THE QUARTO GROUP, INC.

Condensed Consolidated Cash Flow Statement

For the year ended 31 December 2021

THE QUARTO GROUP, INC.

Notes to the condensed financial statements

1.   Basis of preparation

The results have been extracted from the audited financial statements of the Group for the year ended 31 December 2021. The results do not constitute statutory accounts within the meaning of Section 434 of the Companies Act 2006. Whilst the financial information included in this announcement has been computed in accordance with the principles of 'UK Adopted' International Financial Reporting Standards ("IFRS") as adopted by the IFRIC interpretations and Companies Act 2006 that applies to companies reporting under IFRS, this announcement does not of itself contain sufficient information to comply with IFRS. The Group will publish full financial statements that comply with IFRS. The audited financial statements will incorporate an unmodified opinion.

Statutory accounts for the year ended 31 December 2021, will not have been filed with the Registrar of Companies. The accounting policies applied are consistent with those described in the Annual Report & Accounts for the year ended 31 December 2020, apart from changes to pre-publication costs and returns:

a)    The group undertook a review of the amortization period and method of the pre-publication costs in the development of the books title prior to publication. The review resulted in the change of method used to amortize the pre-publication costs in accordance with IAS 38 - Intangible Assets. The amortization rate has now changed prospectively from a 3 year straight line to a 50% reducing balance basis. The impact of this change is that the amortization charge of the group for the current year has been reduced by $1.26m.

b)    During 2021, actual returns reduced by 31% year on year. As the directors believe this to be a short-term issue, the directors have extended the period which they monitor historical returns to ensure that the longer term trend is reflected in the provision. Accordingly, the period that sales and returns are reviewed was extended from 1 to 3 years. The estimated period that returns are made from the point of sale remains at 6 months, being the final six months of the financial year.

The Group financial statements are presented in US Dollars and all values are shown in thousands of dollars ($000) rounded to the nearest thousand dollars, except where otherwise stated.  Each entity in the Group determines its own functional currency and items included in the financial statements of each entity are measured using that functional currency.

Going Concern

The Board assessed the Group's ability to operate as a going concern for at least the next 12 months from the date of signing the financial statements.

The Directors have considered the underlying robustness of the Group's business model, products and proposition and its recent trading performance, cash flows and key performance indicators. They have also reviewed the cash forecasts prepared in detail to 31 March 2023. This is to satisfy themselves of the going concern assumption used in preparing the financial statements. The base case model was built using a detailed sales forecast driven by the publishing program for 2022. Core margins have been reviewed, with the ongoing Issues of freight and shipping pushing margins down. Trade receivable days remaining consistent with 2021.

As part of this work, the model was sensitised initially by a 5% reduction in revenue to ensure headroom within the covenants. This is deemed as a severe but plausible scenario. Management performed a reverse stress test to assess the point in which the banking covenants were breached. This occurred at a reduction in revenue of 9% from the base case. It is considered unlikely that such a reduction of revenue would occur, given, the detailed nature of the sales forecast and even with the challenges of 2020, revenue dropped by only 7% year on year. Should we start to see a reduction in revenue, then mitigating action will be taken, such as reduction in investment in pre-publication costs, print volumes, staffing levels and other variable costs.

Based on the above indications, the Directors believe that it remains appropriate to continue to adopt the going concern in preparing the financial statements.

2.   Operating segments

The analysis by segment is presented below. This is the basis on which the operating results are reviewed and resources allocated by the Chief Executive Officer, who is deemed to be the chief operating decision maker.

   Segmental balance sheet

1 Please refer to Consolidated Balance Sheet.

1 The comparative value for non-current assets held within the United States of America operating segment has been restated. In the prior year financial statements, the non-current assets incorrect included a balance of $3,604k in relation to deferred tax assets. The comparative numbers have been amended to reflect the revision.

3.     Exceptional items

During the year, there were no exceptional Items (2020: $446,000), in accordance with the accounting policy disclosed in note 1. In 2020, costs comprised $251,000 in respect of redundancy costs following restructuring during the Covid-19 pandemic and a further $195,000 of refinancing costs in connection with amendments to the existing facility agreement. There was no charge, net of taxation for the year (2020: $349,000).

4.     Finance costs

5.     Taxation

5.     Taxation (continued)

Corporation tax on UK profits is calculated at 19% (2020: 19%), based on the UK standard rate of corporation tax of the estimated assessable profit for the year. Taxation for other jurisdictions is calculated at the rate prevailing in the respective jurisdictions. An increase in the UK corporation rate from 19% to 25% is effective 1 April 2023. This will increase the company's future current tax charge accordingly and would increase our net tax liability by $361k.The table below explains the difference between the expected expense at the UK statutory rate of 19% and the total tax expense for the year. 

6.     Earnings per share

7.     Goodwill

Quarto identifies its cash-generating units based on its operating model and how data is collected and reviewed for management reporting and strategic planning purposes, in accordance with IAS36 - Impairment of Assets. Corporate overheads have been divided between cash-generating units and factored into the value in use calculation.

The recoverable amount of each cash generating unit ('CGU') is determined using the value in use basis. In determining value in use, management prepares a detailed bottom up budget for the initial twelve-month period, with reviews conducted at each business unit. A further two years are forecast using relevant growth rates and other assumptions. Cash flows beyond the three-year period are extrapolated into perpetuity, by applying a 2% growth rate from the addressable market. The cashflows are then discounted using a country-specific discount rate. The growth rates used are consistent with the growth expectations for the sector in which the company operates and the discount rate has been calculated using pre-tax Weighted Average Cost of Capital analysis.

The key assumptions for calculating value in use are:

Revenue growth rates: forecast sales growth rates are based on those applied to the Board approved budget for the year ending 31 December 2022 and three-year plan. They incorporate future expectations of growth driven by investment plans for each CGU.

Long-term growth rates: the three-year forecasts are extrapolated to perpetuity on the basis that the CGU's are long-established business units. The long-term growth rates are blended rates formed from the territory-specific long-term growth rates.

Gross margins: gross margins are based on historic performance and expected changes to the sales mix in future periods.

The Group has undertaken various sensitivities of the QUK and QUS CGU's. There were no reasonably possible changes in QUK that would lead to impairment. QUS, which has the largest goodwill and non-current assets, carries a greater risk that reasonably possible changes would result in impairment. Based on the above long-term growth rate and discount rate, QUS exceeded the carrying value of goodwill by $9m. The following sensitivities were applied to this CGU:

1.5% increase in discount rate, at which level there was no impairment. The recoverable amount exceeded the carrying value of goodwill by $1.8m. The discount rate would need to increase to 13.05% to record any impairment.

0.5% terminal growth rate, at which level there was no impairment. The recoverable amount exceeded the carrying value of goodwill by $1.8m. The terminal growth rate would need to be 0% before any impairment was recorded.

7.    Goodwill (continued)

5% decline in first year revenues, at which level there was no impairment. The recoverable amount exceeded the carrying value of goodwill by $5.4m.

5% decline in first year revenues and an increased discount rate of 12.3% would cause impairment if there were no mitigation actions.

Should there be a headline change in revenues and margins, this could create an impairment.

8.     Intangible assets: Pre-publication costs

The assessment of the useful life of pre-publication costs and amortization involves a significant management estimate based on historical trends and future potential sales, in accordance with the accounting policy stated in note 1.  The Group undertook a review of the pre-publication cost amortization with the benefits generated from the book title revenues. Specific imprints that had been impaired were excluded from the review. We concluded that a 50% reducing balance method of amortization was now appropriate rather than the 3 year straight line basis.

Pre-publication costs form part of the carrying value of the CGU for each segment and are considered for impairment of goodwill in note 10.

9.     Alternative performance measures

The Group uses alternative performance measures to explain and judge its performance.

Adjusted operating profit excluding amortization of acquired intangibles and exceptional items. The Directors consider this to be a useful measure of the Group operating performance as it shows the performance of the underlying business.

Exceptional items are those which the Company defines as significant non-recurring items outside the scope of normal business that need to be disclosed by virtue of their size or incidence in order for the user to obtain a proper understanding of the financial information.

Free cashflow is the cash generated by operations less pre-publication investment and purchases of property, plant and equipment and software.  

Backlist % refers to book titles that were published in previous calendar years and is a key measure of the performance of our intellectual property assets.

Intellectual property development spend refers to the amounts spent annually on the creation and publication of book titles against which we monitor subsequent sales (see note 8).

Net debt

10.          Post balance sheet events

C.K. Lau and 1010 Printing Limited were repaid $6m and $9m respectively in Q1 2022, including accrued Interest. This repayment was made outside the agreement due to a favourable liquidity position at this point in time.

In February 2022, we received notification from Bank of America advising that $2.272m of the loan relating to government support given under the Coronavirus Aid, Relief and Economic Security Act of the USA of $2.422m was being forgiven. We are still in the process of finalising the repayment of the unforgiven portion, which will take place once agreement has been reached.

11.          Principal risks and uncertainties facing the Group

a.             Economic conditions. The Group has adequate liquidity with up to $24.7m in available debt facilities. In addition, in such an event, the Directors have the ability to take a number of mitigating actions, including the reduction of spend on pre-publication costs, inventory printings and other discretionary Items.  The Group offers non-Chinese printing for customers in order to avoid US tariffs on books.  The Company's management information systems allow it to assess sales performance quickly and so take the appropriate steps to maximise operating performance.  The Group has shown itself to be adaptable by quickly accommodating the changes necessary to its sales and marketing activities during the Covid-19 pandemic. The Group has a very limited exposure to the Russian and Ukrainian markets.

b.             Currency. The Group has a natural hedge that mitigates against currency movements impacting our earnings in that one of our largest costs, which is print costs, are paid in US Dollars.

c.             Loss of intellectual property. A cloud storage solution is integrated into our production workflow to provide storage, back-up and recovery services for product files in development.  Complete backlist archives are stored in a mirrored storage array.

d.             Financial.  In 2020 the Quarto progressed in its goal to reduce its debt when it completed an open offer to shareholders in January; the net proceeds of $17m were used to pay down bank debt. In 2021, a new three year and five months banking facility of $20m was secured, together with additional shareholder support. This has enabled the Company to repay the facility that existed at the year end and a competitive auction platform introduced during 2019 to procure printing services which is providing additional cost savings.  In 2021 the Company reduced its office footprint to accommodate new working styles which will further reduce operating costs.  Meanwhile the Group is pursuing its strategy of organic growth through innovation (as set out on page 8). Performance during 2021 allowed the Company to accelerate its debt reduction.

e.             Customer. The Group has a long-established strategy of diversifying its international customer base, including specialty retailers, resulting in the fact that with one exception no customer has over 20% of the business. Customer relations are managed to ensure a fair-trading relationship. Management monitors debts closely and maintains close relationships with its customers, and distributors, which may provide prior warning of likely failure.  The Group continues to adapt to supporting online selling and continues to offer and promote e-book versions of its books.

f.              Supply chain and raw materials.  The Group maintains relationships with printers in other parts of the world and is confident that printing could be carried out by an alternative range of printers if supply from China was interrupted or to mitigate shipping costs. We maintain close relations with our printers, reducing the risk of a lack of knowledge of any printer being in financial trouble. The Group has worked with its major printers on a plan to adopt sustainable paper and recently instituted a Forest Stewardship Council (FSC) paper or Sustainable Forestry Initiative (SFI) paper policy across all our imprints.

Quarto monitors the Brexit-situation closely, taking note of the advice of the UK Government and key suppliers to ensure minimal disruption. Most of Quarto's product is shipped directly to EU countries from its printers based principally in China. These shipments are not expected to be affected by Brexit.

The Company recognises the disruptions from freight shipping and will take a flexible holistic approach to its supply chain activities and will work closely with logistics suppliers and its network of onshore and offshore printers. The Company recognises the disruptions from freight shipping and will take a flexible holistic approach to its supply chain activities and will work closely with logistics suppliers and its network of onshore and offshore printers.

g.             Cyber security.  The Group uses enterprise level firewalls and IT controls to prevent attack as well as maintaining cloud-based copies and offsite back-up of IP. Computerised files of the Group's books are also maintained by printers. We do not store any personal or credit card data on our websites www.quarto.com or www.quartoknows.com.   The Group undertakes industry standard system penetration testing.

h.             Coronavirus. Quarto monitors and follows government advice making the necessary adjustments in order to maintain the well-being of its employees.  Quarto promotes hygienic practices in its offices and avoids unnecessary travel.  The Group operates modern IT systems that permit remote working with the minimum of interruption and during Q4 2021, hybrid working practices were introduced. The Group also has the ability to immediately reduce its investment in pre-publication costs and inventory and manage discretionary spending. Working with its suppliers and customers, Quarto works hard to reduce the impact of any interruption in its supply chain.

During 2021 Quarto was able to adapt to the increasing value of book sales going online.  It will continue to perfect its approach to supporting sales as necessary.

i.              Climate-related. The Group has a well-developed and flexible supply chain.  It is in regular communication with its customers and their needs. During 2022, it will undertake a risk assessment to identify its principal climate-related risks and incorporate these risks into its risk management practices.

j.              Product safety. All components receive safety testing from specialist and accredited independent third parties. Management carefully selects suppliers for components.

Quarto will monitor the regulatory impact of product testing following the UK's departure from the European Union.

k.             Laws and regulations. During 2018, an information system was introduced Group-wide to harmonise the management of contracts.  Quarto reviews its licensing, permission-acquisitions and other contracts routinely receiving advice from relevant professional firms (including the possible impact of Brexit) so that legal instruments remain current and represent best practices so that we ensure that our practices are aligned and consistent across imprints, and Quarto's IP rights are properly protected.

11.          Principal risks and uncertainties facing the Group (continued)

l.              People. During 2018, an information system was introduced Group-wide to harmonise the management of contracts.  Quarto reviews its licensing, permission-acquisitions and other contracts routinely receiving advice from relevant professional firms (including the possible impact of Brexit) so that legal instruments remain current and represent best practices so that we ensure that our practices are aligned and consistent across imprints, and Quarto's IP rights are properly protected.