Quarto Group

Quarto Group (LON:QRT) is a UK-listed publisher that focuses on these six categories: children’s books (39% of revenue), cookery, home and garden, art and craft, heritage, and wellbeing.

In January 2018 I published a post about the company behind a paywall on this site, presenting it as a speculative special situation. A new shareholder of the company had emerged in the person of Chuk Kin Lau, the CEO of Hong Kong listed Lion Rock Group Ltd (HKG:1127). Some months before Lau reported his holding, an unnamed party had made an offer for the company, but those discussions were ultimately terminated. I put two and two together and figured Lion Rock was probably the bidder (I don’t think this was ever confirmed anywhere btw) and that Lau was now taking a different approach and buying shares on the open market. I figured a bid was still very much possible and that it seemed like a good bet to buy some shares alongside Mr. Lau.

In the end, a takeover offer from Lion Rock for Quarto didn’t materialize. What did happen is that Mr. Lau took effective control of Quarto, replacing a majority of the Board members. That’s where my post ended, in May of 2018. I closed that post by saying I was going to hold on to my shares for a while. I wanted to see how things played out and I really liked Mr. Lau’s track record at Lion Rock (the company’s old name was 1010 Printing). There’s an old VIC write-up about 1010 Printing that describes Lau’s track record in some detail.

The situation three years later

It’s now three years since I last updated that post, and I still own my Quarto shares. And they’re trading at a lower level today. So I can safely say that the special situation didn’t play out the way I hoped… You could make an argument for selling your shares in a situation like that, because holding on to your shares means some serious “thesis drift”. It had really become a turnaround situation at that point.

Still, I really liked Mr. Lau’s track record and he had turned around other (printing) businesses before. Selling my position at such depressed levels (shares ultimately dropped to below 50p in 2020) just seemed like a bad idea to me.

Quarto’s business finally seems to have turned around after three years. In March this year the company announced its results for 2020 and I increased my position after the announcement. I still think the shares are trading at an attractive level today. I’ll post some summary financials and discuss some of things that caught my attention in the company’s latest annual report.

I should also note that I have no idea where you can buy this stock now. Most brokers won’t let you buy Quarto. My previous broker did, but they have been acquired by another broker recently. It looks like I’m only able to reduce my position now and not buy any additional shares.

Here’s some recent financial data:

Share price: 91.50p
Shares outstanding: 40,889,100
Market cap: £37.4m -> $52.8m -> The company’s functional currency is the US Dollar, even though it is listed in the UK! The company is incorporated in Delaware, United States.
Net income 2020: $4.6m
P/E ratio: 11.5x
Adjusted net income: $5.5m
Adj. P/E: 9.6x

The calculation for the adjusted earnings can be found on page 72 of the annual report for 2020. The exceptional items and the amortisation of acquired intangibles seem like reasonable adjustments and I do think headline earnings are a bit understated as a result. I think the acquired intangibles are non-cash charges relating to previous acquisitions, but it isn’t explained in any more detail in the report.

Debt reduction

Quarto has gone through a tough few years with high debt levels plaguing the company. The company finally looks to have brought the situation under control though. In January 2020 the company raised ~$17m in an open offer at 68p. The debt was reduced and Lion Rock Group also provided further financial support.

Looking back, I think the previous management just did a poor job at allocating capital. They tried to do everything at the same time and keep everyone happy:

• The different imprints of the company continued to invest in “pre publication costs”
• The company continued making acquisitions as late as 2016, despite elevated debt levels
• Shareholders continued to get dividend payments as late as 2016

It just seems that the CEO at the time did not have the resolve to do what was needed: disappoint some of these people by saying “no” to them and get the debt level down. Fortunately, Mr. Lau doesn’t suffer from that problem. A successful operator in a very competitive industry like book printing in China knows the importance of keeping costs down and managing cash.

The net debt levels have come down a lot since Lau took control during 2018:

• 2020: $19.7m (includes a $2.4m CARES Act loan)
• 2019: $50.5m
• 2018: $60.4m
• 2017: $64.0m (previous management)
• 2016: $61.9m (previous management)

The company has been in survival mode these past few years. Now there should finally be some room to invest in growth again.

Backlist and pre-publication costs

The company actually has quite a bit of financial flexibility due to its backlist and the investments in pre-publication costs. Pre-publication costs are the costs and overheads incurred in the development of book titles prior to their publication. They are capitalized and show up on the balance sheet as a non-current intangible asset. These are substantial investments. Prior management invested a whopping $35.6m in 2017 (2016: $37.2m) in pre-publication costs. The effects of the management change is most easily seen in the level of pre-publication costs in the last couple of years:

• 2020: $20.3m
• 2019: $23.8m
• 2018: $29.7m
• 2017: $35.6m (previous management)
• 2016: $37.2m (previous management)

This is the accounting treatment for these pre-publication costs:

These costs are amortised on a straight-line basis upon publication of the book title over estimated economic life of three years or less, being an estimate of the expected useful economic life of a book title. The estimated economic life is based on the annual sales profile of the Group.

Source: Quarto AR 2020, page 67. Bold text mine.

But some books end up being quite successful and have an economic life that far exceeds these three years. For instance: page 13 of the annual report shows Quarto’s top ten sellers in 2020. Their number one title was Squishy Human Body, netting almost $2.0m. The year of publication for this title was 2006! Although that was an extreme example, four of the top ten titles in 2020 were published before 2018. So I think there’s value in Quarto’s backlist of 15,000 titles. It will keep producing substantial revenue, even when investments in pre-publication costs are reduced for a while. This backlist gave the company time to restructure operations.

Free cash flow

The two factors above: reduced investment in pre-publication costs combined with the revenue from Quarto’s backlist, meant that the company produced a lot of cash over the last few years.

This was the company’s free cash flow:

• 2020: $16.6m
• 2019: $17.4m
• 2018: $8.4m
• 2017: $7.7m (previous management)
• 2016: $4.9m (previous management)

Of course the free cash flow of the last couple of years is probably inflated. The reduced investment in pre-publication costs does have an effect over the medium term. The company must continue to invest in new titles to replenish the value of the backlist. Individual book titles do become less wanted and less relevant over time.

Outlook and capital allocation

The company seems quite positive about the near-term outlook. During the pandemic, online sales have increased and replaced some of the much reduced revenue from brick & mortar retail sales that were hit by lockdowns in the US and the UK. As the Covid restrictions are eased, the company expects to maintain online sales at current levels and to see brick & mortar recover:

Quarto is in a good position to grow in 2021. The gradual return of the high-street bookshop, gift outlets and heritage sites from Easter onwards will revive bricks-and-mortar retail sales, whilst on-line sales are not expected to diminish from their already high levels.

Source: Quarto AR 2020, page 10. Bold text mine.

Now that the debt level looks manageable and earnings visibility has improved, the company is also looking at potential acquisitions:

‘Bolt-on’ acquisitions: Quarto has built its business through organic growth and a series of acquisitions. Our acquisition objective is to increase our market share in the six key categories: Cookery, Home and Garden, Art and Craft, Heritage, Children’s, and Wellbeing. We will focus on ‘bolt-on’ acquisitions of publishers or imprints that could generate synergistic value by leveraging Quarto’s procurement, operations, and sales platform.

Source: Quarto AR 2020, page 9

This is also echoed in the Lion Rock annual report:

The publishing business is an important strategic focus for us to diversify vertically and will be the Group’s new engine of growth. Working closely with Quarto management, we have managed a successful turnaround of the business after a 3-year effort. It is now a much more streamlined operation with a publishing program that is focused on 6 key book categories. With Quarto in much better financial shape now, we will focus on growing the business organically and via bolt-on acquisitions.

Source: Lion Rock AR 2020, page 6

Minority shareholder protection

There are some concerns about minority shareholder protection now that Mr. Lau / Lion Rock control 40.8% of the shares. I made a mistake in my original write-up, figuring that Lion Rock would have to make an offer for all the shares once they had crossed the 30% ownership threshold under the City Code on Takeovers and Mergers in the UK. I overlooked the fact that the company is incorporated in Delaware, United States and that this means that this provision of the City Code does not apply!

That could mean that shareholders can get screwed in a scenario where Lion Rock decides to delist the company and they’re left holding shares in a private company. Richard Beddard has written a post “When is a bargain not a bargain?” that highlights come of the concerns about Lion Rock and some other issues like limited disclosure about digital revenues and issues with dividend withholding taxes.

I’m still fairly comfortable with these issues. I’ll make a few points about the risk of a delisting. I don’t think it is likely the company is going down this path. If the company does end up delisting in the next few years, I think it is likely that they’ll at least combine this with an offer to buy-out minority shareholders at a price that is above today’s share price.

These are the main reasons why I think this:

1. Regulatory issues due to trade tensions between the US and China
2. The recent open offer
3. The rejected takeover in August, 2019
4. Treatment of OPUS shareholders by Lion Rock

I’ll discuss these four reasons.

1. Regulatory issues due to trade tensions between the US and China

As I wrote at the beginning of this post, I believe Lion Rock is likely to have been the bidder for Quarto in August, 2017. One of the problems that ultimately led to termination of the discussions was this:

It became clear that the regulatory approvals required by the bidder to complete the proposed acquisition were increasingly less likely to be granted on the timeline first indicated.

Shortly after this Lion Rock and Mr. Lau began acquiring shares in the open market. I don’t think it has become any easier to get regulatory approval for a Hong Kong listed company with large Chinese operations to take over a US domiciled business. The trade war and all the associated tensions have made this very challenging, I think.

As an example, another Hong Kong listed public company, Analogue Holdings (HKG:1977), owned 51% of a business domiciled in the US called Transel Elevator & Electric (TEI). In August 2020 they decided to sell 2% of that business back to the local management in order to avoid a control position in TEI. Their explanation about this transaction:

In August 2020, the Company reassessed the regulatory, operating and business environment in the U.S. and determined with the board of Transel Elevator & Electric Inc. (“TEI”) that it was in the best interest for TEI to have TEI’s local management increase their equity stakes in TEI due to latest changing Sino-U.S. tension. On 10 August 2020, Anlev (US) LLC, an indirect wholly-owned subsidiary of the Company, disposed of 1 and 1/3rd of a share of common stock of TEI, representing 2% of the equity interests in TEI, to Mr. Mark Gregorio (“Mr. Gregorio”) at a consideration of US$1.4 million (equivalent to approximately HK$10.92 million) (the “TEI Disposal”). Immediately before the TEI Disposal, TEI was a 51% owned subsidiary of the Group and was owned by Mr. Mark Gregorio as to 29.4%.

Source: Analogue Holdings AR 2020, page 109

Like Lion Rock, Analogue Holdings is a Hong Kong listed company, domiciled in Bermuda. I think this transaction shows that taking control of a US listed company has become more problematic now and that some companies are even taking steps to get below a 50% stake.

In January 2020, the company raised capital through an open offer. This was structured in a way that Lion Rock and Mr. Lau stayed below 50% of the outstanding shares:

If no qualifying shareholders (other than the Underwriters) take up their Open Offer Entitlements, the Underwriters are expected to subscribe for all of the New Common Shares available pursuant to the Open Offer which will result in 1010 Printing, Lion Rock Group Limited (parent company of 1010 Printing) (“Lion Rock”) and Chuk Kin Lau (the ultimate controller of Lion Rock and 1010 Printing and CEO of the Company) (together, the “Lau Parties”), together, holding such number of Common Shares so as to give them control of 49.25 per cent. of the enlarged share capital following Admission […] (Bold text mine)

They also brought in a new European shareholder, the Giunti family, who operate a publishing company in Italy. They now own 20% of Quarto’s shares. So it looks to me that Lion Rock and Lau have been careful not to exceed the 50% threshold.

2. The recent open offer

The company raised new capital from investors as recently as January 2020 in an open offer (comparable to a rights offering in the US) at a price of 68p per share. I think you can expect some legal issues if soon afterwards you decide to delist your shares and inflict damage on the shareholders you’ve just raised capital from. Their shares will be a lot less valuable when they’re turned into unmarketable shares in a private company. I don’t think you can really get away with that without making a buyout offer to all shareholders prior to a delisting. But of course, then Lion Rock would become the majority owner and we’ve just seen above that going above 50% ownership could be problematic.

Another interesting detail is that after the open offer, Lion Rock acquired 400,000 shares at 100p per share from Herald Investment Management. That was almost double the market price at that time. The reason was that Quarto didn’t satisfy the free float requirement after the open offer:

After the completion of the Quarto Open Offer in February (details as stated in the Previous Announcements), Quarto failed to comply with the free float requirements set out in UK Listing Rule 6.14 (“Free Float Requirement”), being that 25 per cent. of Quarto’s common shares must be held in public hands by persons located in the European Economic Area. On 4 September 2020, 1010 Printing acquired 400,000 Quarto Shares from Herald Investment Trust plc (“Herald”), an Independent Third Party, at a consideration of £400,000 (equivalent to approximately HK$4 million) (excluding stamp duty and related expenses). The acquisition of 400,000 Quarto Shares from Herald by 1010 Printing resulted in Quarto satisfying the Free Float Requirement. After the transaction, Herald’s interest in Quarto dropped to below 5% and its holding was counted as shares held in public hands.

Source: Lion Rock filing of Oct. 9, 2020 (.pdf), page 3

So Lion Rock jumped through some hoops to comply with the current rules and to stay below 50% ownership. It just seem hard to argue you can pay 100p to one shareholder for a part of his shares and then simply delist your stock and screw all the other shareholders. But I don’t think they have an intention to go down this route.

3. The rejected takeover in August, 2019

Quarto received a takeover offer (behind a paywall) in August, 2019 for 100p per share. The offer was made by Richard Hurowitz, a US investor and publisher of quarterly “journal of ideas” The Octavian Report. The company confirmed it had received an offer, but rejected the approach:

The Board considered the Proposal following its receipt and concluded that it was not in the best interests of the Company or its stockholders, nor did the Board believe it capable of being consummated.

As documented in its announcement of 16 January 2020, Quarto needed to renegotiate its existing debt facilities prior to 31 March 2020, and hence following the Board’s rejection of the unsolicited preliminary Proposal, it continued with its already well-developed plans to raise additional monies via an open offer to shareholders alongside the renegotiation of its debt facilities. The Board has not received any further approaches from Octavian since October 2019.

Again, it seems pretty hard to argue the Quarto board would be fulfilling its fiduciary duties if they reject a 100p all-cash offer (before the turn around) and then delist the company a few years later. Especially after raising new capital from investors at far lower prices after the proposal was rejected.

4. Treatment of OPUS minority shareholders by Lion Rock

Lion Rock acquired a majority of the shares of then Australian listed company Opus Group. I haven’t followed that situation closely, but I don’t think minority shareholders there were treated unfairly. The company was ultimately renamed to Left Field Printing (HKG:1540) and the listing was transferred from the ASX to the Hong Kong Stock Exchange. Shareholders received shares in the “new” company. A transaction like this could be problematic if your broker doesn’t support the market to which the listing is transferred.

It would have been possible for Lion Rock to take the delisting route for OPUS in Australia, but instead they transferred the listing to a different stock exchange.

Conclusion

I still like Quarto today, even though the situation is completely different from when I entered my position as a special situation. The company seems to have finally turned around their business. There is a concern whether minority shareholders will get to benefit alongside the major shareholder if things do keep improving over the next few years. I think there are some reasons to think that minority shareholders will be treated fairly.

But I could be wrong about this. As a small shareholder you are in a vulnerable position. Take a case like Cambria Automobiles (LON:CAMB), which I also own, and where the CEO is attempting to take over the business at, what I think is, a bargain price. If that attempt succeeds, shareholders there will either receive the lowball offer in cash or elect to get non-transferable shares in a private company. Not a good outcome for minority shareholders there if this scheme passes.

I think this is harder to do and less likely in Quarto’s case for the reasons mentioned above, but it remains a risk.

Disclosure: long Quarto Group, Lion Rock Group and Cambria Automobiles