TEXT - S&P cuts Quad/Graphics Inc rating to BB

Fri Dec 14, 2012 1:45pm EST

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Overview
     -- U.S.-based printing company Quad/Graphics Inc. has received approval 
to complete its acquisition of Vertis Holdings Inc.
     -- It announced a 20% increase in its regular dividend and a one-time $94 
million special dividend to be paid in December 2012.
     -- We are lowering our ratings, including the corporate credit rating, to 
'BB' from 'BB+', and removing our ratings from CreditWatch, where they were 
placed with negative implications on Oct. 12, 2012.
     -- The stable rating outlook reflects our expectation of continued 
mid-single-digit percentage revenue and EBITDA declines in 2013, with leverage 
remaining below 3x.

Rating Action
On Dec. 14, 2012, Standard & Poor's Ratings Services lowered its ratings on 
Sussex, Wis.-based printing company Quad/Graphics Inc., including the 
corporate credit rating, to 'BB' from 'BB+'. This follows Quad's plan to pay a 
$94 million special dividend (about 16% of past 12 months' EBITDA) and 30% of 
discretionary cash flow to shareholders in December 2012. The U.S. Bankruptcy 
Court approved Quad's proposed purchase to acquire the assets of printer 
Vertis Holdings Inc. for $258 million ($170 million net of normalized working 
capital, or 3x estimated 2012 EBITDA). Quad expects to close the purchase in 
January. We have removed our ratings from CreditWatch, where we placed them 
with negative implications on Oct. 12, 2012 when Quad announced the proposed 
acquisition of Vertis.

The downgrade reflects our view that Quad's business risk profile will be 
weakened with the acquisition of Vertis and that leverage will increase as a 
result of the acquisition, the resulting integration costs, and the payment of 
the special dividend. We believe these actions leave Quad with limited 
financial flexibility if trends worsen and the integration of Vertis does not 
go smoothly. We believe the Vertis acquisition will weaken Quad's business 
risk profile by increasing its exposure to a poorly performing company in an 
already declining sector. Vertis will require significant management attention 
to be integrated efficiently. Because of the integration and Vertis' lower 
EBITDA margin, we expect Quad's EBITDA margin to be hurt over the next two 
years. We estimate its margin will decline to about 12% from about 14% pro 
forma for the acquisition (not including synergies or restructuring costs to 
achieve these synergies). We expect the margin to be lower over the first two 
years after the acquisition's close, as restructuring costs exceed synergies. 
At the same time, we believe Quad will continue to face negative structural 
trends and economic pressures that the proposed acquisition and ongoing 
operational restructuring will only partly offset.

Secondarily, we view the payment of a special dividend and a 20% increase in 
the common dividend (increasing the dividend yield to over 7% from 6%) as an 
aggressive use of the company's cash flow and revolver capacity, especially 
given the secular trends impacting the company. We expect Quad to use revolver 
borrowings to finance both the acquisition and special dividend. As a result, 
we expect adjusted leverage, pro forma for both transactions and including our 
adjustments for operating leases and pensions and post-retirement medical 
costs, to increase to 2.9x from 2.7x as of Sept 30, 2012. 
Rationale
The corporate credit rating on Quad/Graphics Inc. reflects our expectation 
that it will continue facing negative structural trends and economic 
pressures, only partly offset by business integration savings from its 
proposed acquisition of Vertis Holdings Inc. We view Quad's business risk 
profile as "fair," based on its size, operating efficiency, and profitability, 
despite the difficult fundamentals in the printing industry. Industry trends 
include intense competition, fragmentation, intense pricing pressures, 
declining demand in key end markets, and significant revenue volatility over 
the economic cycle. We view Quad's financial risk profile as "significant," 
based on its leverage (2.9x on an adjusted basis pro forma for its acquisition 
of Vertis and payment of a one-time special dividend in December 2012) and our 
expectation that discretionary cash flow as a percentage of EBITDA will 
decline in 2013 due to the dividend increase and integration and restructuring 
costs associated with the ongoing business and the Vertis acquisition. 

Quad is the second-largest printer in the Western Hemisphere, and roughly 
one-half the size of industry leader R.R. Donnelley & Sons Co. Quad's print 
products are well diversified, but the majority of its end markets face 
unfavorable structural changes as content and advertising dollars move to 
digital media. In addition, the printing industry is fragmented and highly 
competitive. Industry overcapacity led to more competitive pricing, leaving 
the printing industry more vulnerable to cyclical downturns. 

We expect Quad's revenue performance to reflect continued low-single-digit 
percentage price degradation and low-single-digit percentage volume declines, 
given the unfavorable secular trends in books, magazines, retail inserts, and 
directories. In our base-case scenario, we expect revenue to decline at a 
high-single-digit percentage rate and EBITDA (different from management's 
calculation of EBITDA, and does not include certain add-backs) to decline at a 
mid-teens percentage rate this year. Revenue fell 6.3% in the third quarter 
year over year because of pricing pressure, and volume declines. Adjusted 
EBITDA dropped 10.8% while EBITDA margin declined to 14.9% from 15.6%.

Based on our base-case forecast, we project that, barring an acceleration in 
current pricing and volume trends, revenues and EBITDA could continue to 
decline at a mid-single-digit percentage rate. As a result, leverage could 
remain in the high 2x area for the next two years. Because of the operating 
leverage inherent in the business, we believe Quad will need to keep 
resturcturing its businesses to achieve the cost savings to keep EBITDA 
declines in line with projected revenue declines. We expect leverage to 
increase to about 2.9x debt-to-last-12-months' EBITDA, pro forma for the 
Vertis acquisition and payment of the special dividend. (EBITDA is adjusted 
principally for the present value of operating leases of about $128 million 
and the tax-adjusted underfunded status of the company's pension and 
postretirement obligations of approximately $200 million). Management affirmed 
its target leverage ratio range of 2.0x to 2.5x, translating to pension- and 
lease-adjusted leverage of roughly 2.5x to 3.0x. Conversion of EBITDA to 
discretionary cash flow was about 52% for the 12 months ended Sept. 30, 2012. 
We expect this measure to decline in 2013 because of the dividend increase, 
and integration and restructuring costs associated with the ongoing business 
and Vertis acquisition.

Liquidity
Based on our criteria, Quad has "adequate" sources of liquidity. Our 
assessment of the company's liquidity profile incorporates the following 
expectations and assumptions:
     -- We expect sources of liquidity to exceed uses by 1.2x or more over the 
next 12 months.
     -- We expect the company's net sources to be positive, even if EBITDA 
drops 15%.
     -- We believe Quad can maintain covenant compliance if EBITDA drops 15%.
     -- We believe Quad can absorb low-probability, high-impact shocks in the 
next 12-18 months.
     -- Quad had $18.6 million in cash as of Sept. 30, 2012. Liquidity is 
further supplemented by an $850 million revolving credit facility due 2016. We 
estimate about $550 million will be available pro forma for the Vertis 
acquisition and payment of the special dividend. We expect the company to 
generate about $150 million in discretionary cash flow in 2013. We also expect 
uses of liquidity include about $125 million in capital expenditures. 

The company's credit facility has a maximum leverage ratio beginning at 3.50x, 
a minimum interest coverage ratio of 3.25x (with step-ups), and a consolidated 
net worth covenant. We expect Quad to maintain a good cushion of compliance 
with its covenants over the next 12-18 months.

We believe near-term debt maturities (including amortization payments on 
existing indebtedness) are manageable, given our expectation of positive 
discretionary cash flow. Total debt maturities in 2013 (including amortization 
of the term loan A, amortization of the term loan B, and the maturity of the 
unrated senior secured notes) are $102 million. Roughly $55 million to $65 
million of the company's senior secured notes will mature in each of the next 
few years. The term loan A amortizes at 1.25% per quarter for four quarters, 
starting with the quarter ending Dec. 31, 2012, and then at 2.5% for all of 
the following quarters, with the remainder due at maturity. The term loan B 
amortizes at a rate of 0.25% per quarter beginning with the quarter ending 
Dec. 31, 2011.
Recovery analysis
For the complete recovery analysis, see Standard & Poor's recovery report on 
Quad/Graphics Inc., to be published on RatingsDirect. 
Outlook
The stable rating outlook reflects our expectation of continued 
mid-single-digit percentage revenue and EBITDA declines in 2013, with leverage 
remaining below 3x. We could lower the rating if we believe leverage will 
increase above 3x. This could occur if revenue declines accelerate above the 
mid-single-digit percent rate, leading to further meaningful EBITDA declines.

It is unlikely that we will raise our rating, given the secular trends in the 
sector and Quad's current 2.0x-2.5x leverage range. If industry trends 
stabilize, and Quad reports organic revenue and EBITDA growth, with margins 
back above 14%, we could consider an upgrade if Quad commits to a lower 
leverage target.


Related Criteria And Research
     -- Business Risk/Financial Risk Matrix Expanded, Sept. 18, 2012
     -- Liquidity Descriptors For Global Corporate Issuers, Sept. 28, 2011
     -- Use Of CreditWatch And Outlooks, Sept. 14, 2009
     -- Criteria Guidelines For Recovery Ratings, Aug. 10, 2009
     -- 2008 Corporate Criteria: Analytical Methodology, April 15, 2008

Ratings List
Downgraded; CreditWatch/Outlook Action
                                        To                 From
Quad/Graphics Inc.
 Corporate Credit Rating                BB/Stable/--       BB+/Watch Neg/--

Quad/Graphics Inc.
 Senior Secured                         BB                 BB+/Watch Neg
   Recovery Rating                      3                  3
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