Quad/Graphics, Inc. (QUAD) Q3 2019 Earnings Report, Transcript and Summary

Good morning, ladies and gentlemen, welcome to Quad's Third Quarter 2019 Conference Call. [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 this morning's earnings release. Alternatively, you can access the slide presentation on the Investors section of Quad's website under the Events & Recent Presentations link. [Operator Instructions]. Please note, this event is being recorded. I would now like to turn the conference over to Mr. Kyle Egan, Quad's Director of Investor g

Thank you, operator, and good morning, everyone. With me today are Joel Quadracci, Quad's Chairman, President and Chief Executive Officer; and Dave Honan, Quad's Executive Vice President and Chief Financial Officer. In terms of our agenda today, Joel will lead off the call with a discussion of Quad's Quad 3.0 transformation strategy. Dave will follow with a summary of Quad's third quarter 2019 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 on Slide 2. Quad's 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. Finally, a replay of the call and the slide presentation will be available on the Investors section of quad.com shortly after our call concludes today. I'll now hand the call over to Joel.

Thank you, Kyle, and welcome, everyone. We are making bold decisions to accelerate our transformation through investments in our business that will drive long-term growth and shareholder value and provide us with the ability to take advantage of opportunities in the rapidly changing print industry. I'm pleased to update you on the success we're having on our Quad 3.0 strategy by sharing that it will generate $125 million of expected organic incremental sales growth in 2019, which helps offset over 3 full percentage points of annual print sales decline. Through Quad 3.0, we have created a uniquely integrated marketing solutions platform that includes customer analytics, campaign strategies, media optimization and global production all woven together to effectively address our clients' marketing and process challenges. This non-siloed approach is an important point of differentiation from traditional printers and large agency holding companies. As shown on Slide 3, our integrated offering, which includes an industry-leading manufacturing platform, helps clients reduce the complexity of working with multiple partners, eliminating multiple handoffs that compromise both the strategy of marketing programs as well as the speed at which they are executed. We also enhanced efficiencies through workflow reengineering, content production and process optimization and improved marketing spend effectiveness across all channels through data-driven consumer insights, media planning and creative and campaign strategy. We have invested time and resources to fine-tune our Quad 3.0 platform and continue to scale our solutions to drive additional incremental revenue. To further explain how our strategy is working, I would like to share some recent client wins. On Slide 4, you'll see we've continued to grow our relationship with the leading apparel retailer, Jockey, based in Kenosha, Wisconsin. Our relationship with the retailer began with catalog print and prep work. Then in 2018, we added photography for Jockey's online retail, social and catalog channels. This year, we've expanded into packaging photography and video production, including Instagram live stories that promote the brand and its catalogs. We're also providing additional social media creative direction for Jockey's upcoming holiday catalog. We began doing data analytics and customer prospecting. And for the first time, we're supporting Jockey's international division through print, e-commerce copywriting and photography. Slide 5 provides an example of a large multinational retailer, of which Quad is helping to expand its marketing into digital channels and make better use of data to acquire new customers and drive repeat business. Historically, this was a print-only customer. We capitalized on the opportunity to bring them new thinking on an existing print program to demonstrate how they could be marketing more effectively. This led to Quad planning and executing a new customer acquisition campaign. We started by researching the digital and direct mail behaviors of its customers in underperforming markets. With those insights in hand, we created and launched a new direct mail program that included new creative and a new format supported by complementary digital campaign. Based on the success of this program, we are launching an additional integrated direct mail and digital program in early 2020, leveraging the insights gleaned through Quad's proprietary virtual testing platform, Accelerated Insights. Our ever-expanding relationship with this one account has resulted in over $2.5 million of organic incremental multichannel revenue in 2019 that we otherwise would not have had. Lastly, Slide 6 is about Quad's rapidly growing partnership with a large national discount grocery chain. Until June, we only printed weekly retail circulars for its 1,100-plus stores. Since then, we've been awarded print media placement, creative and production services for the circular program, followed by hosting the chain's digital circular. In addition, the relationship has grown to include all digital and broadcast media planning and buying. We accomplished this through our leading capabilities and thoughtful guidance on the best way to harness media to accomplish the client's multichannel business goals. In particular, our integrated approach to media services matches the right content to the right channel at the most opportune time and in the right geography. It was the solution this client had been looking for because it offers the highest probability of inspiring a shopping trip. Furthermore, we started a media mix modeling study for this client that measures 1 or 2 different media mixes against the client's KPIs. This study will produce the insights necessary to improve media spend performance on into the future. Through this relationship, we also have been able to increase organic incremental multichannel revenue by more than $2.5 million in 2019 that we otherwise would not have had. Furthermore, the media spend that Quad is managing and procuring on behalf of this client will be in excess of $30 million on a go-forward basis. These client examples, along with many others across a wide range of existing and new client relationships, has contributed to the $125 million of expected organic incremental sales growth in 2019 I discussed earlier. Quad will continue to build on our current relationships to provide even more services, products and value and continue to transform ourselves as a trusted marketing solutions partner. Given our success with Quad 3.0, we are taking decisive actions to further accelerate our transformation through optimizing our product portfolio to ensure alignment with our Quad 3.0 vision, further streamlining costs and resetting our dividend, which will provide additional financial flexibility to continue to scale our Quad 3.0 strategy and maintain a strong balance sheet while also being able to take advantage of opportunities in the rapidly changing print industry. In reviewing our product portfolio, we made the recent decision to divest the 2 businesses. The first was Transpak, our industrial wood crating business, which we divested in the third quarter. This was a great niche business, but it was noncore to Quad 3.0. Now we are divesting up our book business, which generates annual revenues of $200 million. Divesting this underperforming business makes sense as we look at our product portfolio through the lens of our Quad 3.0 transformation strategy. Over the years, we have made significant investments in our book platform and talent, all which will benefit the industry long-term. As we pursue this sale, we thank our employees for the continued focus on serving our clients well. Looking ahead, we will continue to proactively optimize our product portfolio to advance our Quad 3.0 strategy and capitalize on the ever-changing media landscape. We also continue our focus on cost management, which Dave will share more details on in a moment. Lastly, to help accelerate our Quad 3.0 strategy, we have made the proactive decision to reset our quarterly dividend. This will provide us with additional financial flexibility for growth-focused opportunities that address our clients' evolving needs and maintain a strong balance sheet over the long term. It will also provide us with the ability to take advantage of opportunities in the rapidly changing print industry. In all that we do, we continue to pride our ability to make decisions that are in the best long-term interest of our client, shareholders and employees, and we have a disciplined capital deployment strategy that helps us through this. With that, I will now turn the call over to Dave.

Thank you, Joel, and good morning, everyone. Please note that today's discussion of our financial results excludes the discontinued operations of the book business in all comparative periods, with the exception of cash flow information. Slide 8 provides a snapshot of our third quarter 2019 financial results. Net sales were $944 million in the third quarter as compared to $974 million in 2018, down 3.1%. Organic sales, which exclude acquisitions, declined 4.3% during the quarter. As Joel mentioned earlier, organic sales benefited from new revenue generated from the Quad 3.0 strategy but were offset by ongoing print industry volume and pricing pressures at a negative 0.5% impact from foreign exchange. On a year-to-date basis, net sales were $2.9 billion, flat with 2018. Excluding acquisitions, organic sales declined 2.6%. The organic sales reflect new revenues generated from the Quad 3.0 strategy, offset by ongoing print industry volume and pricing pressures and a negative 0.7% impact from foreign exchange. Our Quad 3.0 transformation strategy is driving $125 million of expected organic incremental sales growth in 2019, which is helping to offset over 3 percentage points of annual print sales decline. Adjusted EBITDA was $80 million in the third quarter of 2019 as compared to $107 million in 2018, and adjusted EBITDA margin was 8.4% as compared to 11%, respectively. The variance to prior year primarily reflects the impacts from a 4.3% organic sales decline, an $8 million impact from the reduction of market prices for paper byproduct recoveries and an $8 million impact from strategic investments made to increase hourly production wages. As a reminder, last year, we began to make additional investments totaling $40 million on an annualized basis to increase hourly production wages in our most competitive labor markets due to historically low unemployment rates and the challenge of finding enough quality entry-level and skilled employees. This labor strategy incorporated competitive wages, strong benefits and necessary training programs needed to fill open positions and retain our employees. Adjusted EBITDA for the 9 months ended September 30, 2019, was $239 million as compared to $310 million in 2018, and adjusted EBITDA margin was 8.4% as compared to 10.8%, respectively. The variance to prior year was primarily due to the impact from a 2.6% organic sales decline, $24 million in nonrecurring benefits realized in 2018 that did not repeat at the same level in 2019, a $24 million impact from strategic investments made to increase hourly production wages and a $14 million impact from the reduction in market prices for paper byproduct recoveries. Our financial performance in the third quarter was negatively impacted by the prolonged nature of the terminated LSC acquisition, for which we delayed certain cost reduction activities in anticipation of the related integration synergies. Given those delays, we announced a cost savings program in the third quarter, which was subsequently increased by $10 million to total $50 million of annual cost savings. We anticipate $10 million of these savings will be recognized in the fourth quarter of 2019 and be at a full run rate basis by the end of the year to realize the rest of the cost savings in 2020. We continue to proactively work on additional cost savings projects to further grow this $50 million cost savings program into the future. Year-to-date, free cash flow, excluding $60 million of LSC-related payments, was negative $35 million as compared to negative $38 million in 2018. The $3 million improvement in free cash flow is primarily due to higher cash provided by working capital, partially offset by lower net earnings and increased capital expenditures on long-term investments in automation and productivity in our manufacturing platform. As a reminder, we realized our strongest volumes in the back half of the year due to seasonality. And as a result, the majority of our free cash flow will be generated in the fourth quarter. On Slide 9, we've included a summary of our updated 2019 annual guidance. The guidance was update to exclude the discontinued operations of the book business and to reflect updated business trends. We expect full year 2019 net sales to be approximately $3.9 billion, updated from our original guidance range of $4.05 billion to $4.25 billion to exclude approximately $200 million of net sales from the book business. Full year 2019 adjusted EBITDA is expected to be in the range of $300 million to $330 million, updated from our original guidance range of $360 million to $400 million, primarily to exclude the discontinued operations of the book business and to update for current business trends. We previously discussed several trends impacting the quarter and year-to-date results that further impact annual guidance such as the delay in cost reduction activities in anticipation of the related synergies from the now terminated LSC acquisition. Subsequently, these delays were partially offset by $10 million, an estimated fourth quarter savings from our $50 million cost savings program. Also, lower market prices on paper byproduct recoveries, which significantly weakened in the back half of the year, are expected to impact full year 2019 adjusted EBITDA by at least $25 million. And finally, the $40 million long-term investment in hourly production wages is not yet fully being offset by productivity improvements. We have seen strong labor productivity improvements in 2019 from these investments and expect to realize more savings over the long term. Full year 2019 free cash flow, after excluding $60 million in LSC-related payments, is expected to be in the range of $80 million to $100 million. This free cash flow guidance was updated from our original guidance range of $145 million to $185 million, primarily reflecting the impact from reduced adjusted EBITDA and the impact of $20 million to $25 million of expected negative free cash flow from the discontinued operations of the book business, which are included in the consolidated cash flow activity. Slide 10 includes a summary of our debt capital structure as of September 30. Debt increased $242 million since year-end to end the third quarter at $1.2 billion, primarily due to $121 million of net cash paid for the Periscope acquisition, $60 million of costs related to the terminated LSC acquisition and $35 million of negative free cash flow, as previously discussed. Our debt capital structure is 62% fixed and 38% floating with a blended interest rate of 5.3% at September 30. Available liquidity under our $800 million revolver was $748 million, and we have no significant maturities until May of 2022. We have the financial resources to pursue future growth opportunities and return capital to our shareholders through our quarterly dividend. Our next quarterly dividend of $0.15 per share will be payable on December 6, 2019, to shareholders of record as of November 18, 2019. We finished the third quarter of 2019 with debt leverage of 3.24x, which is above our long-term targeted leverage range of 2 to 2.5x. While we may operate outside of this range due to the timing of compelling strategic investment opportunities, such as the Periscope acquisition, we will continue to target our long-term 2 to 2.5x leverage range. In the near term, our priority for cash will continue to be debt reduction. Slide 11 provides an overview of our actions we've taken to strengthen our balance sheet to provide further capital to accelerate the Quad 3.0 transformation. Since 2015, we sold over 20 vacant facilities for $100 million in cash and more recently divested businesses that are noncore to our Quad 3.0 strategy, such as the sale of our industrial wood crating business for $11 million and the decision we announced yesterday to divest our book business. We also remain focused on further improving our cash flows through resetting our quarterly dividend to reserve approximately $30 million of additional annual financial flexibility, reducing interest costs by $12 million annually through the retirement of the Term Loan B in the third quarter, driving more cost savings efforts in addition to our latest $50 million cost savings program and optimizing our working capital levels through continuous improvement efforts. These measures are focused on accelerating our Quad 3.0 transformation, reducing debt leverage and delivering long-term sustainable value to all stakeholders. And now I'd like to turn the call back to our operator who will facilitate taking your questions. Sean?

[Operator Instructions]. Our first question today will come from Jamie Clement with Buckingham.

Dave, if I can just start with you, just one housekeeping item and then I'll -- I've got a couple of questions for Joel if that's okay. If I look at like the reported EBITDA numbers from first quarter, second quarter, third quarter, I would get to like about a $225 million number versus the $239.1 million for the 9 months here. Is the difference there, is that all books going discontinued?

That's correct. And Jamie, we've put out an 8-K yesterday to give you restated quarterly numbers back through 2018 that will help you reconcile that, too.

Right. Great. Just wanted to make sure. Okay. So Joel, on the investments in productivity, I guess, going back to 2018, it sounds like you're getting some efficiency gains but not all of them. As we kind of look into next year, would any gains you expect to get there, is that part of the $50 million cost savings plan? Or is that in addition to?

Well, so let me hit on this. So when you look back to '18, we suffered from a productivity standpoint because of the changing labor market. And so our productivity actually was worse than we had in the past. And given either with or without the LSC transaction, we -- these plans need to have well-trained people to run efficiently. And so we made the tough decision to really bite the bullet and increase significantly the starting wage as well as then you have to deal with compression as a result. And we did that in concentrated areas where we had the biggest problems. What I find interesting these days is that with the known entity of the labor market, everyone's talking about wage pressure, but it seems, as I talk to industry after industry, everyone's putting off the inevitable as long as possible. In our case, if you put that off, you -- we saw it. You get hurt pretty hard. And the problem when you do this, and you do it in the way we did, is all the cost is a light switch. It comes on right away. The productivity improvements come later. And so there's a lot of timing in this. And I'd say that from '18 to '19, it's actually significant, the productivity improvements we've had year-to-date. We've seen incredible increase in productivity wherever we've been able to impact the labor rates because we've definitely seen a higher-quality employee as well as less turnover. And remember, when you have the turnover because of the tight labor market, the training side gets hurt pretty hard because you're spending that money but then you have to start over again. And you don't train someone in one day. So we saw the increase in productivity happening throughout the year. But no, you're correct, we haven't gotten to the point of totally offsetting it. But we feel good about in 2020, continuing that trend upward in terms of productivity improvements.

Yes. And Jamie, to directly get to the point, I think where you're going to, these -- the $50 million in cost savings are specific programs outside of the productivity that we're talking about that will happen over the longer term related to this $40 million investment in wages.

Right. So that's a lot of the typical things we do at continuous improvement, et cetera. The productivity stuff is stuff that will continue outside of that.

How much do you -- I mean, I know it's -- maybe it's a moving target? I don't if it's a specific goal. But I mean, how much more in the way of productivity do you think you'd be able to get maybe over the next 6 to 9 months or 12 or 18?

I don't know. I'd guess we're probably in the seventh to eighth inning. Is it fair?

Yes. I think it's going to take more than 12 months to fully see the impact. And it's really going to be based on what happens on other external factors in the labor markets in which we faced the challenge of low unemployment. And so time will tell on that, but we really like the progress the teams have been making in these plants through increased speeds despite more complexity to what our customers are asking us to do with print because of the personalized nature of where we've moved with print. So it's just been tremendous, as Joel said, to see the quality rise, the retention rates get longer and just -- and put more quality books out the door on time.

And obviously, it's not just wage that does this. We've done a lot of innovation in terms of how we recruit, who we recruit to. We've started things with inner cities, where there's underserved populations. So it's a holistic approach. But one of the things I think you got to really understand here that's really important is as we look at our performance right now, it's not heavily focused on some sort of surprise on the top line. Almost the opposite. We've had -- we've been able to offset top line regular decline by over 3 percentage points so far this year. And that's pretty significant. I mean if I look at the different areas of where we see volume decline, it really is a little bit of sluggishness on the retail side with retail inserts. And if you look at the GDP report this morning, they echoed that sentiment by saying that there's sluggishness in retail. But I'll also say that the retailers, while there may be sluggishness in the retail insert, these are the ones that, and I used a couple of examples here today, are spending more money on the rest of our offering, which actually helps offset, in our mind, some of the revenue we lose on an account-by-account basis. Those weren't insignificant revenue increases through services, which have a smaller invoice number -- dollar amount in typical products, but it also resulted in more products as well. So that's why 3.0 is important.

Joel, borrowing from some of the language in the press release and maybe help us understand this a little bit more. I think that some might think that language around taking advantage of changes in the print industry is not necessarily the same thing as accelerating the 3.0 transformation. Can you bridge those 2 together for us a little bit?

Certainly. It's both. I mean, look, when you look at the potential of the LSC transaction, that -- the industry needed another reset, okay? And we felt, I think LSC felt, that this was a great way to do it in a controlled way for all constituents. That's clients, employees, shareholders. But because of the delay that the DOJ did -- remember, they didn't get to the point of actually blocking it. They sued the block. But we walked away because I think both sides understood that with that uncertainty in a dynamic industry with dynamically changing media trends, that the risk would've been a lot higher if we didn't walk away from it. And so now, that not happening, what hasn't changed is the industry still needs a reset and we're doing it. You saw us close two plants after the deal fell apart, and we continue to look at ways to make sure that our best-performing platforms are running at a high labor rate. Now that being said, there's going to be other shakeout there. And as you know, we always look at consolidating opportunities if they're affordable and if they really lend itself to us creating great, strong free cash flow so we can continue to use that to transform ourselves. And so that's the second part of bridging your question is we're showing you that 3.0 is no longer an experiment. It's not being an experiment like 3 years ago. We've been putting points on the scoreboard now, and it's accelerating faster and faster. And so we've done a lot of heavy lifting in terms of creating the infrastructure it takes to do this type of sale at scale. That's hiring talent, that's reorganizing sales departments, that's bridging gaps between different business units. And so to us, we're going to continue to scale that, whether it's M&A. We've done some of that. But right now, we're adding a lot of great talent in the analytic space, in the video space, in all the different multichannel spaces that represent the examples I keep sharing with everybody. And so it's kind of -- we got to be prepared for both, actually prepared for potential opportunities as the industry has to go through that reset. But we're going forward aggressively on 3.0. And that's why I think it's really important that we have the wherewithal to able to do that. We do have a good balance sheet, but I think we've proven over time, and we've always talked about it, that if we go above our range on where we like to be, we always want to have a path down. Because in a dynamic industry, there's always going to be opportunities, but you can't pick when those come. And so to me, tough decision on the dividend. I mean I'm a large shareholder here. But to me, the -- my responsibility is to making sure that Quad is a very strong company on into the future, and that means making sure we have the wherewithal and some wind at our back to be able to take advantage of things that I can't predict when they're going to happen. I can predict when 3.0 is happening, it already has, and we're going to accelerate that.

Okay. Joel, with respect to some opportunities that may arise, given that a lot of your competitors are way, way, way sub your scale, many of them having problems. I mean do you anticipate kind of opportunity for kind of Vertis-type situations going forward? Is that what you're alluding to?

It could be. If you recall, Vertis was in conjunction with the restructuring. There could be opportunities just to acquire. But again, it really depends on what it brings to the table for us. We're not going to do it for the sake of doing it, as you know. But I have to tell you that -- and by the way, there still is a very large competitor out there with LSC. And -- but I will tell you that as things go forward here, it's tough just to be printing products in this environment because then you're just dealing with the organic decline. What we're showing you is that the 3.0 strategy is about offsetting the organic decline. My goal is to replace the organic decline and then get to grow. But that's not a light switch, as you know. But look at what we've been doing and look at the numbers we keep putting out there. That's what you need to focus on, and that's how we're going to continue to manage ourselves.

Joel, how far along -- I don't know if you want to talk in kind of 9-inning terms. But in terms of like educating your print customer base on all of the solutions and the services related to 3.0 that you all provide, like are you still encountering customers that say, hey, I did not know you did that?

It's changed dramatically. I'd say that this year was a very noticeable change. And to your point, the challenge is that people are used to managing marketing in silos and from different suppliers out there, whether it's the big holding companies in one place. Print has always been really just about buying the execution. But everybody is under pressure from a marketing standpoint. This is -- I'm talking about this broadly. It's not just people who use print. It's people who market. The idea of having a fragmented spend in marketing right now and managing that way is that's going to separate the winners from the losers because you can have a great product, but if you're not marketing to the consumer the way they expect it in an integrated way, using data and using the right analytics at the right time in the right geographies in the right circumstances, someone is going to outpace you. The other thing that we're seeing is an acceleration of nonprint users starting to use print. We were out at Adweek. We sponsored one of the sections. A lot of talk about the power of direct mail. And that's where when you think about our partnership with dtx with Tim Armstrong, we've seen this trend for a while that digital-only marketers have really done well over the years. But now the expense of doing it is rapidly increasing and the effectiveness is dropping. Because even in digital, that's very fragmented and people aren't necessarily able to measure it the proper way. And so now we see people coming into print, very significant names by the way, and I think if you look at direct to consumer, the original ones were catalogers, right? If you think about an L.L.Bean or something like that, they were print-only one channel. When dot-com 1.0 came along, all this digital opportunity came, and they saw it as an opportunity to replace print. They made that mistake early on. And when they tried to cut print, they saw the volume drop off online. And so they learned that when you have different media channels, you have to layer them. You can't use it as a replacement strategy. And so what's happening now on the digital side, where it's digital-only marketers, is they're learning that same lesson. The cost is going up and the effectiveness is petering out. It's not disappearing. It's always going to be a great channel. But they're realizing that they now have to layer back in legacy channels that includes TV, even basic commercials, to billboard, to print, to everything. And so if I were to kind of educate not only the clients about what we're talking about here with 3.0, I think it's about educating people who are investing in anything having to do with marketing, is to truly understand, take the time to understand the shift that is going on and the need for integration and the lack of models out there available for a marketer to help them do it. And so we're kind of coming out of left field here in most people's minds, and I'd say that the early years of this was really hard. The process to get a customer to listen to us took a long time because they hadn't heard it before. But now that process has accelerated. Some of those examples, I mean, we're just printing retail inserts less than 6 months ago. Suddenly, we're buying TV commercials and actually creating video for people. So I see the pace of them understanding what we're doing is increasing. We spent a lot of money in marketing. We've spent a lot of time in educating. And you know what, the pressure is turning up on marketers, not turning down. Sorry for the long-winded answer, but this is...

No. No. Not at all. Very helpful.

This is a really important point for everyone to understand, especially in context of what we've announced today and why we're doing it.

This will conclude today's question-and-answer session. I would now like to turn the conference back over to Mr. Joel Quadracci, CEO, for any closing remarks.

Thank you, operator, and thank you, everyone, for joining us. As we shared on today's call, we are confident in our Quad 3.0 strategy, which is working. We continue to expand work with existing clients as well as win new work. Given our success with Quad 3.0, we are taking proactive steps to further accelerate our transformation, making investments in our business that will drive long-term growth and shareholder value and provide us with the ability to take advantage of opportunities in the rapidly changing print industry. As always, we remain focused on making decisions in the long-term best interest of our clients, shareholders and employees. So with that, I thank you and look forward to speaking with you again next quarter.

The conference has now concluded. Thank you for attending today's presentation, and you may now disconnect.