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Executives

Kelly A. Vanderboom - Vice President and Treasurer

J. Joel Quadracci - Chairman, Chief Executive Officer and President

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

Analysts

James Clement - Sidoti & Company, LLC

Haran Posner - RBC Capital Markets, LLC, Research Division

Quad/Graphics (QUAD) Q1 2013 Earnings Call May 8, 2013 10:00 AM ET

Operator

Good morning, ladies and gentlemen. Thank you for standing by. Welcome to the Quad/Graphics First Quarter 2013 Conference Call. [Operator Instructions] I will now turn the call over to Mr. Kelly Vanderboom, Vice President and Treasurer for Quad/Graphics. Kelly, please go ahead.

Kelly A. Vanderboom

Thank you, operator, and good morning, everyone. With me today are Joel Quadracci, our Chairman, President and Chief Executive Officer; John Fowler, our Executive Vice President and Chief Financial Officer; and Dave Honan, Vice President, Corporate Controller and Chief Accounting Officer. Joel will lead off today with a discussion of our strategic goals. John will follow with a more detailed review of our financial results, followed by Q&A.

With the exception of certain debt ratios, prior year financial results do not include the acquisition of Vertis. All actual 2013 results will include Vertis from the day of acquisition on January 16, 2013.

I would like to remind everyone that this call is being webcast, and forward-looking statements are subject to Safe Harbor provisions as outlined in our quarterly news release and in today's slide presentation. The slide presentation can be accessed through a link on the Investor Relations section of the Quad/Graphics website at www.qg.com. There are also detailed instructions on how to access the slide presentation in our first quarter earnings press release issued last evening. A replay of the call will also be posted on the Investor Relations section of qg.com after the live call concludes today. I will now turn the call over to Joel.

J. Joel Quadracci

Thanks, Kelly, and good morning, everyone. Our first quarter results were in line with our expectations. We continue to generate strong recurring free cash flow of $120 million, and we are pleased with our progress on the Vertis integration following the deal close at January 16, 2013. We are reaffirming our 2013 guidance of approximately $4.8 billion to $5 billion in revenues; $580 million to $610 million in adjusted EBITDA; and recurring free cash flow in excess of $360 million.

Moving to Slide 4. We show a summary of our 4 strategic goals for adding value in a challenging industry environment. They are: transform the industry; maximize operational and technological excellence; empower, engage and develop employees; and enhance financial strength. We walked through these goals in detail on our last call, so today I'm only going to speak to our first goal, to transform the industry, which consists of 3 parts: maximize the revenue our clients derive from their marketing spend through media channel integration; minimize our clients' total cost of production and distribution; and pursue value-driven industry consolidation opportunities like Vertis.

Let's start with how we maximize our clients' revenues. As you can see on Slide 5, today's media landscape offers many more channels than ever before, putting our clients under enormous pressure to coordinate and connect their content across an ever-expanding number of channels. In addition, our clients are constantly bombarded with offers to use the latest and greatest interactive technology dreamed up by what I call, Two Guys in a Garage.

These developers have some really good products but our clients don't always know how to integrate and monetize them. As I meet with clients, I keep hearing the same 2 questions: "How do I make all these channels work together in support of my marketing strategy?" and "How long will the 2 guys in the garage even be around?" That's where we can help. We are a printer and a media channel integrator. We are a strong stable partner who knows our clients and understands their challenges. We can help them navigate changes in today's media landscape and incorporate the latest innovations in technology into their overall marketing strategy.

We are a huge part of our clients' business, handling their content for distribution in both print and digital forms. We honed our expertise in processing digital content more than 15 years ago and today, we know how to integrate content efficiently across all channels. One powerful way we are accomplishing media channel integration is through our suite of interactive print solutions powered by Actable, our app for smartphones and tablets. With Actable, we're able to launch interactive experiences from print to various digital media channels seamlessly and in realtime and then measure the results. These experiences are activated by QR Codes, image recognition or Near Field Communication technology and effortlessly connect the print channel with all other channels.

Smithsonian Magazine used our Actable app to bridge the print and digital world on the cover of its December 2012 issue. The issue featured the American Ingenuity Awards and the innovators who are rocking our world. With Actable, the cover came to life with an amazing audiovisual tribute to American innovation. Inside the magazine, each of the featured innovators came alive with on-page videos. It was a creative way to extend content and engage readers. Iconic toy maker LEGO also used Actable to power its LEGO Connect app. In spring 2013, shop-at-home catalog contains 19 interactive experiences, including Augmented Reality animations, interviews with label designers and website links. And finally, National Geographic will be using interactive print of the future, utilizing Actable to power its app. The integration of print with other channels presents a great opportunity for Quad to further expand our Media Solutions offering.

For example, just last week, we announced our investment in Pixability, a YouTube and online video marketing company that specializes in video search engine optimization or video SEO. Pixability solution complement our existing video production services. Now we not only can concept, produce and host videos but also optimize them as they reach the right audience with the right message and trigger the right action. Realtime analytics provide clients with useful information for managing their YouTube channel and optimizing campaigns. This includes how well their videos rank on YouTube, Google and other search engines and how well their videos are performing along with specific ideas for improvement.

We are encouraged by the business potential in this area. All of our Top 50 clients have a presence on YouTube and collectively, have produced approximately 21,000 videos, presenting an opportunity to help optimize that video content and integrate it with print, complementing our expanded strength in online video SEO editorial content services. Recently, we partnered with Skyword, a company that creates editorial content designed to appear prominently in organic or non-paid search engine results and in social media. Skyword's products, which include writing, tracking and realtime analytical services enhance our existing editorial services. What's more, Skyword's products will be integrated into our automated workflow solutions and strengthen our total media solutions offering.

With all that we're doing with media channel integration, we are well positioned to help our clients make effective use of all their assets and drive their top line growth.

The second part of our strategy to transform the industry is our ability to minimize our clients' overall total cost of production and distribution. Mailing and distribution is our clients' single largest production-related expense, and we continue to advance our co-mail solutions that merge multiple magazine or catalog titles into a single mail stream to earn postal discounts. As I've shared previously, we are a leader in co-mailing, having co-mailed approximately 5 billion mail pieces in 2012. Included in that 5 billion is letter-sized mail we co-mingled for direct mailers, another one of our well-established postage savings programs.

We recently announced a multimillion dollar investment to create 2 regional co-mingling centers near our facilities in the Northeast and the Midwest. These co-mingling centers augment our already robust co-mingling services to provide clients with additional efficiencies and cost savings.

I'd like to take a moment to note that our leadership in mailing and distribution recently earned us the distinguished Partnership for Growth award from the U.S. Postal Service. The award recognizes how we are developing and using technology, like our suite of interactive print solutions, to make mail more powerful and responsive in conjunction with other forms of media.

The final part of our strategy to transform the industry is our ability to select and successfully execute value-driven industry consolidation opportunities. I'd like to spend a few minutes now on the progress we are making on the Vertis integration. As with Worldcolor, we will measure our success on 4 key metrics: client retention; IT and platform integration; employee integration; and financial metrics. Since closing on the acquisition in January, I've spent time visiting with new clients and employees across the country. From a client perspective, we've done well to renew a number of retail insert accounts especially in the grocery vertical, where we now have a significant position.

For example, grocer A&P has renewed 100% of its retail advertising insert program with us under a new multi-year agreement. In terms of direct mail, the Vertis acquisition strengthened our direct mail platform. We are confident that as we proceed with integrating our Direct Marketing operations and making investments like the state-of-the-art co-mingling centers I already mentioned, we'll further enhance our capabilities and grow this part of our business. IT platform integration is crucial to achieving acquisition synergies in the near term and ensuring that Quad keeps our cost low.

We've realized a number of early successes, including integrating HR and payroll systems and integrating procurement systems to consolidate vendors and ensure common practices. From an employee integration perspective, I personally welcomed all Vertis employees to the company during the live video downhaul on the day we finalized the acquisition. Afterward, employees attended group orientation sessions so they can learn more about how our company operates, including our commitment to quality, safety and continuous improvement.

A number of our newest managers and supervisors already have started our Leading Within Quad educational series, which teaches our corporate values and how we use them to drive business decisions. This series also helps our newest employees understand how to navigate the company so they can succeed.

From a total company perspective, the addition of Vertis enhances our ability to generate strong, sustainable, recurring free cash flow so we can continue to pay down debt and pension liabilities, invest in our business and return cash to shareholders. With that, I will hand it over to John, who will present more details on the quarter's financials.

John C. Fowler

Thanks, Joel, and welcome, everyone. Slide 10 is a snapshot of our first quarter 2013 financial results, including Vertis, as compared to our first quarter 2012 results. We remind you that we will report 2013 results from a total one company perspective because we feel it will be arbitrary to differentiate what is original Quad or Vertis EBITDA and what is synergy versus what are normal ongoing cost reductions required to be successful in the printing industry today.

Further, we want to remind you that 2012 results do not include the acquisition of Vertis, which occurred on January 16, 2013. Net sales were $1.1 billion as compared to $990 million, representing a 14% increase due to the acquisition of Vertis. Although, as I said, it is not practical to break out revenue and operating results, we did include first quarter 2012 pro forma revenue in our 10-Q. If we look at the Vertis business as if we acquired it at the beginning of 2012, our pro forma consolidated revenue declined 6.7%.

We knew when we acquired Vertis that it was a challenged business with an accelerating revenue decline due to its financial challenges, including its bankruptcy. We estimate that of the 6.7% pro forma revenue decline, Vertis represented approximately 3 points of the decline and our core business represented the remaining decline. This is consistent with our revenue expectations for both the quarter and the year that are inherent in our guidance.

Cost of sales was $910 million as compared to $773 million. SG&A expense was $106 million as compared to $92 million. Depreciation and amortization was $89 million as compared to $85 million. Restructuring, impairment and transaction-related charges were $26 million as compared to $38 million. Interest expense was $22 million as compared to $21 million. Our adjusted EBITDA was $114 million as compared to $126 million. Our adjusted EBITDA margin was 10.1% as compared to 12.7%. The adjusted EBITDA margin of 10.1% was as we expected and reflects a number of factors related to the Vertis acquisition, as well as continued industry pricing pressures.

The factors related to the Vertis acquisition include: Vertis's margin profile was historically lower than the profile of the Quad/Graphics core business. The seasonality of Vertis's business, which has volumes and profitability more heavily weighted in the back half of the year, where we see higher margins and continued downward pressure on Vertis margins due to pre-acquisition financial challenges including its bankruptcy filing. We remain confident that we will achieve our 2000 annual guidance, which includes implicit higher margins in the back half of the year and for the full year.

Our recurring free cash flow was $120 million for the first quarter of 2013 as compared to $107 million for the same period in 2012. The increase in our recurring free cash flow was primarily related to a $35 million improvement in working capital partially offset by a $7 million increase in CapEx and $15 million in lower cash earnings. The $35 million working capital improvement was driven by an estimated $70 million of additional cash generated from the restoration of normalized working capital related to the Vertis acquisition. This was partially offset by decreased working capital cash flows of $35 million, which was primarily driven by a $15 million decrease in cash flows due to higher inventory and a $12 million decrease in cash provided from working capital of the Canadian operations, which were sold during the first quarter of 2012.

We define recurring free cash flow as cash flow from operating activities, net of pension contributions, less capital spending and excluding nonrecurring items, such as restructuring costs. We believe this is an important metric for us and we expect our business to continue to generate a significant amount of recurring free cash flow. The reconciliation of recurring free cash flow for the 3 months ended March 31, 2013, is included in the supplemental information located in our slide presentation.

Looking ahead to full year 2013, we feel comfortable with our guidance for recurring free cash flow in excess of $350 million. Our strong recurring free cash flow provides us with the ability to pay down our debt and pension liabilities, invest in our business and return capital to our shareholders. The company increased consolidated debt and capital leases by $160 million during the quarter due to the $237 million in net cash paid for the Vertis acquisition.

Our interest coverage ratio was 7.0x versus 6.7x. After completing the acquisition of Vertis, our leverage ratio was 2.54x, as expected. We continue to believe that operating in the 2.0x to 2.5x leverage range is the appropriate target. However, we acknowledge that at times like this first quarter, we may go above that range given economic changes, working capital, seasonality, timing of investments like Vertis and growth opportunities.

At the top of Slide 12, you will note that we have $223 million of borrowings under our $850 million revolver as of March 31, 2013. Interest expense increased 2% to $22 million as a result of our debt increase of $160 million due to the $237 million in net cash we paid by -- for Vertis offset by free cash flow. Our floating rate debt today is at an average interest rate of 3%. Long-term fixed rate debt, consisting of private placement bonds continues to be at an average interest rate of 7.4% and has an average maturity of 10 years with a weighted average life of 6 years.

The blended interest rate on our total debt is 4.7% and the outstanding principal balances are 62% floating and 38% fixed. We have no significant debt maturity until July 2017. During the fourth quarter, we extended the maturity of our term loan A which had a balance of $439 million at quarter end, and our bank revolver by 1 year to 2017. Given the flexibility under our revolver and our strong free cash flow, we believe we have sufficient liquidity for current business needs, returning cash to shareholders and supporting future investments.

I would now like to turn the call back to the operator, who will facilitate taking your questions. Operator?

Question-and-Answer Session

Operator

[Operator Instructions] Your first question comes from the line of Jamie Clement.

James Clement - Sidoti & Company, LLC

First question maybe, John, if I could. I know you commented on this. I was getting caught between the slides. Of the roughly I believe it was $97 million of working capital kind of pre-investment, if you will, as part of the Vertis transaction, how much have you recaptured during the first quarter?

John C. Fowler

We estimated $70 million.

James Clement - Sidoti & Company, LLC

So it's almost already done?

John C. Fowler

Yes.

James Clement - Sidoti & Company, LLC

Now are you including that in your definition of recurring free cash flow for the year or are you not?

John C. Fowler

Yes, that's included.

James Clement - Sidoti & Company, LLC

That's included, okay. So then you're -- I was just surprised by the high level of "recurring free cash flow" during the quarter vis-à-vis guidance so, it just seems like absent that, you're basically following your typical seasonality, right?

John C. Fowler

Yes, I think, free cash flow was a hard thing to look at just the quarter because you've got just the noise around the timing of when CapEx is hitting, CapEx was higher this year. You have a little noise around last year was essentially the liquidation of the Canadian working capital. We had some higher inventory so you always have a little bit of noise. But both the recoupment of the Vertis working capital, as well as the other elements of free cash flow was basically what we expected for the quarter as we built the overall guidance in excess of 360 for the year, Jamie.

James Clement - Sidoti & Company, LLC

Got it, got it. And Joel, if I could change gears to you. If you could talk, I mean, obviously, there's secular changes going on in the industry but as you look at the cyclical factors that impact some of your larger business lines, and I don't know if we keep it to maybe to retail in the magazine and catalogs. If you want to expand beyond that you can feel free, but to the extent that you're noticing any kind of changes in terms of advertising and marketing, willingness to spend by your customers on some of these things, I don't know, first quarter is always hard to conclude anything but can you give us your initial takes on kind of what the year is looking like?

J. Joel Quadracci

Yes. I think that there's been a trend towards more stability. When I look at the magazine industry, for instance, on advertising pages, if you go back a year ago, first quarter 2011 to 2012, it was about a decline of 8.2% industry-wide. This year, they're reporting more like a 4.8% decline so quite a bit of an improvement there. But we always kind of look at our mix of publications and we call it sort of our Quad top 50. We've actually experienced more like a decline of maybe 1.5%.

James Clement - Sidoti & Company, LLC

And that's when you say top 50, that's top 50 customers?

J. Joel Quadracci

Top 50 sort of the magazine customers, so maybe a year before it was closer to a 6% decline. So better than the industry. A lot of it has to do with the mix of publishers we have. But we went from approximately 6% decline last year in the first quarter to just about 1.5% decline this year. And I think if you kind of break it down clearly, there's a lot of spend going on in sort of the luxury goods areas and some of the other categories are starting to take flight as well. But I think we continue to be cautious because visibility is still pretty tough to see. There are, I think, people are still kind of looking at this economy and trying to figure out how are things going to play out. But I guess first quarter so far so good. We've seen obviously a better stabilization and less decline by a pretty good margin. On the catalog side, I think the picture is stable year-over-year. I think things are flat when you look at total catalogs mailed and I think that's industry-wide as well as at Quad. And as I talk to customers, I think they're feeling that things have stabilized to a degree. I think depending on who you talk to, I mean, the spring's weather for both retailers and catalogs is probably throwing some of them for a little bit of a loop.

James Clement - Sidoti & Company, LLC

Threw them for a loop last year, too, just on the other side.

J. Joel Quadracci

Yes, I think the consistency of weather these days is all over the place.

James Clement - Sidoti & Company, LLC

Or the lack of consistency is consistent.

J. Joel Quadracci

That's probably more accurate. But again, I think you take that noise out of it, and I think the message is stable. We'll continue, though, I think as you know us, we're in a low growth economy and as much as the market's taking off and I think you read in the papers some good positive momentum on job growth, I think visibility is still hard to see, and I think there's a long way to go for this economy. Therefore, as a company, we will always sort of manage cautiously, especially when visibility from our customers is still pretty limited. But that's kind of the overview from what we're seeing.

Operator

Your next question comes from the line of Haran Posner.

Haran Posner - RBC Capital Markets, LLC, Research Division

Maybe just going back to Vertis and certainly appreciate you guys have decided to kind of group it in with the rest of the business but you were kind enough to give us the pro forma revenue trend in Q1. I was wondering if I could kind of push you a little bit further and see if you'd be willing to share kind of what the EBITDA contribution from Vertis was, if that's possible.

John C. Fowler

Haran, this is John. It really is impossible. I mean, essentially, a date of close -- between date of close and plants that we've closed since the acquisition, we've closed 6 plants. We've moved a significant amount of work around and really to try to break out what would have been legacy Vertis and what would its EBITDA have looked like had it been separate would just be impossible.

Haran Posner - RBC Capital Markets, LLC, Research Division

That's fair. So I guess, John, can I ask maybe because I haven't seen a quarterly breakdown of Vertis's results in 2012. And I guess from a seasonality perspective, you've alluded to that business being more seasonal than the core Quad and Worldcolor businesses. I guess I'm wondering if, when I look into Q2, is that more like Q1? Is that fair? And then kind of really the bulk of EBITDA as being generated in the back half?

John C. Fowler

The bulk of the EBITDA is going to be generated in the back half, historically, Haran. Q2 in the printing industry has probably been the softest. When you look at Vertis, the other thing you have to recognize that is accentuating some of the seasonality that we're seeing is that their business was deteriorating as it went through 2012, that was exasperated by the pending acquisition and their need to file the bankruptcy. So you also had this accelerating trend going into the year. Frankly, we were aware of that and we shared on the last call what we thought was going to be happening to their overall revenue of declining from approximately 1.1 to 1 as we acquired the business.

Haran Posner - RBC Capital Markets, LLC, Research Division

Okay, that's great color. And maybe staying with you, John, you did not provide in your presentation this quarter sort of a bridge to EBITDA. I was wondering if outside of the obvious Vertis dynamic whether there's any kind of factor that is worth pointing out?

John C. Fowler

No, there really wasn't anything that was unusual or unique in the quarter.

Haran Posner - RBC Capital Markets, LLC, Research Division

Okay. And then maybe just last one for me to follow up on the earlier question on working capital. So a few moving parts obviously but when you look for the full year in 2013, is there -- how should we think about that line I guess?

John C. Fowler

Well, I think -- Haran, are you asking as it relates to the recoupment of the remaining Vertis working capital?

Haran Posner - RBC Capital Markets, LLC, Research Division

No, I mean, I guess I can factor that in but you made some comments on the Canadian business, the investiture, so I guess I was just wondering.

John C. Fowler

No, I don't think there's anything unusual that we're going to see from a working capital point of view. Frankly, the sale of Canada that was completed in the first quarter of '12 essentially was like a liquidation of the working capital, so that becomes a one-time increase of the approximately $12 million to Q1 2012 working capital. But there's nothing else unusual as we look back to the other quarters of '12 or as we look at what's happening in '13 other than some, a little bit of additional recoupment of working capital as we normalize Vertis through the balance of the year.

Haran Posner - RBC Capital Markets, LLC, Research Division

Okay, that's perfect. And then, sorry, just maybe one last one. Just wanted to confirm that there's no changes or no material changes to any of your other cash guidance items like taxes CapEx and pension.

John C. Fowler

Correct, no change.

Operator

At this time, there are no further questions. Do you have any closing remarks?

J. Joel Quadracci

No. Thank you, all, for joining us. And we look forward to speaking to you again in August. Thank you.

Operator

This concludes today's conference call. You may now disconnect.

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