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In today's Digest holiday series essay, Mike reveals how you can earn an 11% annual return with one of these opportunities right now. It's one of the leaders in a dying industry...

Make a Safe, Double-Digit Annual Return With This 'Quintessential Survivor'

By Mike DiBiase, editor, Stansberry's Credit Opportunities

Suzanne Zak never forgot the exact day the "light bulb" flashed in her head...

July 24, 1998.

Zak – the head of a money-management firm called Zak Capital at the time – joined several other money managers and analysts at a meeting hosted by a young, relatively unknown CEO. He wanted to discuss his bold vision for his burgeoning, four-year-old company.

Although this company was growing rapidly and had gone public a year earlier, Zak hadn't taken it too seriously or paid much attention to its plans up to that point.

But as the company's CEO revealed his ideas, Zak started to worry... While sitting in the meeting, she realized that this company would soon crush one of her firm's largest holdings.

Zak Capital was a large shareholder of brick-and-mortar national bookseller Barnes & Noble. The CEO at the meeting was 34-year-old Jeff Bezos... the now-famous founder of Amazon (AMZN). Back then, it was the dawn of the Internet age... and Amazon only sold books.

As Zak explained to Fortune magazine in 1999...

Initially, like a lot of people, we were skeptical of Amazon. But at that meeting, listening to Bezos, a light bulb went off. I said, "We're going to have a problem here."

Zak realized traditional bookstores couldn't compete with Amazon...

The online bookseller didn't have to pay to operate expensive retail locations. And Amazon's investors didn't care about making a profit. They only cared about sales and customer growth. So Amazon could sell its books for much cheaper than traditional bookstores.

Within a few months after Bezos' speech, Zak had sold all 400,000 of her Barnes & Noble shares. The company's share price fell from $20 to less than $10 by the end of 1999.

It was easy for most folks to conclude that Barnes & Noble would soon be wiped out. But we're now two decades after Zak's "light bulb" moment... And it's still around today.

Some businesses take much longer to die than people think. With patience and research into the best opportunities in these dying industries, you can make big profits. The key players often consolidate and adjust to the new dynamics. And that's exactly what Barnes & Noble did...

It was the largest, most financially sound bookseller. Despite the threat from Amazon, it kept opening new stores... just at a slower pace. And its sales continued to rise – from $2.8 billion in 1998 to $5.3 billion in 2006, the year its stock peaked at more than $30 per share.

When Amazon launched its first Kindle e-reader in late 2007, people again started writing Barnes & Noble's eulogies. "Get ready for the bookstore massacre," they wrote. By the end of 2008, Barnes & Noble's stock had once again fallen to less than $10 per share.

The company was declared dead yet again when its largest brick-and-mortar competitor – Borders – went bankrupt in 2011. Wharton School of Business marketing professor Stephen Hoch said, "I don't think Barnes & Noble has a prayer." But once again, Barnes & Noble survived...

Since 2011, the company has cut its store count by 11% to 627. Its sales have fallen by an average of 4% each year over this period. And yet, it's still kicking...

In August, hedge fund Elliott Management bought the company for $475 million (about $6.50 per share). It plans to tailor each store to the needs of the surrounding community.

So at least for now – more than two decades after its initial death sentence – Barnes & Noble lives on. It has survived far longer than anyone expected for two reasons...

First, the company's debt has always been manageable. Second, its annual sales declines were low enough that management had time to cut expenses and shut down stores.

Today, we're targeting another industry that's in a slow and steady decline – commercial printing.

The Internet has devastated commercial printers – much like brick-and-mortar bookstores. But the printing industry won't die anytime soon. The largest, most financially sound commercial printers will survive. That's where Quad/Graphics (NYSE: QUAD) fits in...

Like Barnes & Noble, Quad/Graphics – better known as just Quad today – is one of its industry's major players. With more than $4 billion in sales last year, it's the second-largest commercial printer in the U.S. And like the bookstore chain, its debt is manageable.

When you add everything up, it's clear to us... Quad will live longer than anyone expects.

So today, we're recommending the Quad/Graphics 7% bond due May 1, 2022 (CUSIP No. 747301AC3) up to $920. It's the only outstanding bond from the company. And this isn't the first time we're investing in it...

We recommended this bond in our July 2016 issue of Stansberry's Credit Opportunities, when it traded for around $915 and came with a yield to maturity ("YTM") of about 9%. We sold the bond above par value ($1,000) roughly six months later... booking a 13% gain, or about 25% annualized.

Now, more than three years later, the "sky is falling" again in the commercial printing industry. Quad's bond fell more than 25% in a matter of weeks – from as high as $1,040 at the end of October to around $750 by mid-November.

At the time, the bond was yielding more than 20% to maturity. That's when we recommended it in our November issue of Stansberry's Credit Opportunities. As we go to press today, it trades at around $920 per bond and yields roughly 11% to maturity.

So it still gives us an opportunity to buy this bond and earn a safe, double-digit return.

As we'll explain, nothing has really changed with this story in recent years...

Quad is still a well-managed business, navigating its industry's slow and steady decline. And to make a solid double-digit return, we only need Quad to survive two and a half years.

This Family-Run Printing Business Keeps Rolling

Quad is a family-run business...

The late Harry Quadracci founded the company in 1971. His son, Joel Quadracci, now runs it. The Quadracci family owns around 14% of Quad's stock, but it controls about 80% of the voting power through its "class B" shares. (Only the "class A" shares trade publicly.)

The company currently prints famed magazines Time, Bloomberg Businessweek, People, and Sports Illustrated. And throughout its 48-year history, Quad has also printed many other popular magazines... like Playboy, Newsweek, and National Geographic.

Quad operates 60 manufacturing and distribution facilities, including 52 in the U.S.

It's the second-largest commercial printer in the U.S. in terms of sales... Last year, its sales totaled $4.2 billion, trailing only market leader R.R. Donnelley's (RRD) $6.8 billion.

The industry's slow and steady decline started in the late 1990s... You see, advertising drives the business. And as more people started turning to the Internet for news and entertainment, so did advertisers – flocking to digital channels like Google and Facebook.

This year, for the first time ever, total spending on digital advertising is exceeding the money spent on print and TV advertising. Print advertising is expected to fall nearly 18% this year, according to market-research firm eMarketer. As advertisers continue to shift their dollars online, businesses are printing fewer magazines, catalogs, and direct-mail ads.

As a result, Quad's print sales have fallen by an average of 5% annually over the past four years. And we must be clear... This trend isn't going to reverse. We expect it to continue for the foreseeable future. We project Quad's sales will fall about 5% per year going forward.

Falling sales are just one of Quad's current problems... The company also suffers from overcapacity in the space.

The commercial printing industry is highly fragmented... No single printer accounts for more than 5% of the market. Hundreds of small companies exist. With too many commercial printers and not enough business to go around, companies must settle for charging lower prices. There's little to differentiate their services, so the lowest price usually wins.

Because Quad must accept lower prices to win business, its gross margins – the direct profit on each sale, measured as a percentage of sales – have shrunk... The company's gross margins averaged around 20% for many years. But last year, they slipped to 18%.

You might wonder why we're interested in Quad with all this doom and gloom... But remember, we're not recommending Quad's stock. We're only interested in its bond.

And as longtime Stansberry's Credit Opportunities subscribers know, that means we only care about one thing when it comes to Quad... if the company can survive long enough to pay us the money we're owed. We don't care what happens to Quad after we get paid in full two and a half years from now.

As we said, you should be familiar with this bond if you've followed our bond research for a few years, since we recommended buying this bond in July 2016 – more than three years ago. The same industry dynamics were in play at the time. We described Quad as a "quintessential survivor"... making it an ideal fit for our portfolio.

The bond traded for about $915 when we recommended it. Within six months, it returned to par value of $1,000 per bond. That's when we told subscribers to sell it... We closed our position slightly above par for a 25% annualized gain.

As you can see in the following chart, this bond has mostly traded at par or higher since then. (The black line shows the bond's price, while the blue line shows its YTM.) Back in October, it traded at $1,040. Now, notice the steep price decline on the right side...

Here's why the bond sold off so rapidly this past fall...

In October 2018, Quad agreed to an all-stock deal to acquire LSC Communications (LKSD) – the No. 3 commercial printer in the U.S. for $1.4 billion. It would've made Quad the country's largest commercial printer.

But in June, the U.S. Department of Justice ("DOJ") blocked the deal. And it fell apart a month later. The failed merger distracted Quad from its day-to-day operations...

The company missed sales and profit estimates in the third quarter and lowered its sales and profit guidance for the year. Management cut the company's dividend in half to conserve cash... And the market responded by cutting the company's stock price in half.

Then, in November, credit-ratings agency Standard & Poor's ("S&P") downgraded Quad's credit rating from "B" to "B-." S&P specifically cited weakness in the commercial printing industry.

The price of the company's bond plunged as a result... It fell to as low as about $750 and came with a YTM of 21% in mid-November – more than double the 9% YTM when we recommended it in 2016.

But here's the thing...

We believe the bond is even safer today than the last time we recommended it.

As we noted earlier with Barnes & Noble, slowly dying businesses can present fantastic opportunities for distressed-debt investors. If the business is managed well, it can provide safe ways to profit. The key is knowing which companies can handle their debt.

Now that we know Quad just needs to survive another two and a half years, let's review...

Why We're Not Worried

Although the U.S. commercial printing industry is in slow decline, it's far from dead...

The industry still generates an estimated $76 billion in annual revenue, according to a September 2018 report from market-research firm IBISWorld.

The commercial printing industry won't disappear completely. It's just shrinking. And as this decline continues, the largest printers – like Quad – should survive the longest.

You see, the big printers have a clear advantage over the smaller printers...

They can raise more capital to invest in newer machinery and plants. And their size and scale allow them to do the same jobs for less money than smaller printers. So they can profitably absorb lower prices.

The smaller printers will go out of business first... or the big boys will gobble them up for cheap. If the industry were to consolidate, Quad would hold an advantage over other big printers. It has the highest margins and least amount of debt among these companies...

In other words, Quad is in the best financial shape to absorb the industry's low prices. And it's in the best shape to buy smaller companies.

Plus, we aren't worried about Quad's future for another major reason...

The company isn't just sitting still, watching its revenue melt away. Instead, it's on the offensive, trying to replace its lost sales from commercial printing in other ways...

Quad is in the process of transforming into a new kind of company. It no longer identifies as just a commercial printer. It now calls itself a "marketing solutions partner." That's why Quad dropped the word "graphics" from its official logo and brand name earlier this year.

In February 2018, Quad began acquiring advertising agencies that create, produce, and source both digital and print advertising. The company has spent around $225 million in cash to buy several media companies over the past 22 months. With these moves, when it comes to advertising, Quad wants to become more of a "one-stop shop" for its customers.

This new revenue source has helped offset the losses from Quad's traditional print sales... In fact, last year, Quad grew its total annual sales for the first time since 2014.

That's because the company's "services" revenue – which includes the sales from this new source – grew 33% in 2018 over the previous year. Quad's services sales now account for around 20% of the company's overall sales... That's up from 14% just two years ago.

(As we explained earlier, we're being more conservative with our projections of the company. We forecast that Quad's sales will fall by an average of 5% annually starting next year.)

More important, the company's gross margins on its services sales (around 30%) nearly double those of its legacy printing business (about 16%). So Quad's new advertising-services strategy won't just slow the sales declines in its overall business...

It will also help boost the company's profits and cash flows. Larger cash flows make our bond safer. It means the company has more cash to pay our interest and principal.

And unlike the commercial printing business, advertising services is a growing industry in the U.S... The industry is expected to grow at an average annual rate of 4% through 2022, according to a recent research report from business-analytics firm Dun & Bradstreet.

Quad isn't a business nearing the end of the line any time soon...

The print industry has been declining at a slow and steady rate. And even if the company's transformation to a marketing services company fails, it will at least buy it more time.

Remember, we just need Quad to survive until May 2022 so we can get paid in full. Now that you know why we're not worried, let's take a closer look at Quad's debt...

Breaking Down the Company's Debt

It only matters whether Quad can pay us all our interest and all our principal in May 2022.

Quad has been whittling down its debt over the past four years. The company's debt has declined from $1.4 billion at the end of 2014 to around $950 million at the end of last year.

Regular readers know banks and credit-rating agencies often assess a company's debt burden by comparing its debt with its earnings before interest, taxes, depreciation, and amortization ("EBITDA"). EBITDA is a measure of cash earnings before interest and taxes are deducted. A debt-to-EBITDA ratio above five times is considered highly leveraged.

Over the past four years, Quad has decreased its debt-to-EBITDA ratio from 2.9 times to 2.1 times. Quad's long-term targeted leverage ratio is between 2 times and 2.5 times.

Today, that ratio is a bit higher, at 3.3 times... That's because Quad's debt has climbed back up to $1.2 billion following its $120 million acquisition of an advertising agency earlier this year and increased costs associated with its unsuccessful purchase of LSC Communications.

Still, as we'll explain in a minute with our analysis, we believe Quad's debt is manageable. But before we get to that, it's important to know where our bond stands in line among the company's creditors. Quad's debt, listed in order of payment rank, is made up of...

1. Senior secured credit facilities: This is Quad's most senior debt. It stands at the front of the line. It includes a revolving credit facility ("revolver") and a term loan. Only $20 million was outstanding on the revolver at the end of September (the company's most recent reported period). And it has $815 million outstanding on the term loan maturing in 2024.
2. Master note: Secured by the company's facilities and equipment, it's payable over time with a final maturity in 2031. Today, only $75 million is outstanding.
3. International term loan and credit facilities: This piece of debt is Quad's earliest maturing debt. Only $22 million is outstanding today, and its final maturity is in 2021.
4. Our unsecured bond due in May 2022: Only $243 million remains outstanding of the $300 million originally borrowed. Quad bought back $57 million of the bonds in the open market in 2016, when the bond price dipped to around $750 per bond.

Overall, Quad's debt-maturity schedule looks like this today...

When we recommended the May 2022 bond back in 2016, it came due last. But as you can see in the table, only a few small principal payments that total around $34 million stand in front of us today (payments on its master note and international credit facilities).

This makes our bond safer because it's more likely that Quad could repay it without having to refinance its debt. The last time we recommended this bond, we were counting on the company refinancing.

Quad refinanced its revolver and term loan this year as it was attempting to acquire LSC Communications. That tells us the company still has good relationships with its banks.

With that said, we'll now answer the first question to ask before buying any bond...

Can It Pay Us?

First, we'll look at whether Quad can afford to pay the interest on all its outstanding debt...

We must address that first. If the company can't, its creditors could force it into bankruptcy.

To figure this out, we always compare a company's "cash profits" before interest to its total interest costs. We like to see coverage of at least two times. (Cash profits are the cash a company generates from its operations. They're listed in the statement of cash flows under "net cash provided by operating activities.")

The interest on all of Quad's debt costs the company around $70 million annually.

From 2014 to 2017, Quad's interest costs averaged $70 million and its cash profits before interest averaged around $410 million per year – or about six times its annual interest obligations.

In 2018, the company's cash profits fell 24% from the previous year to $261 million. But as you can see, that still covered Quad's interest 5.3 times... That's extremely safe coverage.

However, we expect Quad's cash profits to fall further this year... to about $210 million.

With Quad's services business contributing higher gross margins, we estimate the company's cash profits will average $230 million annually from next year through our bond's maturity in 2022. Keep in mind... our cash-profit estimates are 12% lower than the company's $261 million in cash profits last year and 33% lower than two years ago.

Here's the key point we want to make...

Even with these lower cash-profit projections, Quad will have no problem paying its interest costs. With $230 million in cash profits, the company could cover its interest 4.3 times ($230 million in cash profits plus $70 million in annual interest costs divided by $70 million).

In short, our interest is safe.

Let's now turn to analyzing whether our principal is safe...

Remember, $243 million remains outstanding on our bond today. And Quad has around $34 million in principal on other debt due before our bond. So the company must come up with a total of $277 million to pay off our bond and all the debt that matures ahead of us.

To determine the safety of our principal, regular readers know we always look at a company's free cash flow ("FCF") – its cash profits minus capital expenditures ("capex").

For Quad, capex is cash costs for things like replacing printing equipment and investing in new technologies. FCF is the cash that's left over for debtholders and equity holders. The company can use it to pay for things like debt reduction, dividends, and stock repurchases.

Quad has spent about $100 million annually on capex over the past three years. We project that the company will need to spend that amount for the foreseeable future. Subtracting those costs from its $230 million in cash profits would leave $130 million per year in FCF.

That's a lot lower than Quad's average FCF over the past five years (about $200 million per year).

We're also assuming Quad will use some of its FCF to pay a dividend in this analysis. In reality, the company would likely cut the dividend if it gets into trouble. Going forward, the dividend will cost Quad $30 million per year after the company cut it in half earlier this year.

When you subtract the dividend payments from our projections for Quad's FCF, you're left with $100 million per year that the company has left to pay down debt.

We project the company will end this year with $80 million in cash. Adding that to two years of our projected FCF ($260 million) and subtracting two years of dividends ($60 million) leaves $280 million to pay down debt. You can see the company will have just enough cash to pay off all its debt when it comes due, including our bond...

Even if our conservative projections are wrong, Quad could also still borrow from its revolver to help pay off our bond as long as it stays within its financial covenants.

Now, if management uses its cash to make more acquisitions over the next two years, then Quad will have to refinance its debt to pay off our bond. That could include issuing another bond.

However, we don't think refinancing will be a problem... Even in our conservative projections, Quad will still generate solid cash profits and FCF in the years ahead.

With $230 million in cash profits, Quad would cover its interest more than four times. With that coverage – and its solid relationships with the banks – it shouldn't have refinancing issues.

In short, our principal is also safe.

Still, as always, we must understand our maximum downside risk before investing in any bond. So now, let's look at what a worst-case bankruptcy scenario would mean...

Liquidation Analysis

Let's assume Quad's sales decline much faster than we expect... and that management can't cut the company's costs fast enough. Its FCF could turn negative.

We always assume a more conservative "liquidation" bankruptcy... in which a company closes its doors for good and sells off all its assets to pay its creditors.

If Quad is forced to keep lowering its prices to compete in the commercial printing space and its sales fall 10% annually, we project its FCF would eventually turn negative. In other words, the company wouldn't have any money left over for debtholders and equity holders.

Its EBITDA would also fall. Quad's debt covenants require it to maintain debt-to-EBITDA ratios below certain thresholds. In this scenario, Quad would be in violation of these covenants... And its creditors wouldn't likely agree to waive them or to refinance its debt.

We'll assume Quad would be forced into bankruptcy at the end of 2020.

As you can see from our analysis in the following table, we don't expect to recover any of our bond's principal in a forced liquidation. That doesn't surprise us... It was also the case when we recommended this same May 2022 bond back in July 2016.

The $1 billion in estimated proceeds after selling Quad's assets would be enough to cover the company's senior secured debt, but not enough to pay off priority claims like lease and pension obligations. Nothing would be left for unsecured creditors like us as bondholders.

S&P agrees... Assuming a more likely reorganization bankruptcy, the credit-ratings agency estimates no recovery for unsecured bondholders. So before you buy, you must know...

That means we should expect to collect none of our bond's principal in an unlikely, worst-case scenario bankruptcy. If Quad were to go bankrupt at the end of 2020, you would only collect two interest payments that total $70. Your total loss would come to 91%.

Of course, we don't believe Quad will go bankrupt. We would never recommend a bond from a company that we expect to file for bankruptcy before our bond matures. As we explained earlier, we believe Quad will be able to pay off our bond in full in May 2022 with cash – or by refinancing, if needed.

Here's how we believe this investment will actually play out...

What You Can Expect With This Bond

This bond pays a semiannual interest payment of $35. That's $70 per bond each year.

Quad made its last interest payment on November 1. So you'll need to pay around $9.25 in "accrued interest" to the bond's seller. (Accrued interest is just the interest earned by the bond's seller since the last coupon payment was made. Bond buyers have to pay all earned but unpaid interest to the seller when buying a bond.)

You'll collect your first interest payment of $35 on May 1, 2020.

Your "cash-interest yield" will be 7.5%. That's your annual interest ($70) divided by your purchase price of about $920 (including the accrued interest owed to the bond's seller).

For every bond you purchase, you have the legal right to collect $1,000 at maturity on May 1, 2022. If you hold the bond to maturity, you'll also receive five interest payments that total $175. That means you'll collect a total of $1,175 per bond on a $920 investment.

It works out to a total return of about 26% in less than two and a half years (11% annualized YTM).

And just like the last time we recommended this bond, we believe we'll do even better...

When we recommended this same bond in 2016, it traded at around $915 and yielded just 9%. We sold the bond above par six months later, realizing a total gain of around 13% (25% annualized). As we "double dip" on this bond today, we hope to do the same again...

If this bond were to return to par value before it's due to mature in May 2022, we would be happy to sell early and collect our capital gains. By doing so, we would increase our YTM.

For example, if the bond returned to par value six months from today, we would sell and realize a YTM of 23%.

Let's take advantage of another opportunity to earn a double-digit return on this bond...

Buy the Quad/Graphics 7% bond due May 1, 2022 (CUSIP No. 747301AC3) up to $920 per bond. (As we go to press, it's trading right around our buy-up-to price.)

Please don't pay more than $920 for this bond. Do not chase prices higher. If you can't get the bond at or below our recommended buy-up-to price, please do not buy it.

Quad doesn't have any other bonds available to buy. This is the only one.

Be patient when trying to buy this bond... Remember, the bond market is less liquid than the stock market. The price you pay for a bond determines your ultimate return.

You only get one chance to buy. Make it count.

Your broker will typically quote bond prices in two digits. But each bond actually costs 10 times that amount. For example, a bond quoted at $92 will actually cost $920, plus any interest that has accrued since the last interest coupon was paid.

Regards,

Mike DiBiase

Editor's note: In the spirit of the holidays, we're offering all Digest readers a chance to receive some of our most popular research at a significant discount to what it would typically cost. Right now, you can get instant access to all of Mike's research in Stansberry's Credit Opportunities for the next year at half off the normal price. Get started right here.