Interactive Investor

Stockwatch: 27% upside potential for patient buyers

4th April 2017 09:21

Edmond Jackson from interactive investor

Is it worth buying the 2017 drop in this international book publisher? AIM-listed Quarto has fallen from its long-term high around 320p last January, to about 250p, possibly linked to the sale of a subsidiary - Books & Gifts Direct (BGD) - that retails in Australia and New Zealand.  

It has dirtied the 2016 results by way of losing US$8.3 million equivalent (£6.6 million) last year, and writing down its assets to a recoverable amount means a $14.2 million impairment charges, hence a $0.5 million related loss overall for this disposal.  

Otherwise, the continuing publishing operations achieved a 17% rise in operating profit to about $20 million on a 6% rise in publishing revenue, helped by recent acquisitions. A 12p equivalent dividend covered 3.6 times by adjusted earnings per share (excluding BGD) implies the dividend yield rising towards 5%, hence the stock finding support to edge up to 253p. 

Mind, an issue with US companies is a dividend withholding tax (the company has to collect on dividends paid to non-US shareholders) which is 30% nominally, but reduces to 15% for UK individual shareholders. It's hardly a main issue if one to be aware of. Thus, institutions being tax-exempt means they may see an attractive risk/reward profile sooner than individuals.

Business now in good shape operationally

In Quarto's favour, it offers a hedge against weaker UK consumer spending, the business being well-established internationally since founding in 1976. Children’s publishing revenues are up 34% and foreign rights by 8% despite some currency headwinds.  

The chief executive of five years looks to have settled well into his role. Book sales generally have been undermined by web-browsing, but the industry shows signs this may have run its course and the pleasures of genuine books is returning.  

Quarto creates and owns content, publishing books with long-lasting content across specific niches of interest.  It sells across 50 countries and in 39 languages and is resolved to become global leader.  A tighter consumer environment would hurt discretionary spending, although the UK represented just 11.1% of 2016 revenues, the US 55.2%, Europe 14%, Australia/Far East 13.4%, and rest-of-world 6.3%.  

My sense is that if Quarto hits a difficult patch, say in the event of a US recession, it is looking an attractive bid target given its "off-radar" status, which helps explain the modest share rating.

I’ve not been a fan of this share in the past, but recall Christopher Mills, the fund manager of North Atlantic Smaller Companies Investment Trust, certainly was going back 15 years when he argued its rating was too cheap even then. But news-flow was variable and Mills got into a long-running battle with Laurence Orbach, the now 75 year-old founder of Quarto who used to be executive chairman. Mills challenged the acquisitions he made on grounds of lacking focus and rationale (which included Books & Gifts Direct).  

This came to a head in November 2012 when Mills' fund management group collaborated with Wellcome Trust: owning 29% of Quarto they pushed for an EGM that deposed Orbach with 55% overall shareholder support. Tim Chadwick, a turnaround specialist, was installed as executive chairman, but left a year ago.  

Mills appears to have sold down, although the stock rose usefully from 120p to 320p between 2013 and end-2016. Among major shareholders currently, Liontrust owns 12.6% and Herald Investment Trust 8.9%, both respected fund managers.

Pure focus on book publishing is expected to help 2017 performance, despite a "difficult" market. Reflecting its quality, Quarto has won an illustrated children’s book award for a second year at Waterstones. On a medium to longer-term view I anticipate Quarto delivering shareholder value operationally, or via a takeover in the event of recession.Industry leaders - Quarto is getting there - on modest share ratings tend to get taken out. 

Balance sheet further explains weak share rating

Quarto's legacy balance sheet also contributes to the modest rating.  As expected of an acquisitive group in intellectual property, goodwill represented $36.1 million at end-December and other intangibles $4.4 million. 

Furthermore, pre-publication costs of $61.1 million are capitalised, the cash flow statement showing $37 million investment in pre-publication costs.  The pros and cons of doing this are debatable, but capitalising costs can be a point of criticism. More positively, it reflects the chief executive’s aim to "invest more in the quality of our books..." if unclear from the release whether it includes investment in "global sales and marketing teams". 

Trade receivables of $54.2 million compared with $59.7 million trade payables, although $18.8 million cash helped the current ratio (of current assets versus current liabilities) to a satisfactory 1.4 times.  

Additional to $5 million short-term debt there was $75.7 million longer-term (down from $79.6 million), which meant $3 million net finance costs versus $17.7 million normalised operating profit.  Mind, the service cost may rise if the US Federal Reserve finds itself having to tackle inflation with serial interest rate rises.   

Further down the results release, note 7 declares: "The cashflow cover covenant test was not passed at end-2016; this does not constitute a breach of the group’s banking facilities" given it was a first time and occurred due to an adverse working capital movement.  

"Having identified mitigating actions... the group will comply with all financial covenants for the foreseeable future." This and the departure of the chief financial officer, further conveys a sense of risk.  The chief executive says the CFO "has decided to resign" if impossible to decipher whether of his own will.  

Altogether these issues may deter some investors, but unless a recession arrives soon then it looks like Quarto can continue to reduce its debt - that, I believe, is the chief financial risk going forward. The balance sheet and CFO resignation aren't exactly what you want to see, but Quarto’s commercial substance tilts risk positively.

Forecasts are elusive but target a recovery over 300p

I'd conservatively look for 2017 sterling EPS of about 46p, for which a slightly improved price/earnings (PE) of 7 times implies 322p where Quarto would only need a small dividend rise to yield close to 4%.  

If trading updates remain fairly resilient, then this stock should reward patient buyers: the group is in overall better shape and illustrated books have a future.

The Quarto Group Inc  
Summary financial results  
(US$ million)20162015
   
Revenue188.4182.2
Publishing revenue154.6145.3
Adjusted publishing operating profit21.718.5
Adjusted operating profit (exc Books & Gifts Direct)18.615.6
Operating profit1.715.3
Exceptional impairment charge relating to BGD-14.2 
Loss/profit before tax-5.38.5
Adjusted earnings per share (exc BGD) cents54.746.0
Basic loss/earnings per share cents-28.541.3
Net debt61.959.5
Total dividend (cents)15.014.5

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