Quad/Graphics, Inc. (QUAD) Q3 2016 Earnings Report, Transcript and Summary

Good morning, ladies and gentlemen. Thank you for standing by. Welcome to the Quad/Graphics third 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 Web site 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 that this event is being recorded. I will now like to turn the conference over to Kyle Egan, Quad Graphics' Manager of Treasury and Investor Relations. Kyle, please go ahead, sir.

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 Web site shortly after we conclude. The slide presentation will remain posted on Quad/Graphics Web site for future reference. I will now hand over the call over to Joel.

Thanks, Kyle and good morning everyone. We are pleased with our third quarter performance and remain on track to achieve our 2016 financial objectives. We continue to be disciplined in how we manage all aspects of our business to minimize the impact of ongoing industry and economic pressures and be the industry's high quality, low-cost producer. Adjusted EBITDA, adjusted EBITDA margin and free cash flow, all increased organically and top line results for the quarter came in as we expected. As we move forward, we will continue to improve productivity and operational efficiencies across our platform and match our platform capacity to our topline revenue. Quad's culture of continuous improvement translates into a culture of ongoing sustainable cost reduction. Due to industry pressures, continuous improvement is our way of life not a once a year initiative and is woven into the fabric of our company. This culture was evidence following our announced $100 million cost reduction plan last year, which we exceeded. Our disciplined approach to continuous improvement also drives our ability to generate sustainable strong free cash flow which allows us to support our disciplined capital deployment strategy including paying down debt and pension liabilities and returning capital to shareholders for our sustainable quarterly dividend. Our focus to strengthen to our balance sheet has translated into continued improvement in our debt leverage ratio. As of September 30, our debt leverage ratio was 2.37 times, well within our targeted leverage range of 2 to 2.5 times. We also continue to remain focused on transforming our business through new and innovative solutions that will make it easier for our clients to understand and measure the through ROI of their media spend through integrated solutions. As a global printer and marketing services provider, Quad/Graphics now holds a truly unique position in the industry. Through our highly integrated end-to-end solutions, we help clients improve both the efficiency and effectiveness of their media spend across channels. Creating efficiencies for our clients includes helping them improve their own internal processes to reduce their overall production and distribution costs and streamline the creation of content regardless of the channel through which it will be distributed. When it comes to marketing spend effectiveness, we help better inform and measure our clients marketing decisions across print, digital, social, mobile and other channels. Accordingly, clients can more effectively coordinate the strengths of different channels and increase the return on investment for each dollar they spend on marketing. Our recently announced partnership with Rise Interactive combines Quad's expertise in optimizing our clients marketing spend in offline channels with Rise's expertise in online channels to create more integrated powerful marketing campaigns, bridged by the expertise we already have in place with our BlueSoho integrated marketing agency. Lastly, I want to share how we are transforming our company through ongoing investments in our core business to create further value for our clients. For example, just last week we announced how we are transforming our Dallas commercial facility through strategic investment in digital presses, finishing technology and expanded kit packing and fulfillment solutions. This transformation will help us better serve the next generation of marketers and [van] [ph] owners in a variety of verticals including retail, travel and hospitality, fast casual restaurants and automotive. In recent years we also have made significant investments in digital presses to help direct marketers and book publishers meet their business goals. In the direct marketing space we are helping our clients gain a competitive advantage with data driven, hyper-personalized print marketing that is impactful, cost effective and delivers maximum return on investment. Our best-in-class solutions help marketers perform better while also reducing the production and distribution cost. In the book space, we are producing and delivering books on demand, bringing zero inventory and just in time delivery closer to reality. In 2017, we will continue to invest in our book platform to match our client's portfolios of products and redefine the book supply chain through increased customization and versioning capabilities, faster time to market, reduced waste, inventories and obsolesce and lower fixed cost. Before I hand the call over to Dave, I would like to recognize and thank all of our employees who continue to work hard in finding a better way, especially during our busiest time of year. Through our employees focus and determination, we are achieving exactly what we set out to achieve. Every day we are making progress on increasing productivity, reducing waste and controlling cost while delivering an excellent client experience by a truly integrated offering. With that, I will now hand the call over to Dave.

Thanks, Joel, and good morning, everyone. As Joel mentioned, our operational efficiencies and cost reduction programs have propelled us to stronger adjusted EBITDA and free cash flow in 2016, allowing us to further strengthen our balance sheet through debt and pension liability reduction. Our team continues to be focused on proactively matching our cost structure to the realities of the top lines pressures we face in our industry. As Joel mentioned, we are on pace to achieve more than $100 million in productivity improvements and cost reductions in 2016, which allowed us to increase our earnings and cash flow guidance earlier this year during our second quarter call. Our focus moving forward is to drive sustainable, continuous improvement programs to reduce cost by a minimum of $60 million annually. To ensure we meet our minimum cost reduction targets, we identified projects in excess of $60 million to deal with the changing nature of our operating environment, such as competitive pressures on starting wages and from newly enacted government mandates under the Fair Labor Standards Act, both of which result in higher labor cost for us. Our disciplined continuous improvement process allows us to react to these changing dynamics and helps drives us to our goal of a stabilized level of earnings and cash flow. Slide 4, provides a snapshot of our third quarter 2016 financial results as compared to 2015. Our net sales for the quarter were $1.1 billion, down 7%. Organic sales declined 4.6% due to ongoing industry volume and pricing pressure, after excluding 1% positive impact from acquisitions, 0.5% negative impact from foreign exchange and a 2.9% negative impact from pass-through paper sales. We believe that net sales for the full year of 2016 will be near the low-end of our guidance range of $4.35 billion to $4.45 billion. Third quarter adjusted EBITDA increased $2 million to finish the quarter at $122 million as compared to $120 million in 2015. Our adjusted EBITDA margin improved 100 basis points to 11.5% versus 10.5%. The increase in adjusted EBITDA and margin primarily reflects ongoing improvements in manufacturing productivity and sustainable cost reductions as a part of our previous announced and implemented cost reduction programs. We believe that adjusted EBITDA for 2016 will be near the middle of our guidance range of $460 million to $500 million. On Slide 5 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 $202 million of free cash flow through the first nine months of 2016, representing $134 million increase or three times the free cash flow generated in the first nine months of 2015. The increase was driven by $54 million in cash generated from sustainable reductions and ongoing controllable working capital levels, primarily improvements made to our order to cash revenue cycle. Another $54 million of the increase is due to reduced capital expenditure needs. As we discussed in previous calls, the reduction in capital expenditure is not a matter of reducing investment in our platform but rather is a result of decreasing capital needs. We completed much of the required catch up investments in our platform related to consolidating, integrating and improving the efficiency of acquired facilities. As a result, we have been able to reduce our capital expenditure from a rate of 3% of net sales to 2% of net sales, which is still nearly double the industry average and allows us to build on what we believe is the most efficient, automated and dependable manufacturing and distribution platform in the industry. The final component of the increase in free cash flow is due to a $26 million increase in adjusted EBITDA. Free cash flow is the foundation of our disciplined capital deployment strategy. We will continue to be a significant free cash flow generator and believe that free cash flow for 2016 will be near the middle of our guidance range of $230 million to $270 million. On Slide six, you will see that we ended the third 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 reduce debt by $346 million since September 30, 2015. This represents a 23% reduction in debt over the past 12-months and a corresponding decrease in our debt leverage ratio of 70 basis points to finish the quarter at a leverage ratio of 2.37 times. This is well within our long-term and consistent policy of targeting 2 to 2.5 times leverage. We are pleased with our ability to reduce leverage, especially during the quarter -- in the third quarter, which is the peak period for seasonal working capital needs. We will continue our focus on debt reduction as a primary use of cash and continue to believe that operating in the 2 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 opportunity and seasonal working capital needs. Another way in which we are strengthening our balance sheet is reducing our unfunded pension liability which totals $197 million as of September 30. As a reminder, the pension plans are frozen and were acquired as part of our World Color acquisition in 2010. These plans were underfunded at the time of acquisition by $562 million. We have worked diligently over the past six years to improve the funded status of these plans by $365 million. As part of our ongoing efforts to continue to de-risk and reduce the pension liability, we made discretionary contribution of $10 million during the quarter. Our strong free cash flow has allowed us to make this elective contribution which is greater than the minimum funding requirement and resulted in an improvement in the pension's funded status, in addition to lowering future government mandated PBGC insurance premiums. This additional funding combined with our lump sum pension program completed earlier this year that reduced $90 million of pension liability for a cash payment of $71 million, have allowed us to continue to reduce our ultimate pension liability. Slide 7 is a summary of our debt capital structure as of September 30. Available liquidity under our $850 million revolver when measured against our most restricted financial covenants, was $706 million and we have no significant maturities until April, 2019. The weighted average duration under our debt capital structure is 4.2 years and is 62% floating rate interest and 38% fixed. Our overall blended interest rate of our debt is 4.7%. Slide 8 shows our commitment to our dividend which is the key way in which we return value to our shareholders. Our next quarterly dividend of $0.30 per share will be payable on December 9, 2016 to shareholders of record as of November 28. We have consistently paid 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. We will continue to be diligent in our focus on driving operational productivity and sustainable cost reductions to help offset the impacts of top line pressures and to reinforce Quad is the industry's high quality low-cost producer. Our strong earnings and cash flow results through the first nine months of 2016 have allowed us to strengthen an already healthy and flexible balance sheet. The strength of our balance sheet and earnings continues to allow us to adjusted to changing industry conditions while also investing in our business and returning capital to our shareholders through our quarterly dividend among other priorities. And now I would like to turn the call back to our operator who will facilitate taking your questions. Operator?

[Operator Instructions] And today our first question comes from Jamie Clement of Macquarie. Please go ahead.

Joel, so about a year ago, I think you all said that 2016 was going to be a year where you are focusing the free cash flow on deleveraging the balance sheet a little bit. We are now about a year later, about to enter a new year. Are you all now looking a little bit more outside the company in terms of acquisition opportunities that are out there or the current course of just paying down debt, are you going to stay with that?

No, I mean we have consistently kept our eyes open for opportunities such as the investment we did in Rise Interactive. There is a lot of focus on our go-to-market strategy which is changing rapidly because of demand with our clients. I mean we are in an age where marketing is starting to kind of swing the other way from everything digital to let the data tell you what channels that you need to be in and actually work on measurement, because we are in sort of a crisis of measurement in marketing that everyone is dealing with. So we are investing a lot in building that strength but at the same time we will continue to look at opportunities that come our way but save that, we do think right now paying down debt and really focusing on the balance sheet is a good thing. But again we have, I think, consistently said that we are not scared to look outside the company and look for new opportunities. So you will see us continue to balance the different needs of capital and right now without announcing something in the works, we like where we have gone with our balance sheet. I think Dave Honan and his team have done an incredible job of managing working capital, which by the way is a result of the continuous improvement process that we talk about. That wasn’t just you know a matter of managing payables and receivables and things like that, it was a matter of really looking at the total process and improving working capital tremendously. So we will continue to watch the world go and take advantage of it where we think we have an opportunity.

Yes. And Joel, with that said, obviously I saw in the press release from a week or so ago about Williamson. You had some comments on the call today. It feels like that, I would imagine, would be substantially less expensive than your average packaging deal out there. Have you seen enough here with Williamson that you might -- I don’t know what the industry is calling businesses like that, specialty, local, digital, I don’t know what they are calling them these days. But are you more open to that kind of thing now, having [indiscernible] Williamson and now having invested in [there][ph]?

I would say it's -- the way I look at it is, Williamson is a part of our commercial platform and we do a lot of things like if you look at Wild Wings, we do a lot of their promotional stuff within the stores, the placemats etcetera. So, again, it goes back to what is the demand of the market of today and it's really about integration of all the different things that we do. And they are looking for us to do more and they are looking to manage fewer people. An investment like Williamson is consistent with what we did in DirectMail, what we have done in, again with like Rise Interactive or in books. Just because the world is changing doesn’t mean that technology in our industry hasn’t changed. I mean when we think about digital, everyone jumps to the Internet. Well, guess what, digital presses, digital printing is changing the way we think about marketing. From highly personalized direct mail pieces to being able to create things like at Williamson that support the rest of their sort of marketing continuum needs. So, yes, it's all part of supporting the go to market strategy and it's really being driven by the CMO's of this world in terms of really wanting to have an integrated approach to marketing. And print just happens to be a part of that. I mean the days of, I think the big shift that we see going on is that the Internet online, mobile was considered a replacement strategy for traditional channels. That’s not true anymore. Now it's being considered that we have to integrate offline and online to better get an understand the measurement of what actually produces a transaction. There is a lot of [ways being] spent on channels that have measurements such as [eyeballs] [ph] or clicks and things like that. Well, what people are getting frustrated with is what actually turns into a transaction. What is the interplay between each channel. So that’s really you know the way we are focusing right now and it's going to require investment but the investment isn't the big heavy iron, it's a lot of things such as continuous automation but also technologies like digital printing so that we could be much more one to one and focused.

Joel, last question and I am going to let somebody else get in there. In terms of the big three product lines, can you just give us some flavor, 30,000 feet in the sky, kind of what you saw during the quarter? How the markets are for magazine catalogs and inserts?

Yes. I mean it's no secret that we are dealing with a skittish economy and I think that represented a little bit in, if you think about ad pages, they were probably in, publication was probably off more than we would like. And then you think about catalogs, they are actually hanging in there okay and I think they may have some [indiscernible] coming up with some post office corrections here in terms of what they charge these people. But I think the flavor that we have and we came out of the second half seeing backwards at the first half, I mean we came out of the first half seeing that it was a lot weaker than people had expected, as we kind of look backwards. And again what we are seeing is consistent with a skittish economy that’s not helped by a circus like election process here.

And our next question comes from Dan Jacome of Sidoti. Please go ahead.

A [set] [ph] of questions. I guess first, again, taking the 30,000 foot view as Jamie said, just on the pension and stripping down the liability. You have done an excellent job so far. I was just kind of wondering, big picture, where you stand on that? Thinking ahead over the next few years. Would you say you are kind of like in the fourth inning or the eighth inning of this plan?

Good morning, Dan, this is Dave. I would tell you, we are in the middle innings on our pension plan. We have already started our glide path on de-risking the investments in the pension plan. We started that process in order to just mash the ultimate future cash flows coming out of it with our investments. So we feel really good about where we have positioned that. I think there is some more opportunity for us to take advantage of market conditions moving forward. And quite frankly, a bit of help on discount rates would really help the liability here. We re-measure that liability in the third quarter as we did our lump sum program. So we measured basically this pension liability at the low point of rates and so hopefully with rates changing a bit and will give us some tailwind as they move up in the future to reduce that liability. But I call it middle innings and I think we have got some good ideas moving forward, how we can continue to de-risk that liability on our balance sheet.

Okay. Excellent. And then just turning back to free cash flow. Also a pretty big year for you guys and I know we are not calling out 2017 targets just yet. But thinking about what working capital you have now and how much leaner you might get, do you think next year you might be kind of like in the similar neighborhood or should we expect a big swing or delta in one direction given this was such a big year. Or do you think you could -- can you speak to that at all yet?

Sure. It's a great question. Because working capital by its very nature, as you take those levels down on a sustainable basis, it's tough to continue to repeat that at the same level. But we really believe we still have ways to go on the working capital side. Just for instance, our focus just on the receivables side and the point in time an order comes in the door to the point in time we get paid by our customers. We have taken ten days out of that cycle and we think we've probably got another five to go on that. And that’s driven the bulk of what you have seen and the improvement and since we started this program it's close to $190 million of cash flow generation coming solely from that. And we do think there is a bit more to go on that in addition to other components of our working capital. But I think there is other areas of business where you think from a cash flow perspective there could be some tailwind. I think the amount of cash we are needed on spend on restructuring activities has come down quite a bit. You continue to see us get more and more progressive with the pension plan which hopefully reduces future needs of cash going to pension. And then capes, we still, we talk about bringing our level of CapEx down to about 2% sales. We are still nearly double of what the industry is spending on CapEx. So there is always room, I think, there to have some tailwind on our cash flows moving forward. And of course our focus on cost reductions in a stabilized level of underlying cash flow coming from the adjusted EBITDA, really puts us in a position where we would like to, year-in, year-out deliver free cash flow above that $200 million range.

Right. No, exactly. And then I think you brought up the M&A environment. I was just more curious if kind of like the acquisition you did earlier in the summer, approaching the year-end. How are you guys finding that in terms of, I know it was a small company, but you guys have a unique culture without a doubt. How are they adapting to yours? Do you have any comments on that, big picture?

You know our culture is pretty simple actually. I mean it's really pretty much non-hierarchical, easy culture to understand. So we find that as we brought both acquisitions in, certainly on the manufacturing floor, it's easy to understand the culture. I mean I were the same uniform that people on the floor wear. So it's a very manufacturing friendly culture. But as we have interacted with people like Rise that come from an agency background, I think we have shown a very creative flair that people like. So I am not at all concerned about our ability when there is a good acquisition to make people feel comfortable regardless of different versions of corporate culture that we can have them not only do well with us but actually be a big part of being a very successful company on into the future.

Okay. Great. And then last question. Just wondering if you guys have like any visibility or thoughts on kind of just the overall printing industry utilization of capacity and operating rates. I mean obviously they are still quite depressed and I know you talk about the obvious headwinds. But do you any like sight into maybe some capacity coming out that might help the bigger players in the industry.

Look, I mean I think we focus on our platform. I think certainly the industry have always been pretty slow to take corrective action on inefficient capacity or under-utilized capacity. But I think we have shown a very aggressive approach to this for our own platform because ultimately when you look at the thesis around the consolidation we have done, we have the legacy Quad plants have been the best, most invested in platform in the industry. And so as we have closed 34 printing plants over the past six years, we have taken out a tremendous amount of inefficient capacity and loaded up more of our efficient capacity. And by the way, part of our future cost takeout is about continuing to tweak that to make sure the more efficient plants are running at very high capacity. So we don’t have visibility into what others are thinking but clearly I think that a smart industry is one that really recognizes the balance of available work to capacity that’s installed. And hope is not an operating strategy. I mean we deal with and believe that we are going to be with a slow growth economy for a while or at least plan that way and if it changes, we will enjoy that surprise. But I do think that the discipline we have done with our platform has been very good for not only our shareholders but our employees because it talks about sustainability on into the future.

Okay. And then just to clarify the last thing. You said you have got pretty confident about stripping down another $60 million of cost annually. Did I get that right?

Yes. That’s our target, Dan. I think we look at, based on top line pressures every year, year-in, year-out, we have to target at least 60. Last year we went for more than that and we over-achieved on that. But you will see us talk to that because we believe that’s the ultimate fall through on top line pressures that face this industry as well as, I mentioned in some of my comments about wage pressure that we have been feeling from things beyond our control.

Yes. Trying to hire up in the platforms that we have increased capacity has been more of a challenge than you would like. But we have tackled that through better wages and better approach to hiring. So that’s just been a real important part for us in terms of viewing cost takeout as a regular part of things. And because we are so process-oriented, we look at cost takeout as things that have to be sustainable in nature. And we have a very aggressive process about identifying opportunities to match up with that goal of $60 million a year and I meet with the -- our group meets every week on that and we become very good at measuring success and also making sure that we are taking things of the list that may not be realistic but at the same time adding things that come up as a part of that ongoing process. Operator, do we have more questions?

I am afraid not, sir. At this time this concludes our question-and-answer session. I would like to turn the conference back over to you for closing remarks.

Thank you and thank you, everybody. Obviously, you know it's an interesting year and we are very proud of what we are doing and we will see you next quarter. Thank you.

And ladies and gentlemen, the conference has now concluded. Thank you for attending today's presentation. You may now disconnect.