The Quarto Group

40 years young

Final results

Media

21 March 2016

Price	256.0p
Market cap	£50m
£1:$1.45
Net debt ($m) at end December 2015		59.5

Shares in issue	19.7m
Free float	75.2%
Code	QRT

Primary exchange	LSE
Secondary exchange	N/A

Share price performance

%	1m	3m	12m
Abs	13.3	14.5	48.8
Rel (local)	9.1	12.8	64.0

52-week high/low

267.5p

165.0p

Business description

The Quarto Group is the leading global illustrated book publisher and distribution group

Next events

Annual Meeting

24 May 2016

Analysts

Fiona Orford-Williams	+44 (0)20 3077 5739
Bridie Barrett	+44 (0)20 3077 5700

media@edisongroup.com

Edison profile page

The Quarto Group, Inc. is a research client of Edison Investment Research Limited

At the start of its 41st year of operations, Quarto delivered a strong FY15 performance, as indicated by January’s pre-close update. Revenue and margin were both ahead, there was notable progress on debt reduction and a step-up in the dividend. With the activists off the share register as of November 2015 (their shares placed with a spread of institutional funds), the board structure is also now being normalised, with two independent non-executive appointments (one to take the chair). Investment in content, talent, sales and marketing and systems underpin the growth now coming through, with acquisitions likely to supplement organic progress.

Year end	Revenue ($m)	PBT* ($m)	EPS* (c)	DPS (c)	P/E (x)	Yield (%)
12/14	171.3	11.9	44.1	13.7	8.4	3.7
12/15	182.2	14.1	49.5	14.5	7.5	3.9
12/16e	187.0	15.0	53.1	15.3	7.0	4.1
12/17e	192.5	15.8	55.4	15.8	6.7	4.3

Note: *PBT and EPS are normalised, excluding amortisation of acquired intangibles, exceptional items and share-based payments.

Children’s list delivers on promise

The group is effectively a portfolio of portfolios and there is an inevitable divergence between performances of the underlying elements. Children’s books were identified as a particular target for investment by CEO Marcus Leaver, who joined the group in 2012. This has been paying off handsomely, with the children’s offer now making up 22% of publishing revenues. The FY15 numbers also benefited from the fashion for colouring books for adults, which the group’s North American imprints latched on to at an early stage, building on its position in art instruction. The main drag on performance was Books and Gifts Direct, the distribution business in Australia and New Zealand, which suffered from the weakness in the local economy and earlier overstocking by the master franchisers, exacerbated by currency translation.

Investing in new titles, building IP for future sales

Quarto has a clear emphasis on producing high-quality books, which then sell over an extended period, giving much higher levels of backlist sales than industry norms – 61.4% in FY15, down slightly from 66.6% in FY14 but ahead in absolute terms. Furthermore, 28% of backlist sales in FY15 were of titles over three years old. The focus on backlist sales has rather overshadowed the scale of the investment in developing new titles ($34.9m in FY15), spread over a very large number of titles and not dependent on any particular imprint, genre or author.

Valuation: Strong performance, discount persists

November’s institutional placing cemented Quarto’s market rehabilitation, which has seen the share price climb by 49% in a year. Achievements in reducing absolute debt levels and the strong performance of acquisitions both reduce earlier potential areas of concern. The possibility of equity issuance for fund purchases may limit full closure of the discount to other smaller publishing companies, trading on an 11.2x FY16e P/E vs 7.0x for Quarto.

FY16 revised up, FY17 forecasts published

We have revisited our forecasts in light of the detailed FY15 numbers. While the US numbers undoubtedly saw a boost from the colouring book phenomenon, it would be misleading to suggest that this has distorted the reported figures, as the first books went into production in 2013, with Zentangles, and is likely to morph into some other form of art instruction rather than vanish overnight. FY15 results were modestly ahead of our earlier projections and we have edged our FY16 forecasts upwards, predicated on a top line growth assumption of around 3%. Our new FY17e numbers anticipate a similar rate of progress.

Exhibit 1: Revisions to numbers

	EPS (c)			PBT ($m)			EBITDA ($m)
	Old	New	% chg.	Old	New	% chg.	Old	New	% chg.
2015	47.6	49.8	+5	13.3	14.2	+7	34.9	37.0	+6
2016e	51.7	53.1	+3	14.6	15.0	+3	36.3	37.9	+4
2017e	-	55.4	N/A	-	15.8	N/A	-	38.7	N/A

Source: Company accounts, Edison Investment Research. Note: 2015: Old – Edison estimates; New – reported actuals.

As had been indicated earlier in the year, Quarto’s publishing business has become increasingly second half weighted, although the effect in 2015 was masked by the poorer outturn from the distribution business, Books and Gifts Direct. The three publishing divisions, between them generating 80% of group revenues, are now approximately weighted one-third: two-thirds between the half-years. Operating profits are even more heavily skewed to the second half.

Exhibit 2: Half year breakdown and forecasts

Year to December ($000s)	H114	H214	2014	H115	H215	2015	2016e	2017e
Quarto Publishing US	26,957	37,101	64,058	27,234	45,207	72,441	74,000	76,467
Quarto Publishing UK	7,624	13,853	21,477	7,582	15,183	22,765	23,500	24,350
Quarto Intl Co-Ed	12,645	30,031	42,676	15,106	35,041	50,147	51,850	53,146
Books & Gifts Direct ANZ	11,814	19,356	31,170	8,875	13,185	22,060	22,250	22,584
Quarto Hong Kong	6,526	6,737	13,263	7,417	7,335	14,752	15,400	15,930
Total revenue	65,566	107,078	172,644	66,214	107,078	182,165	187,000	192,477
Normalised operating profit
Quarto Publishing US	2,188	4,448	6,636	1,812	7,072	8,884	9,028	9,176
Quarto Publishing UK	329	2,770	3,099	293	3,009	3,302	3,396	3,555
Quarto Intl Co-Ed	737	5,326	6,063	-1,110	7,461	6,351	6,533	6,696
Books & Gifts Direct ANZ	585	2,382	2,967	413	1,200	1,613	1,780	1,863
Quarto Hong Kong	623	489	1112	799	688	1,487	1,448	1,474
Total operating profit	4,462	15,415	19,877	2,207	19,430	21,637	22,184	22,764
Corporate expenses	-2,079	-2,405	-4,484	-1,984	-2,405	-4,431	-4,200	-4,250
Norm op profit (post amort prod'n costs)	2,383	13,010	15,393	2,383	17,025	17,206	17,984	18,514
Operating margin
Quarto Publishing US	8.12%	11.99%	10.36%	6.65%	15.64%	12.26%	12.20%	12.00%
Quarto Publishing UK	4.32%	20.00%	14.43%	3.86%	19.82%	14.50%	14.45%	14.60%
Quarto Intl Co-Ed	5.83%	17.74%	14.21%	-7.35%	21.29%	12.66%	12.60%	12.60%
Books & Gifts Direct ANZ	4.95%	12.31%	9.52%	4.65%	9.10%	7.31%	8.00%	8.25%
Quarto Hong Kong	9.55%	7.26%	8.38%	10.77%	9.38%	10.08%	9.40%	9.25%
Net interest	-1,638	-1,619	-3,257	-1,322	-1,776	-3,257	-2,984	-2,714
Pre-tax pre-goodwill & exceps	745	11,391	12,136	1,061	15,249	13,949	15,000	15,800

Source: Edison Investment Research, company accounts

This seasonality should not be taken to imply that the group does not have visibility on its forward sales. It also has a clear idea on the commerciality of each title before it proceeds to print. Frontlist sales will reflect a multiple of prior year intellectual property spend, on a (product efficiency) ratio which has steadily improved over the last four years from 1.02x in 2012 up to 1.34x in the year just reported. Backlist sales have been running consistently in the $85-89m over the last three years, but should tick up in FY16 as the higher frontlist titles move across to the backlist.

Corporate changes signal next phase

The shift around in the share register as the activists have moved on was sorted with a placing into the hands of institutional shareholders, as described in our note of November 2015. The sequence of changes at board level was completed with the changes announced alongside the final results. Tim Chadwick, who was brought in as Chairman in 2012, and Christopher Mills, who represented the previous activist shareholders, will both leave the board at the AGM in May. The new chairman designate is Peter Read, formerly chairman of KPMG’s TMT practice. The other new non-executive is Marie Louise Windeler, who, like Peter Read, holds a number of non-executive positions and who was CEO of Hill & Knowlton. There are two other non-executive directors on the board, along with the CEO and CFO. Having looked extensively into moving the registration from the US state of Delaware, the costs of doing so, in money and in management time, rule out doing so.

Operational progress continues

Through all the changes, Quarto’s publishing businesses have concentrated on their core function: publishing books that are beautiful, useful or both. More recently, the management focus has been on building the platforms and infrastructures that enable the publishing imprints to sell more smartly. This has involved investing in financial and publishing systems, the www.Quartoknows.com website (which incorporates an ecommerce facility), and leveraging spend on common needs such as print.

The drive to build sales in the children’s category has been very successful, with both organic and acquisitional activity producing strong sales growth, with the category making up 22% of FY15 publishing revenues. Of the eight imprints, three were in-house (including the Frances Lincoln imprint, which has been reinvigorated), three have been start-ups and two, acquisitions. Two new children’s imprints are being launched in the US, but there is a strong appetite to grow the US children’s offer more rapidly, ie by acquisition. Wide-Eyed Editions, within Quarto Publishing UK, was launched in 2104 and has been particularly successful with its over-sized, beautifully illustrated and informative children’s titles. It generated $2.3m of sales in its second year of operation.

While the pay down of the debt remains a key objective, it is not an imperative that has to be pursued ahead of taking other opportunities. Last year’s buy of Ivy Press (for £1.5m including debt, February 2015) has been far more positive than anticipated, contributing revenues of $8.2m and operating profit of $1.9m to the International Co-Editions (and group) numbers. This should provide a degree of comfort to the market that Quarto is unlikely to get caught up in any bidding wars for larger assets. It also has no ambition to take on imprints which need extensive resource to optimise, either in cash or in management time. Our model assumes no further substantive transactions and cash conversion of a little over 100% (FY15 was unusually high at 114%), resulting in a reduction of around $6m in the debt position. Although the debt level is still high, the multiple to EBITDA reduced from 4.9x in FY12 to 3.2x for FY15, with all covenants easily met. Managing the debt position has been done without compromise on investment in intellectual property, the lifeblood of the business, or in the systems to optimise the sales and marketing effort. The dividend (now declared in US$) has also been increased to reflect the good financial performance, giving an above-market and sector yield.

Exhibit 3: Financial summary

Year end 31 December	2013	2014	2015	2016e	2017e
Accounting basis	IFRS	IFRS	IFRS	IFRS	IFRS
PROFIT & LOSS
Revenue	176,318	171,339	182,165	187,000	192,477
Cost of sales	(111,807)	(116,326)	(122,803)	(126,038)	(129,730)
Gross profit	64,511	55,013	59,362	60,962	62,748
EBITDA	15,418	17,025	18,395	19,174	19,704
Operating profit (before GW and except)	14,044	15,919	17,206	17,984	18,514
Amortisation of intangibles	(434)	(503)	(724)	(724)	(724)
Exceptionals	(3,405)	566	(445)	0	0
Amortisation of pre-production costs	(30,099)	(30,933)	(33,258)	(34,128)	(35,127)
Operating profit	(19,894)	(14,951)	(17,221)	(16,867)	(17,337)
Net interest	(4,443)	(3,977)	(3,098)	(2,984)	(2,714)
Profit before tax (norm)	9,601	11,942	14,108	15,000	15,800
Profit before tax IFRS	5,762	12,005	12,939	14,276	15,076
Tax	(1,416)	(2,922)	(3,685)	(4,150)	(4,480)
Adjustment to tax for normalised earnings	(1,013)	(16)	(645)	0	0
Minority charge	(412)	(310)	(388)	(375)	(388)
Profit after tax (norm.)	6,760	8,696	9,778	10,475	10,932
Profit after tax (FRS3)	3,934	8,773	8,866	9,751	10,208

Average number of shares outstanding (m)	19.7	19.7	19.7	19.7	19.7
EPS - normalised fully diluted (c)	37.7	44.1	49.5	53.1	55.4
EPS - IFRS (c)	20.0	44.5	45.0	49.5	51.8
Dividend per share (c)	12.3	13.7	14.5	15.3	15.8

EBITDA margin (%)	9%	10%	10%	10%	10%
Operating margin (before GW and except) (%)	8%	9%	9%	10%	10%

BALANCE SHEET
Fixed assets	104,557	102,416	104,433	105,148	105,174
Intangible assets	42,358	42,025	41,622	41,648	41,674
Tangible assets	5,978	2,857	3,368	4,500	4,500
Investment in associates	56,221	57,534	59,443	59,000	59,000
Current assets	99,103	99,702	108,369	110,521	115,026
Intangible assets: pre-publication costs	0	0	0	0	0
Stocks	19,181	24,851	26,147	26,841	27,627
Debtors	56,043	51,741	57,163	58,680	60,399
Cash	23,879	23,110	25,059	25,000	27,000
Current liabilities	(70,485)	(144,919)	(70,635)	(73,525)	(78,690)
Creditors	(53,882)	(55,769)	(65,635)	(68,025)	(70,690)
Short-term borrowings	(16,603)	(89,150)	(5,000)	(5,500)	(8,000)
Long-term liabilities	(83,229)	(6,875)	(87,127)	(78,100)	(70,100)
Long-term borrowings	(78,291)	0	(79,562)	(73,000)	(65,000)
Other long-term liabilities	(4,938)	(6,875)	(7,565)	(5,100)	(5,100)
Net assets	49,946	50,324	55,040	64,044	71,410

CASH FLOW
Operating cash flow	47,914	47,529	52,941	53,430	53,600
Net interest	(4,701)	(3,310)	(2,749)	(3,152)	(2,882)
Tax	(2,087)	(759)	(1,981)	(3,801)	(4,233)
Capex	(28,805)	(33,018)	(36,882)	(36,000)	(36,000)
Acquisitions/disposals	1,057	(2,008)	(1,614)	(1,618)	0
Financing	14	0	0	0	0
Dividends	(2,427)	(2,739)	(2,346)	(2,857)	(3,004)
Other	(382)	0	0	0	19
Net cash flow	10,583	5,695	7,369	6,003	7,500
Opening net debt/(cash)	80,978	71,015	66,040	59,503	53,500
HP finance leases initiated	0	0	0	0	0
Loans acquired with acquisitions	0	0	0	0	0
Translation differences	(620)	(720)	(832)	0	0
Closing net debt/(cash)	71,015	66,040	59,503	53,500	46,000

Source: Company accounts, Edison Investment Research

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