Quad/Graphics, Inc. (QUAD) Q2 2016 Earnings Report, Transcript and Summary

Good morning, ladies and gentlemen. Thank you for standing by. Welcome to the Quad/Graphics second quarter 2016 conference call. During today's call, all participants will be in listen-only mode. [Operator Instructions]. A slide presentation accompanies today's webcast and participants are invited to follow along, advancing the slides themselves. To access the webcast, follow the instructions posted in last night's earnings release. Alternatively, you can access the slide presentation on the Investors section of Quad/Graphics website under the Events & Recent Presentations link in the left-hand navigation bar. Following today's presentation, the conference call will be opened for questions. [Operator Instructions]. Please note this event is being recorded. I will now turn the conference over to Kyle Egan, Quad Graphics' Manager of Treasury and Investor Relations. Kyle, 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, our Executive Vice President and Chief Financial Officer. Joel will lead off today's call with key highlights for the quarter and Dave will follow with a more detailed review of the financial results 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 have included in the slide presentation, reconciliations of these non-GAAP financial measures to GAAP financial measures. A replay of the call will be available on the Investors section of our website shortly after we conclude. The slide presentation will remain posted on Quad/Graphics website for future reference. I will now hand the call over to Joel.

Thanks Kyle and good morning everyone. We are very pleased with our second quarter results which reflect our ongoing efforts to improve manufacturing productivity and sustainably reduce cost. Adjusted EBITDA, adjusted EBITDA margin and free cash flow, all increased organically compared to the same period in 2015. Given these better-than-expected results, we are updating our full-year 2016 guidance which includes increasing adjusted EBITDA and free cash flow. Our results were made possible by our disciplined and consistent approach to managing all aspects of our business. We will continue to be disciplined to minimize the impact of ongoing industry and economic pressures to be the industry's high quality, low cost producer. On our path forward, we remain true to the strategy and plans we outlined long ago. As you will recall, we started addressing industry overcapacity in 2010 following the World Color acquisition. Through a series of additional consolidating acquisitions, we were not only able to expand our product and service portfolio, but create what we believe to be the most efficient and automated manufacturing and distribution platform in the industry today. With no recent acquisitions or integrations of size, we have been focused on fine tuning our platform, bringing aboard talent to strengthen and expand our integrated product and service offering and improving the client experience. We continue to see positive results from our key areas of focus in 2016, the first of which is continuing to generate sustainable, strong free cash flow to support our disciplined capital deployment strategy. This strategy includes paying down debt and pension liabilities and returning capital to shareholders through our sustainable quarterly dividend. Second, we continue to improve manufacturing productivity and create sustainable cost reductions and operational efficiencies. Our clients benefit by having their work produced on a highly automated, well-maintained and dependable platform. Third, we continue to focus on strengthening our balance sheet through debt reductions. Our debt leverage ratio improved significantly in the quarter due to our disciplined approach to paying down debt and today we are within our targeted leverage range of two to 2.5 times. Most importantly, we continue to focus on enhancing and expanding the value we create for clients as a printer and marketing services provider. We help our clients perform better in an ever changing media landscape in two significant ways. First, we help clients improve their own internal process efficiencies to reduce their overall production and distribution cost and accelerate speed to market. To identify process efficiencies, we create significant cost savings for our clients. This not only helps them improve their bottom line but also provides them with the ability to reinvest the savings into revenue generating activities. In May, Cabela's, the world's foremost outfitter of hunting, fishing and outdoor gear expanded it's more than 25 year relations with us by transitioning its in-house creative services to BlueSoho, our integrated marketing agency. These services include design, copywriting and production as well as photography and videography for the outfitter's catalog, advertising and online presence. Based on our history of working with retailers, both large and small, we are confident in our ability to help Cabela's realize tremendous process efficiencies. The second way we help our clients is by improving the effectiveness of their marketing spend through solutions that coordinate and measure the strengths of multiple digital and traditional channels to increase engagement, response and therefore revenues. We have more than 30-plus years of expertise in data driven marketing and we leverage that expertise to create timely, relevant and consistent experiences using multiple channels. We see a convergence taking place within marketing with channels becoming more integrated and interdependent. Now more than ever, marketers and publishers are looking for a single partner to help them orchestrate and measure the effectiveness of their marketing efforts across all channels. We are that partner. By leveraging and integrating data, we are able to better inform our client's marketing decisions. As a result, clients can more effectively coordinate the strengths of different channels and thereby increase the return on investment for each dollar they spend on marketing. To strengthen our multichannel offering, we recently made a minority investment in Rise Interactive, a well-established award-winning digital marketing agency, with whom we have a long-standing relationship. Our partnership combines Quad's expertise in optimizing a client's marketing spend in off-line channels, with Rise's expertise in online channels to create a more integrated powerful marketing campaigns bridged by the expertise we already have in place with BlueSoho. In short, we have fortified our ability to help clients drive consumers to the door and track their behavior in the store, whether brick-and-mortar or online and then use that information to refine marketing strategies and increase responsiveness on into the future. As we move forward as a printer and marketing services provider, we will continue to listen to our clients and develop ways to make it easier for them to understand and measure true ROI through integrated solutions. But before I hand the call to Dave, I would like to take a brief moment to recognize and thank all of our employees who are part of Quad's 45-year legacy of finding a better way. We just celebrated this milestone anniversary on July 13. Through our employees' focus and determination, we are achieving exactly what we set out to achieve. To our employees, I say thank you for all who have done and continue to do increase productivity, reduce waste and control costs, while working safely and delivering an excellent client experience. You give us all reasons to be Quad Proud. With that, I will turn the call over to Dave.

Thanks Joel and good morning everyone. As Joel mentioned, our second quarter results reflect continued progress in reducing our cost structure through operational efficiencies and a relentless focus on cost reduction initiatives throughout Quad. This allows us to maximize cash flow and strengthening our balance sheet through debt reduction. Slide four provides a snapshot of our second quarter 2016 financial results as compared to 2015. Our revenue came in as we expected for the quarter as net sales were $1 billion, down 2.6% from 2015, primarily due to ongoing industry volume and pricing pressures. Second quarter adjusted EBITDA increased $6 million or 7% to finish the quarter at $98 million as compared to $92 million in 2015. Our adjusted EBITDA margin improved 80 basis points to 9.5% versus 8.7% in 2015. The increase in adjusted EBITDA and margin primarily reflect ongoing improvements in manufacturing productivity which drove operational and administrative efficiencies and sustainable cost reductions as part of our previously announced and implemented cost reduction program. Our strong free cash flow generation in the quarter of $93 million represents a $75 million increase or over four times the level of free cash flow generated in the second quarter of 2015 and continues to be the foundation of our disciplined capital deployment strategy. Our free cash flow was used to reduce debt levels and in conjunction with increased earnings resulted in a significant improvement in our debt leverage ratio to 2.43 times as of June 30, well within our long-term targeted leverage range of two to 2.5 times. On slide five, we included a summary of our updated 2016 financial guidance. The productivity and cost reduction momentum established in the first half of the year is driving stronger earnings and cash flow results and therefore allowed us to increase our guidance. Full year 2016 net sales are expected to be in the range of $4.35 billion to $4.45 billion, reduced $100 million at the midpoint of our guidance. This reduction solely reflects a reclassification of byproduct proceeds out of revenue and into cost of sales to be treated as a reduction in material cost. This treatment is consistent with how other companies in the industry classify these transactions. It better matches the byproduct proceeds with the underlying cost. We previously discussed this change on our first quarter call and while the reclassification had no impact on earnings, it is the reason for the reduced net sales guidance. Full year 2016 adjusted EBITDA is expected to be in the range of $460 million to $500 million, increased $40 million at the midpoint of our guidance. As previously mentioned, the increase in earnings is primarily attributed to operational efficiencies and continued cost reduction momentum. Full year 2016 free cash flow is expected to be in the range of $230 million to $270 million, also increased $40 million at the midpoint of guidance. This $40 million improvement in free cash flow reflects our improved earnings and continued working capital improvements. Other guidance changes include full year 2016 interest expense to be in a range of $75 million to $80 million, a $10 million reduction due primarily to lower debt levels. Full year 2016 cash taxes to be in a range of $20 million to $30 million, increase $15 million due to our higher profitability levels. And full year 2016 pension cash contributions to be approximately $25 million, increased $5 million due to a discretionary pension contribution we elected to make to improve on the funded status of the plan and reduce future plan expenses. On slide six, you will see a summary of our year-to-date free cash flow, which we define as net cash provided by operating activities including pension contributions less purchases of property, plant and equipment. We generated $179 million of free cash flow through the fist six months of 2016. This represents $139 million or 350% increase over 2015, primarily due to $72 million in cash generated from sustainable reductions in ongoing controllable working capital levels, primarily from improvements in our order to cash revenue collection cycle. It also represents a $24 million increase in adjusted EBITDA and $43 million in reduced capital expenditure needs. The reduction in capital expenditures is not a matter of reducing investment in our platform, but the result of decreasing needs. We have completed much of the required catch up investments in our platform over the previous five years, much of which was to consolidate, integrate and improve the efficiency of acquired facilities. We have been able to reduce our capital expenditures from a rate of 3% of net sales to 2%. Even at our current level of investment in the platform, it is nearly double the industry average. It allows us to continue to build on what we believe is the most efficient, automated and dependable manufacturing and distribution platform in the industry. We continue to be a significant free cash flow generator and as indicated in our revised guidance, we expect to finish the year with free cash flow in the range of $230 million to $270 million. The midpoint of our free cash flow guidance represents a $35 million or 16% increase over 2015 free cash flow. On slide seven, you will see that we ended the second quarter with just under $1.2 billion in debt and capital lease obligations. We continue to remain focused on strengthening our balance sheet through debt and pension reductions. Our strong free cash flow has enabled us to reduced debt by $323 million since peak debt levels at September 30, 2015. This represents a 21% reduction in debt over the past nine months and a corresponding decrease in our debt leverage ratio of 64 basis point to finish this most recent quarter at a leverage ratio of 2.43 times. This is well within our long-term and consistent policy of targeting two to 2.5 times leverage. We will continue to focus on debt reduction as the primary use of cash and continue to believe that operating in the two to 2.5 times leverage range over the long-term is the appropriate target. As a reminder, we may operate outside this range depending on the timing of compelling strategic investment opportunities and seasonal working capital needs. Another way in which we are strengthening our balance sheet is reducing our unfunded pension liability, which totals $173 million as of June 30. As a reminder, the pension plans are frozen plans, acquired as part of the World Color acquisition in 2010 and were underfunded at the time of acquisition by $562 million. We have worked diligently over the past six years to improve the funded status by $374 million. As part of our ongoing efforts to continue to derisk and reduce this pension liability, we recently provided certain eligible participants the option to receive a lump sum pension settlement payment. Approximately $80 million of pension liabilities were settled as part of this program for $63 million in payment. These payments were made directly from the pension plan assets and did not require further contributions from Quad. The net result of the lump sum plan was to continue to derisk and reduce the ultimate unfunded viability in a cash efficient manner. We will report a noncash settlement charge of approximately $7 million during the third quarter in connection with the pension plan's lump sum payment program. Slide eight is a summary of our debt capital structure as of June 30, 2016. Available liquidity under our $850 million revolver under our most restrictive financial covenants was $644 million and we have no significant maturities until April 2019. The weighted average duration under our debt capital structure is 4.4 years with a blended interest rate of 4.7% and our debt capital structure is 62% floating and 38% fixed. Given the flexibility under our revolver and our strong free cash flow, we believe we have sufficient liquidity for our current business needs including investing in our business, pursuing future growth opportunities and returning value to our shareholders. Slide nine shows our commitment to our dividend which is a key way in which we return value to our shareholders. Our next quarterly dividend of $0.30 per share will be payable on September 9, 2016 to shareholders of record as of August 29, 2016. We have consistently paid out a quarterly dividend and our annual dividend of $1.20 per share is yielding approximately 5%, but represents less than 25% of our free cash flow at the midpoint of our guidance. Our results through the first six months of 2016 were strong and have provided us with an opportunity to increase our earnings and cash flow guidance. As we move into our seasonally busiest time of the year, we will continue to be diligent in our focus on driving operational productivity and sustainable cost reduction. This will help offset the impacts of topline pressures and reinforce Quad as the industry's high quality, low cost producer. Equally important, we will remain focused on serving our clients well. Through our long-standing one company unified approach, we help clients more easily coordinate and measure their efforts across online and off-line channels while providing them with single source simplicity and the consultative expertise they covet as they deal with the challenges and opportunities of today's multichannel marketplace. And with that, I would like to turn the call back to our operator who will facilitate taking your questions. Operator?

[Operator Instructions]. And our first question will come from Jamie Clement of Macquarie.

Gentlemen, good morning. Thanks a lot for taking my questions.

Good morning Jamie.

Good morning Jamie.

Hi Joel. Okay. So for a topline decline of 2% and change, I think you may have had, I guess the Specialty Finishing was that August of last year? So you would have had a little from them in the second quarter but most of that should be organic apples-to-apples, right?

Yes. The second quarter, if you really threw it all, the 2.6% decline approximates the volume and pricing pressure on our organic base. We did have negative impacts from FX and negative impacts from pass-through paper sales and that was completely offset by the incremental acquisition from specialty packaging. So those two --

Yes. So basically what I am getting at though is, if you are looking at, if the long-term trend, as you guys have described, it is volume minus 2% to 4% or 35 to 4%, there was another 1% to 2% on price, this is one of the best topline quarters I think we have seen in actually a while from an organic standpoint. I mean the big deal is obviously cost and obviously you called that out, but what were the positive and negative puts and takes, Joel, as you saw from a product line perspective?

Let me just jump in real quick, Jamie and I will turn it to Joel.

Sure.

You absolutely read that right. It is a lot of hard work internally done to reduce the cost structure, improve productivity in the plant. That's what's while driving the strong earnings and the free cash flow result. But I would point out too, as some people read our guidance on revenue and said, well that's a reduction in guidance and it's really with the reclassification of taking byproduct revenue, our guidance wouldn't have change. That's purely a reclassification from the topline to the cost of sales.

And Jaime, I think we have been very consistent about our view of the marketplace and also the economy. I mean I wish we were surprised that second quarter GDP was as light as it was, but I think I even referenced in the first quarter that I was a little bit skeptical about the headlines were saying about the underlying economy. So we know we are going to continue to deal with that and therefore the continued pressure on the industry, it just hasn't changed. If I look at the magazine industry, they continue to have in the quarter about 9% reduction in ad pages. In our mix of work which tends to be a little bit different, only a 6% decline.

But Joel, 9% is a lot better than 11.5%.

Yes. Well, it is. And then I think we have a pretty good high-quality mix of types of publications that changes our mix. And even printing catalogs, they were off a little bit as an industry, but we were actually up a little bit. And there is stuff going on with the post office and things like that that I think will start to stabilize some of those costs. And then printed books continues to be the story that people thought it was --

Because that was going to be my second question.

The industry was up 6% in the quarter.

Yes. And you all have been, obviously you didn't get Courier but you did commit to a multiyear CapEx plan to increase the digital platform and all that kind of stuff and presumably you learnt a lot about books through the Courier process. So can you talk a little bit about books? Like where are we with respect to how the percentage of the way through of your spending is and how well rolled out all that stuff us?

To be clear, we understood, the opportunity of books because we knew that digital was going to play a big role, but everyone that meant digital substitution, when in reality we believed it would be about platform change with the impact of the quality of digital printing where the industry's waste could start to be impacted dramatically. The book industry has a lot of unsold product that sits in warehouses. Lots of cash tied up because that's what the technology allowed you to do. But now you get digital printing in place and suddenly you can do much smaller batch sizes and you are pruning the inventory. So we actually committed to the investment in the digital platform in books before we even started talking to Courier. If you remember, we announced them separately, but Courier was a platform we would have loved to have it. We didn't get it. But I think it's a good indication that the industry as a whole is helping address that sector's opportunity with using technology. It's not just us, it's other people in the industry. And that's a good thing for the long-term viability of print.

So Joel, your CapEx spend in books, is that all done? Is that rolled out across your platform? Or you still have more to go?

Well, look at all areas of our business. Remember, I think we have been consistent on this, is we will keep investing into our customers and that means investing in furthering the book platform, whether it be digital or even some traditional assets. But also in terms of automation in the core business of amazing catalog retail the more we can the cost reduction sustainable and the more we can pull waste out, that creates the opportunity to then harness what the true power of print is with what's going on in multichannel. And so while we like to focus on the cost reduction we have done, we have said that chapter one was the organic growth, chapter two was about consolidating the industry and doing the heavy lifting to redesign what was more than a $4.7 billion platform, if you take into account the divestiture of the Canadian assets. So we literally redesigned the entire $4.7 billion worth of capacity over the past six years, which by the way, wasn't for the faint of heart. This was not easy nor quick as people looked at what we are doing. Chapter two was very busy time that you wouldn't always like to hearing in our results, but ultimately with a long-term view, as we are as a family based company, we believe that we have been making the right decisions. And quite honestly and we have been very consistent about that message. And so now, as you see the stabilization of the platform which is happening, you are seeing the fact that in 2015 we didn't have to do a lot of integration, we could step back and look at what we assembled and fine tune it. At the same time we could switch to chapter three which was about impacting people's topline. And that's the exciting thing that's happening regardless of what happens with the economy. In fact, the worse the economy, the more pressure our customers have and the more opportunity we have because we are a big line item in their cost. Therefore we get access to the right people and as we look multichannel, by the way, we call it multichannel, because the world tends to use omnichannel which is an often used buzzword. And they seem to think that's more Facebook through Twitter whereas AM radio is still alive. So it's really the marrying up of online and off-line that chapter three is about. And with print being a big core of that, it allows us to really help customers tie things together. Again, I think you have to look at multichannel being, what is the impact of one channel to the other because none of these can act in a vacuum. And so we are proving that by tying together brand awareness that can happen in print with activates that can happen online.

Very good. Thank you very much for your time. I appreciate it.

All right. Any other questions, operator?

No. Actually this concludes our question-and-answer session. I would like to turn back the conference to Joel Quadracci for any closing remarks.

Well, look, we thank you all for joining us. And I just want to remind you, we are doing what we say we are going to do, but also we continue to look towards the future as continue pressure on our customers and economy and so while we are showing great results today, we expect to continue that momentum on the cost side and manage what's within our control and be ready and willing and able to deal with whatever comes our way that's not in our control. So thank you for joining us and we will see you next quarter.

The conference is now concluded. Thank you for attending today's presentation. You may now disconnect.