industries.

This just lays out the -- our major competitors. Clearly, you look at the chart and you'll see that Quad and R.R. Donnelley are the 2 major competitors. Donnelley is approximately a $10 billion business as compared to us at a $5 billion business. And then the drop-off is relatively significant after the 2 of us.

I think this is worth spending some time on, on the what are our strategic goals and this is really how we're trying to drive the business. Number one, we recognize that we're an industry, let's call it, in the middle innings of a very painful consolidation and we're very oriented towards how do we transform the industry. And that's looking at it from our client's point of view of how do we help them with channel integration, I'll show you a slide.

The reality is, that no one form of media has replaced any other form of media, it has taken another piece of the pie but none of the forms of media have gone away. The biggest challenge we hear from our clients is, okay, print maybe at the backbone of what a retailer, cataloger, publisher is doing, but they want to be accessing what they're doing with the mobile strategy, with the social media strategy, but how do you bring all these together into an integrated way? We're spending a lot of time with our clients working on that. I don't want to say that we're trying to become an agency but we're providing some agency-type functions, which we think helps make print more relevant as we go into the future.

Second, we're all about trying to take cost out for our clients from their printed work. And then, frankly, pursuing what we consider value-oriented industry consolidation, I'll talk a little bit more about that. We're really focused in how do we be -- how are we the low-cost producer in the industry, whether it's looking at our platform, whether it's looking at our IT system and especially around manufacturing and logistics, which I'll talk about a little bit more.

As I said, we have 25,000 people. So what we're doing to empower our people, to have a common culture, a common value system, we've done 2 large acquisitions. One of the things we found is a lot of acquirers historically have not done their own integration, so when people ask us what was the hardest thing about the Worldcolor acquisition and integration, it was really integrating Worldcolor to Worldcolor. And so we have a real focus on having one employee group so we're all focused and all headed at the same direction. And then financial strength is really important to us.

As we look at the industry, it is a challenged industry. It is consolidating. There are winners, we are really proud of what we accomplished in 2012 and the value that we created for our shareholders. We feel we're able to get there because of how we positioned the balance sheet, how we're focused on the free cash flow and how we're focused on being able to make sure that we have access to the capital markets and that we frankly have the flexibility from the strength of our balance sheet that we can both "weather any storms that come our way" and be opportunistic to make investments, similar to what we're able to do with Vertis.

When we look at -- we've been a public company for a little over 2.5 years now and sometimes I think it's hopeful to step back and say in that 2.5 period of time, what has this management team accomplished? We acquired and successfully integrated Worldcolor, we became a public company, we acquired the Mexico operations of Transcontinental, we divested our Canadian operations that we acquired as a result of Worldcolor, we have very much of a portfolio approach to our businesses and geographies. Our view is that every business and geography we're in, over a 3-year period of time, needs to create value either by growing enterprise value or generating free cash flow or some combination. We felt we couldn't do that with Canada, so we divested it.

We've expanded our commercial platform, just completed the acquisition of Vertis in the middle of January, started our dividend policy in 2011, frankly, have increased the regular quarterly dividend twice and at the end of the year, we were able to pay out a special $2 dividend per share.

Frankly, this is all in the context of, call it, a modest economic recovery and a difficult time in the industry. During this time, we also paid down $444 million of debt, $169 million of pension obligations, despite the increase and the decrease in the discount rate, and we've kept our leverage where we said we were going to be when we became a public company, which was frankly consistent with what we were as a private company, between 2.0x and 2.5x.

As we look at our clients, our clients have a lot of pain points, whether it's postal rate increases, whether it's all the different media channels, whether it's environment, the competition, and so our challenge is, how do we create value for our clients? And we look at it that we want to create value on 2 lines of our income -- of the income statement of our clients. The first is how we're going to help them maximize their revenue with better response rates, more effective advertising. And the second is, how are we going to reduce their cost of producing and distributing a magazine or catalog to the individual consumer.

This is the graph I was relating to before that you go back to 1990 and you had a relatively limited number of media channels and you look at it exploding, it has just absolutely exploded over the course of the last 20 plus years. But frankly, none of them have gone away. But the biggest issue our clients have, when you go to the right side of this chart, is how do you integrate all these things and make them work together, because if you just have a siloed approach to what you're doing with social media or what you're doing with mobile technology and you haven't tied it into what we can do with the printed page and the coordinated program, it's going to be nowhere near as effective.

So we've talked a lot about media channel integration and we've been doing a lot with how do people do it and how do you use technology such as image recognition, where you can take a smartphone, you can hold it over a page, it can recognize the page going up to the cloud, it can bring down a video, it can bring down a product demonstration, it can bring down additional specs. It can do a lot of different things in a -- if it's a movie advertisement, it can bring down the trailer, it can then tell you what movie theaters are -- that the movie is playing at based upon where your smartphone is. There's a lot that we're doing here around what we call interactive print solutions and channel integration.

Again, to understand print -- I think you have to understand what drives our client cost. Printing itself is only 20%, paper is 30%, 50% of it is postage and distribution. Therefore, whatever a printer can do to help a client reduce their postage and distribution cost is monumentally more. Taking 10% out of postage and distribution is equivalent of taking 25% out of the print bill, and that's been a big part of our focus.

And so what we do is we -- call it, co mail, it's the idea that you're putting multiple magazines or multiple catalogs, merging their mail strings, putting them in the same mail pool, so that they're actually bundled to the local postal carrier, the 9-digit zip code, and they're actually in the sequencing, which your postal carrier will walk or drive their route. For that, the post office gives deep discounts. If you think about it, the post office is very efficient, from the local post office to your home, the last mile, because they have a monopoly and they do it every day. They're relatively inefficient with the rest of what they do, probably because it's a post office and probably because Congress doesn't give them the flexibility to operate.

So we co-mail over 5 billion magazines and catalogs, it's more than anybody else in the industry. This creates tremendous savings. So again, if we could save 10% on postage and distribution for a client, that's a flow-through to them, that's 10% of the 50% or a 5% reduction in their cost, which is the equivalent of taking 25% out of their print cost. And this is where we feel we have a substantial lead over both our large and small competitors.

Part of it is we have large plants and the thing that large plants do is number one, it creates the volume to be able to combine and the other thing is we've operated and consolidated geographic areas, so it's both mega plants and mega zones that allow you to take all of these different volumes together in order to be able to have enough girth to be able to both get to the minimum number of magazines or catalogs required for a 9-digit zip code bundle, as well as to be able to ship it in consolidated truckloads.

As I said, a significant piece of our strategy over the last 3 years has been the right consolidating acquisition opportunities. We're very disciplined about how we do this. Frankly, that's the reason we've been successful at doing it. We have 4 criteria. They have to meet all 4 for it to make sense. Number one, it's got to be a good strategic fit. We're not trying to get big for the sake of getting large, sooner or later, you're just really trading dollars with sellers. So it's got to have a strategic fit first and foremost. Second, the economics need to make sense, I prefer to actually say, the economics need to be compelling as to what we do. Third, we got to feel confident that we can execute the integration, that there's nothing unique about the culture of the business, the location of the assets, the nature of the customers that's cause us -- going to cause us to have significant problems as we go about the integration. And finally, we don't want to do anything that's going to hurt the balance sheet. The balance sheet is one of our key strengths, so we're not going to do a stretch on the basis that, "Okay, if this works perfectly, then our leverage is going to come down." We worked really hard to not do leveraging transactions.

When we try to measure our success, and we did this with Worldcolor, we're approximately 60 days into the acquisition of Vertis, we measure it 4 ways, it's very much of a balanced scorecard approach. Obviously, it's the financial metrics. It's how well are we doing at retaining customers; are we doing a good job with employee integration, so we truly have, as I said before, one employee workforce; and are we integrating the platform and especially integrating the IT. Those are critical and this is how we measure ourself.

So Worldcolor, we completed our integration in 2012, generated $285 million of synergies. We exceeded our original guidance, which was $225 million. Our cost to achieve were roughly $0.80 out of every dollar. It was an absolute success. And of the customers that we had to relocate, we had a 97% customer retention rate.

Vertis, that I talked about, say, closed in the middle of January. Our net purchase price was $170 million in 2012. Vertis was a $1.1 billion business with $55 million of EBITDA, and we think we're going to generate over $50 million of synergies. It's a great strategic fit whether we look at geographic or product lines, it's in 2 businesses that we feel very good about, the retail inserts and the direct mail. And so we think it's going to be very good. As I said, as a standalone business, we think that Vertis, as it -- it went into 2013, would have been about $1 billion in revenue with $45 million in EBITDA, synergies in excess of $50 million, cost to achieve $1 for -- $1 of cost to achieve for $1 of synergy. Going forward, we are going to report it as one company, as opposed to keep trying to break out all of the individual components. But when you go through the math, you can see that it's a real value creation and accretive transaction, whether you're measuring it on the income statement or whether you're measuring it in a value creation model.

So with that, I'll turn it over to Dave Honan.

David J. Honan

Thanks, John. I just roughly wanted to cover off on our financial results from '12, give you a little bit of look at our guidance for '13, but more importantly, talk about our financial objectives. And what you'll notice about Quad is, we've had a historical accounting financial policies, we continue to stick to those policies and objectives, have been very successful with that. Now our biggest objective, really, is to stabilize our core revenues and adjusted EBITDA in a very mature industry. So that's really getting down to as treating all costs in our platform as if they're variable costs, that then able to reduce those costs proportionately to the top line. But one thing that a printing company does generate is a lot of free cash flow, and our objective is to maximize that free cash flow because that provides us with a lot of capital allocation flexibility.

We have a strong balance sheet. We continue to maintain that strong balance sheet because that enables us to weather the economic and industry challenges but also provides us a little bit of dry powder to take advantage of opportunities as they come around. We've been -- and some of those opportunities have been, what John has mentioned, with the Vertis and the Worldcolor acquisitions and executing on consolidating acquisition in a very disciplined manner. But also, we're investing in growth markets for -- to drive future revenue and also to be accretive to our EBITDA earnings.

Finally, we look at our businesses, their overall objective is we want to create long-term value to make it our own best investment. This slide really gets at where we sit in our marketplace. As you see, Quad is #2 player in the printing industry behind Donnelley, we have $4.1 billion in revenues, we're #2 also in terms of profitability at 13.8% adjusted EBITDA margin.

For 2012, we ended the year with $566 million of adjusted EBITDA. As I mentioned, adjusted EBITDA margin of 13.8%, that drove strong recurring free cash flow for our business. 2012 finished with $375 million of recurring free cash flow, that's an increase from $340 million in 2011. We use that free cash flow in a number of different ways in how we allocate our capital. Number one, as I've mentioned, we've been maintaining a strong balance sheet.

We continue to pay down debt, we paid down $120 million in debt in 2012 alone. Since the Worldcolor acquisition in 2010, we've paid down $444 million of debt, that's roughly a 25% reduction in our overall debt load. We also continue to derisk our balance sheet. When we acquired Worldcolor, we acquired a defined benefit pension plan, Quad/Graphics historically did not have a defined benefit pension plan. We've reduced those pension liabilities by $169 million since the acquisition for roughly a 30% reduction in those liabilities, all those plans are frozen.

In addition to this, we've used the recurring free cash flow to allocate capital back to our shareholders. We had $1 per share annual dividend last year. We increased that, going in to 2013, by 20%, so that now will be $1.20. In addition, we paid a special one-time dividend at the end of 2012 of $2 a share to our shareholders.

We also have done this and maintained the leverage that we wanted to on our balance sheet. We have a stated target of 2x to 2.5x leverage, which we want to operate in, and we've finished 2012 at 2.39x.

Looking forward to our debt. The key notes on this slide is number one, we've got a lot of availability under our revolver. We finished 2012 with $50 million of outstanding debt under an $850 million revolver. Number two, we have a really healthy mix of debt. 57% of our debt is floating, 43% is fixed, with an average interest rate across all the debt of 4.9%. And then from a refinancing standpoint, we have no significant maturities until 2017 and over the next decade, we really have no year with an unusual balloon amount of payments, have a nice, smooth repayment schedule over the next decade.

For 2013, we introduced our guidance last week on our earnings call. From a revenue standpoint, and all these numbers include our recent acquisition of Vertis in them, from a revenue standpoint, we have a range of $4.8 million to $5 billion -- sorry, $4.8 billion to $5 billion, adjusted EBITDA of $580 million to $610 million, and recurring free cash flow of greater than $360 million. That was one of the enablers to allow us to increase our dividend going into 2013 by 20%.

So again, our consistent financial policies, we will continue to operate in a leverage ratio of 2x to 2.5x, although at times, we may go below it or above it based on timing of growth opportunities. We continue to use that free cash flow in a way to take down our leverage, to derisk our balance sheet. We have good relationships with our bankers and our lenders, we continue to maintain a real staggered -- nice staggered maturity level for our debt going out, as I said, over the next decade. We've got enough dry powder to take advantage of those opportunities as they come about and weather the difficult times coming through the industry at this point. And overall, our return of capital to shareholders, we'll continue a disciplined allocation strategy and as we maintain these financial policies.

So with that said, why invest in Quad? I've gone through 3 points here. One, we're a substantial free cash flow generator. Number 2, we have a strong balance sheet that's going to enable us to compete very healthily in this market as the market continues to consolidate, which is evidenced by -- and also, we have a very balanced approach to how we allocate our capital as evidenced by our increase in our quarterly dividend. As John mentioned, strategically, we believe we have the most efficient, flexible, and modern manufacturing and distribution platform in the industry and that we have the right strategy to transform this industry to create value as we move forward.

That's the end of our prepared remarks, we'll take Q&A in our breakout session after this. Thank you very much.

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