Quad/Graphics, Inc. (QUAD) Q2 2014 Earnings Report, Transcript and Summary

Good morning, ladies and gentlemen. Thank you for standing by. Welcome to the Quad/Graphics Second Quarter 2014 Conference Call. [Operator Instructions] I will now turn the call over to Kelly Vanderboom, Vice President and Treasurer for Quad/Graphics. Kelly, please go ahead.

Thank you, operator, and good morning, everyone. With me today are Joel Quadracci, our Chairman, President and Chief Executive Officer; and Dave Honan, Vice President and Chief Financial Officer. Joel will lead off today with key highlights for the quarter and an update on the acquisition of Brown Printing. Dave will follow with a more detailed review of our financial results, an update of 2014 guidance, followed by Q&A. 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. Our financial results are prepared in accordance with generally accepted accounting principles. However, this presentation also contains non-GAAP financial measures, including adjusted EBITDA, adjusted EBITDA margin, free cash flow and debt leverage ratio. We've included in the slide presentation reconciliations of these non-GAAP financial measures to GAAP financial measures. The slide presentation can be accessed through a link on the Investor Relations section of the Quad/Graphics website. There are also instructions on how to access the slide presentation in our second quarter earnings news release issued last evening. A replay of the call will also be posted on the Investor Relations section of our website after today's call. I will now turn the call over to Joel.

Thanks, Kelly, and good morning, everyone. Our performance for the second quarter was consistent with our expectations, and we remain on track to achieve our 2014 financial objectives. A key area of focus for our company during the second quarter was the acquisition of Brown Printing, a well-respected company that served premiere magazine publishers and catalog marketers with printing, distribution and integrated media solutions. We are pleased with our decision to acquire Brown, and all integration efforts are going well. I'd like to take a few moments to briefly revisit our strategy for acquiring companies like Brown. Our M&A strategy is focused on 2 types of acquisitions: expansion into higher growth print product categories, like packaging and specialty printing, through our recent acquisitions of Proteus and UniGraphic; and value-driven consolidation opportunities, like Brown, which support our strategy to transform Quad/Graphics and the industry and create value for our clients and shareholders. Consolidation opportunities create client value by enhancing the many ways in which we help them drive top line revenue, while reducing their overall total cost of print production and distribution, especially through volume-driven postage savings: programs like co-mail. As far as shareholder value, these types of opportunities create value through achieved synergy targets and incremental cash flow. These types of consolidating opportunities also support our strategy to maximize operational and technological excellence as we continue to transform our platform. We believe our platform is one of the most integrated, automated, efficient and modern in the printing industry. We strengthen our platform with targeted capital expenditures to improve platform efficiencies, as well as rationalize inefficient capacity that if left to operate indefinitely would further compress margins. Ultimately, this would work against our client base. In today's industry environment, pricing pressures are much more difficult to offset than volume fluctuations, which is all the more reason to close aging, inefficient and underutilized plants and equipment and transition work to the most efficient plants to maximize the capacity of the entire platform. Overall, our M&A approach is highly disciplined, and each opportunity must meet 4 criteria before we enter into an agreement. First, the company has to be a good strategic fit. Second, the economics need to make sense. Third, the integration plan must be executable in a timely manner and without risk of significant client disruption. And fourth, after the acquisition integration, we retain the financial strength and flexibility we had prior to the acquisition. We are committed to the integrity and strength of our balance sheet to ensure we are able to take advantage of opportunities as they arise. As far as Brown Printing, we were interested in making the acquisition for several reasons. First, it enhanced our position in high-quality publication and catalog printing and gave us additional volume to feed our co-mail programs that drives client savings opportunities. Given that mailing and distribution represents more than 50% of the total cost of producing and delivering a publication or catalog, our co-mail solutions continue to be a competitive advantage. In addition, publications represent steady year-round work. While ad pages fluctuate, overall circulation and print-run counts are relatively consistent, and the work integrates well into our existing platform. Notably, Brown's parent company was financially solid, which gave the printer the ability to regularly invest in its platform, including preventative maintenance. As a result, Brown's platform was in good operating condition unlike some of the other consolidating acquisitions we have done. Lastly, Brown has a talented employee base with deep roots in printing, as well as a great mix of healthy clients, which we believe we can retain long into the future. Our integration plans are well underway and include a strong focus on serving all of our clients well, while we are also improving the efficiency and productivity of our platform and driving future cost savings. As we do with all integrations, we take a holistic approach to measuring our success. Our key focus areas include financial metrics, client retention, employee integration and IT and platform integration. We are feeling good about all 4 of these focus areas as they relate to the Brown acquisition. Looking specifically at our employee integration efforts, we're spending time helping our new employees understand who we are and how we run our business. Integrating corporate cultures is one of the most complex and important efforts following any acquisition, and we are putting a strong focus on it. As far as employee benefits, our new employees will transition to our health and retirement plans on January 1, 2015, as planned. Also in January, they will begin receiving a matched contribution from the company to their 401(k). Historically, Brown, like most of the printing industry today, had not offered a 401(k) match. I am pleased that we can make this important investment a key differentiator for our employees and our company. I want to thank all of our employees for their help so far with the integration activities. Although there is still more work to be done, I am pleased with our progress and with the fact that we have proven expertise within our company to effectively integrate large, complex acquisitions. Before I turn the call over to Dave, I'd like to reiterate, our second quarter results were in line with our expectations, and we are proud of the progress we have made so far in the Brown integration. We remain confident in our future. And as always, we will continue to focus on our goals to transform our company and the industry; improve our client's experience with us each and every day; maximize our operational and technological excellence to achieve productivity improvements; empower, engage and develop our employees; and enhance our financial strength and create shareholder value. We are here for the long term, and we continue to make decisions in the best long-term interest of the company. With that, I will turn it over to Dave.

Thanks, Joel, and good morning, everyone. Slide 6 is a snapshot of our second quarter 2014 financial results as compared to our second quarter of 2013. The recent acquisition of Brown is included in our 2014 results since the date of acquisition on May 30. Accordingly, our 2013 results do not include the acquisition of Brown. Net sales were $1.1 billion, representing a 1% decline from 2013, which was consistent with our expectations and our guidance. Our adjusted EBITDA was $102 million as compared to $111 million, and our adjusted EBITDA margin was 9.3% as compared to 10%. The quarterly results reflect expected volume and price pressures, as well as an $8 million net decrease of adjusted EBITDA due to certain event-driven favorable gains in 2013 that did not repeat in 2014, such as the resolution of certain legal, environmental and Worldcolor bankruptcy matters. These decreases were partially offset by lower employee-related costs, including labor productivity improvements. We have updated our 2014 guidance to reflect the financial impact of the Brown acquisition. As a reminder, we previously disclosed that we expect the Brown acquisition to realize an adjusted EBITDA multiple of less than 4x the $100 million purchase price we paid after all synergies are realized. Going forward, we will measure our financial success from the Brown acquisition in a total one-company perspective, like we did with Vertis. The cost savings we have identified through our SG&A procurement and plant consolidation efforts will be reflected in our total company EBITDA as we progress through the integration and have been included in our updated 2014 financial guidance that I'll discuss shortly. As Joel mentioned, our integration plans are well underway. We recently announced 2 plant closures associated with reducing excess capacity and aligning the print volume to the most efficient plants in our platform. The plants are a former Brown facility in Woodstock, Illinois, near our Wisconsin network of plants; and an existing Quad/Graphics facility in St. Cloud, Minnesota near Brown's Waseca, Minnesota plant. Through these closures, we are rationalizing capacity and consolidating work where we believe we can achieve the greatest manufacturing and distribution efficiencies. Additionally, we have begun deploying our own proprietary brand of ERP software tools to our new manufacturing locations acquired from Brown in each East Greenville, Pennsylvania; and Waseca, Minnesota. This deployment will provide increased efficiency and operational visibility. And with the plant closures, we'll create a stronger, more unified platform to help us compete more effectively moving forward and better serve our clients. We have increased our guidance to reflect the contribution from the Brown acquisition, which was completed at the end of May. We anticipate that our net sales will be in a range of $4.8 billion to $4.9 billion, increased from our prior guidance range of $4.6 billion to $4.8 billion. Our 2014 adjusted EBITDA will be in a range of $535 million to $560 million, increased from our prior guidance range of $520 million to $550 million; our 2014 restructuring and transaction-related cash expenses to be in the range of $45 million to $65 million, increased from our prior guidance of $35 million to $55 million; our capital expenditures to be in a range of $160 million to $175 million, narrowed from our prior guidance of $150 million to $175 million; and finally, our free cash flow guidance remains unchanged at a range of $155 million to $165 million. This reflects the EBITDA contribution from Brown, offset by integration costs that are front-end loaded and higher capital expenditures associated with integrating the Brown acquisition. Year-to-date, free cash flow was in line with our expectations. We define free cash flow as net cash provided by operating activities, including pension contributions, less purchases of property, plants and equipment. Free cash flow was a negative $5 million for the first 6 months of 2014 versus $147 million for the same period in 2013. The variance is attributable to an estimated $77 million benefit we realized in the first 6 months of 2013 from the restoration of normalized working capital levels related to our 2013 acquisition of Vertis, which was acquired without normalized levels of accounts payable and accrued liabilities. The remaining variance reflects $54 million in higher working capital, primarily related to decreased accounts payable balances due to timing of payments between years, and $14 million of higher CapEx, which include a carryover project from 2013. We realized our strongest volumes in the back half of the year due to seasonality, especially in our retail advertising insert business. And as a result and consistent with our past, our free cash flow will be primarily generated in the fourth quarter of the year. On Slide 9, you will see our interest coverage ratio has increased to 6.8x at June 30 versus 6.7x at December 31. Our quarter-end debt leverage ratio increased to 2.69x at June 30 as a result of $176 million increase in debt in 2014 to fund acquisitions and strategic investments, such as Brown and UniGraphic, seasonal working capital needs and higher capital expenditures. We continue to believe that operating in the 2x to 2.5x leverage range is the appropriate target over the long term. But we may, at times like now, operate outside of this range depending on the timing of compelling strategic investment opportunities and seasonal working capital needs. Quad continues to be a significant cash generator. The Brown acquisition will further contribute to our cash generation after expending the upfront initial integration costs and, consistent with our past consolidating acquisitions like Worldcolor and Vertis, will help us deleverage our balance sheet over the long term. Since the close of the Worldcolor acquisition on July 2, 2010, we have reduced our debt by a total of $212 million. As it relates to our pension, postretirement and multiemployer pension liabilities, we continue to make progress in reducing the underfunded liability that was acquired as part of the Worldcolor acquisition. We have reduced that underfunded liability by $391 million and have a remaining liability of $156 million as of June 30. Slide 10 is a summary of our debt capital structure. As discussed last quarter, we completed our $1.9 billion debt financing in April 2014. Our new debt capital structure enhanced our company's financial flexibility by extending and staggering our debt maturity profile, further diversifying our debt capital structure and providing more borrowing capacity to better position Quad to execute on our strategic goals. This is consistent with our ongoing disciplined approach to maintaining a strong and flexible balance sheet from which we create value for all our stakeholders. Availability under our revolver is $767 million, and we have no significant debt maturities until April 2019. The weighted average duration under the debt capital structure is 6.1 years with a blended interest rate of 5.1%. Our fixed rate debt is at an average interest rate of 7.1%, and our floating rate debt is at an average interest rate of 3.2%. Total debt outstanding balances are now 50% floating and 50% fixed. We believe this balanced fixed-versus-floating rate debt structure will provide us with the financial flexibility we need over the long term. Given the financial flexibility of our revolver, we believe we have sufficient liquidity and financial strength to support our capital deployment strategy. We remain flexible and opportunistic in terms of our future plans for capital deployment, which includes balancing our key priorities to pay down debt and pension liabilities, invest in our business, pursue future growth opportunities and return value to our shareholders. One key way in which we return value to our shareholders is through our quarterly dividend program. Our next quarterly dividend of $0.30 per share will be payable on September 19, 2014, to shareholders of record as of September 8, 2014. I would now like to turn the call back to our operator, who will facilitate taking your questions. Operator?

[Operator Instructions] Your first question comes from the line of Jamie Clement with Sidoti. James Clement - Sidoti & Company, LLC: Joel, I was wondering if I could ask you some general questions about the magazine business, particularly, in light of Brown and kind of getting your long-term thoughts. Obviously, in recent months, some substantial trouble with a distributor, some comments out of a major magazine publisher related to that. Obviously, that's something you all would certainly have been aware of prior to buying Brown. I think that it seems like a lot of investors might perhaps overstate the volume that actually flows through the newsstand versus flows through the mailbox. So can you help us out on some of the basics of the magazine business, kind of magazine 101?

Yes. So only about 10% of the total volume we print for magazines goes through the newsstand. And I'll say that the newsstand infrastructure is rather archaic, and I call this sort of disruption that happened as sort of the 20-year car crash you could see coming. It's a structure that hasn't kept up with the times. And ultimately, people knew that it was going to be disrupted. In this case, Time Inc. made a decision -- a strategic decision about one of their suppliers, Unisource, which really put them into bankruptcy. It caused a short-term blip, which -- of volume, primarily on the West Coast, where suddenly, we had a lot of titles that had nowhere to go, and people kind of pulled back for a month or 2 here as the holes get filled, and it will get filled. So I would look at that distribution disruption as a pretty short-term phenomena. However, I think there is an opportunity in the industry right now, and many of us have been talking in terms of -- with our customers and such about, is this an opportunity to kind of redefine what the newsstand distribution infrastructure looks like? Because of -- through consolidation of printers and things like that, you can start to think differently about how you get product to market. But I said, I think it's important to note that, again, it's about -- total newsstand is about 10% of our volume. And of the disruption, it's a pretty small part, and it's a short-term disruption because it's -- the holes are already being filled. And then in just terms of magazine 101, when you think about volumes and what our plants are made up of, a lot of our long-time, large long-run plants have a mix of like retail, catalog, magazine. And it's important to note that there's differences in how these things perform throughout the year from a volume standpoint. When we think about seasonality of product and how we're very second-half focused, that's because that the selling season, back-to-school, Christmas, all the holidays, the retailers tend to put out a lot more retail inserts during this time. The catalogers tend to put out a lot more catalogs for obvious reasons and do more prospecting to create more customers. Magazines still have their subscriber base that stays relatively the same throughout the year. And so they are seasonal from the standpoint that the number of pages may fluctuate, but we're still going to print the same number of books throughout the year. And so what we like about the Brown acquisition is it continues to help us manage our portfolio of product within the mixed plants that we have, which are significant to manage that capacity. And so we also believe very strongly that magazines are here to stay. I mean, if you have a chance, I'd go online to Bloomberg and look at the recent interview they did with David Carey and Michael Clinton from Hearst. David is the President, and Michael is in charge of Marketing, the Marketing Director. And my favorite quote is, "Print is the economic foundation of our business." Now this is a company that's also doing a lot of stuff on the digital side and I think doing a great job of figuring out that mix between traditional and online. Condé Nast is doing a lot of the same stuff. Time Inc. is doing a lot of the same stuff. And if you listened to Time Inc.'s call yesterday, they talked a lot about the opportunity on the digital side of growing -- it's growing like 15%. That's because, I think, when they were a part of the parent company, they were probably a little bit underinvested in, in terms of making use of all these. And as you know, Jamie, I've been a big proponent, in whatever is related to marketing, that all channels will be used. Again, if you're mailing a magazine or a catalog to Steve from Hawaii, no longer is it about just being Steve is a person from Hawaii. Now it's about Steve being a surfer who likes certain types of products. And let's take that data and make sure that we're really speaking to them, whether it's in conjunction with our advertisers, our editorial or what catalog content and messaging you play to him or what experience they have on mobile device as they're interacting with your brand. And so I think -- I'm kind of long-winded here, but I think for those who don't know us and don't know magazines, I think it's a great question you ask because each one of these categories brings a different thing to our plant, which helps us with running the efficiency of our overall platform. James Clement - Sidoti & Company, LLC: I -- Joel, I appreciate that. And I have 1 last question, and then I'll let somebody else get on. If I just sort of take what you all have said about kind of long-term volume trends, long-term price trends and then maybe subtract another 2% based on the USPS from earlier in the year and make some assumptions on Brown, it looked like the quarter was better than what those numbers would have added up to? Is my math wrong?

Jamie, this is Dave. No, your math's right. I think as you look at our guidance that we gave at the beginning of the year, we talked about pricing impact on the business of down 1% to 2%. Now we had also referred to -- we had a larger-than-normal renewal period in 2013 that impacted pricing for '14, and that was about double what we typically had for renewals. If you pulled that out of pricing, it would have probably been down below 1% decline. And then from a volume perspective, we talk about volume down 1% to 3%. I think when you add those 2, we're at the lower end of that when you back out the impact of Brown. Now Brown, we've owned them since May 30, so 1 month in the quarter, and we immediately started integrating that business to our existing plant structure. We announced the 2 plant closures that I've mentioned in my prepared script. So you lose visibility to where all that volume moves in terms of what was owned before the acquisition, after the acquisition. That's why we talk about we're going to look at this on a one-company basis and not be able to split it out. Our best estimates, though, if you tried to split it out in the month of June, was that Brown contributed about $25 million. James Clement - Sidoti & Company, LLC: That sounds about right, yes.

Yes. And so when you look at that, and you add that on to the -- it would say we were down in the upper-2% to low-3% for the quarter, which is right in line with where we expect it. And again, the first 2 quarters of a year are just not going to tell you how the full year is going to be when you're so seasonal like we are with the third and fourth quarter. So with that, we like where we're at coming through 2 quarters because you certainly -- the first 2 quarters of the year can certainly blow up a year for you, but it's not going to make a year for you. We're coming out feeling pretty good about where we're coming for the first 2 quarters. We got a lot going on in the back half of the year, but we feel positive about what we see in the business.

And Jamie, just to add on, because you mentioned the post office. I think there's some reason for optimism in sort of an ultimate fix here. The 6% increase is here to stay for the year. So as we said, if we see an impact, we think that will be second half. On the other hand, as you sort of hear rumblings of an improving economy, we're also anecdotally seeing people reinvest in their marketing plan. Some people thinking about pulling back because they can't find the cost, but -- so it'll be a little bit hard to see until we actually get further into the busy season. But I will say the industry, my reason for some optimism on an ultimate fix is the industry, I think, has taken a great approach and come up with an agreement or at least a common approach with all 4 unions of the post office to move forward with a bill that ultimately fixes it and addresses most of the main structural issues of the post office. And we've been working with both Reid and Boehner to try and get this thing going. So I think from a standpoint of an ultimate solution with enough support to do it is really developing nicely. I'll counter that with the dysfunction of Washington on when they will actually do something. James Clement - Sidoti & Company, LLC: Sure. And we've got elections coming up and all of that.

Yes, yes. So we're a bit like attached to that. But I'm more optimistic than I've been, about getting to a better long-term solution to fixing the post office. That being said, we're going to not take our foot off the gas pedal in really working that issue.

Your next question comes from the line of John Leonard with Singular Research.

I have 2 questions. I'll just go to one at a time. First, in their earnings release last week, our RR Donnelley noted some pockets of strength and they reiterated guidance, which, along with your results last night, I think, provides evidence that the industry fundamentals are really better than implied by the valuations. And my question is, are you seeing similar pockets of strength in your business? And if so, where? And which segments do you think are really going to be the main growth drivers going forward?

I think -- again, I think Dave kind of pointed to some of it when we talked about some of -- if I start with pricing, we have been guiding to 1% to 2% declines in pricing per year, and we've experienced that. But again, I know you're new to the story. One of the things that happened in '13 is we had twice the amount of contracts come due than is our normal runoff. And so those were mark-to-market hitting 2014 here, so that's been a little bit of headwind for us because you can't always pull the cost out at the same pace that that's kicking in. But if you took that out, our pricing decline was less than 1%. So at the lower or low end of what we had been talking about. So I think that's reason for some positive feelings. When you think about volumes. Volumes, they're going to be a little bit all over the place in terms of where people are, but we've guided to 1% to 3% volume declines, which is a rather manageable number because, again, that's about matching capacity with demand. It's the pricing side that -- where you really have to have the best platform, and that's why we've focused so much on making sure that the most efficient plants are really fully utilized, while also, as we close these outdated plants, making sure we melt that equipment down because while it's still mechanically viable, it's not economically viable either for us or for our clients, quite frankly. And so we continue to see that marketing, in general, is -- people are realizing that it's a mix of everything. For a while, we spent most of our time trying to explain why print isn't dead, and I think the world is starting to realize that, and it's really about the combination of all of it. So we've seen continued interest and focus on how do retailers do more direct mail, how do they do more aggressive things with in-store signage. Magazines, again, I think, are here to stay. I think you'll see continued consolidation. But as people like Time Inc. -- I think one of the benefits of Time Inc. being spun out is now they can kind of be in control of their destiny and, hopefully, reinvest in content because I think some of it -- some of what's happened in some part of the industry when things are tough, it's easy to deinvest in the quality of what you have. And while their properties are very high quality, I think, in general, the industry is reinvesting in it, but also getting more savvy about multichannel. And so again, I think the big challenge is long-run print. You're still -- we still plan for that, call it, the 1% to 3% decline. But I think there's a lot of good things going on to kind of say that we're starting to see some stability.

Okay. Great. Just the second question is regarding acquisitions. Are you considering any more bolt-on acquisitions in the near term now that you've got Brown under your belt? Or are you really going to be focusing on integration for the next few quarters?

Believe it or not, I mean, we've really developed a very strong capability in integration. And Brown, we've done a couple of acquisitions this year, a couple of small bolt-ons, but Brown is still significant a size, but not nearly as big as what Vertis and Worldcolor was. And so you're -- we're really talking about -- with -- they came with 3 plants. We're closing 2, one of theirs and one of ours. All -- the playbook's already being played out. The teams are focused on it. There are separate teams than would have been focused before. And so it's not the integration that drives our ability of whether or not to take advantage of M&A. We can definitely -- we can actually execute on multiple fronts at the same time. It's really whether or not the acquisition would make sense for us. And I think we've done a really good job of walking the line of being patient and not being too patient or not being patient enough because, for instance, Brown, this wasn't the first conversation. And so we played over time, maintained a good relationship with the parent company. But after they lost some work because it is a very competitive environment, they started to understand where we were coming from, from a valuation standpoint. And so I think we played that well. Vertis was -- I think, 3 times we had conversations with them. So just because something's available, we're not like quick to go acquire them just because they have a client list or something like that. It's really about the disciplined approach to our use of capital that, is it integratable? There's a lot of things out there we've looked at that we just don't think you can integrate well. And then do we really need to do it? Or can we acquire them one client at a time? And so there's a lot of work that we do, because we do compete in a pretty fragmented marketplace, to continue to take the strengths we have and bring them to bear on bringing on market share. And scale does matter here because in the places we play, having that ability to distribute varied [ph] cost effectively is a big deal. Being able to invest in sort of tool sets and efforts on multichannel and how print links to it is a big deal. And when you look at the fragmented competitive set out there, it's harder and harder to not have scale. So -- and the other thing is, as we say, we will also look for other opportunities in more growth areas like commercial, like in-store, like packaging and other things. So we're always looking. But again, we're pretty disciplined about it, and we also got to make sure that we got the managerial capital to focus on it. And like I said, I think that we're in good shape there because we've honed our process for integrating companies so well and have such a big team who have been part of it that we've grown more and more talent, who are able to take on these challenges.

At this time, there are no further questions. I will now turn the call back over to Joel.

Great. Well, thank you, all. Again, we look forward to coming back to you in the next quarter, and we'll have more color on how the year is going as we get into our real busy season. Thank you.

Ladies and gentlemen, this does conclude today's Quad/Graphics conference call. Thank you for your participation. You may now disconnect.