QRT.L Regulatory News (QRT)

29 March 2018

The Quarto Group, Inc.

("Quarto" or the "Company" or the "Group")

Final Results for the Year Ended 31 December 2017

The Quarto Group Inc. (LSE: QRT, "Quarto" or "the Group"), the leading global illustrated book publisher, announces its audited results for the year ended 31 December 2017.

*Adjusted items exclude the amortisation of acquired intangibles and exceptional items.

Included in the 2016 results was a one-time reduction in the amortisation charge arising from a change in the Useful Economic Life (UEL) of capitalised pre-publication costs of $2.1m.

Headlines

· Stronger trading performance in H2 - revenue up 5.8% vs prior year.

· Children's publishing revenues up 19% (7% excluding becker&mayer acquisition in Q3 2016), now representing third of Group revenues. Up 165% since 2012.

· Foreign Rights business continues to perform strongly - revenue up 6%.

· Frontlist/backlist revenue split comparable year-on-year - 60.3% revenue generated from backlist titles.

· Net debt at $64.0m (2016: $61.9m) down from $75.8m at 30 June 2017.

· As previously announced, with the competing pressures of paying dividends, reducing debt and investing in the core business, the Board has not recommended the payment of a final dividend.

· Transitional year:

o Refocused vision and strategy - now pure-play intellectual property business.

o Tough retail environment, finance team restructured and unsolicited offer.

· Change to financial year-end from 31 December to 31 March to better balance seasonality between fiscal H1 and H2.

2018 Focus

· Momentum from H2 2017.

· Organic revenue and margin growth.

· Continuing restructuring in parts of Adults portfolio to support more operational agility.

· Strengthening the balance sheet as a platform for growth.

Commenting on the results, Chief Executive, Marcus Leaver said:

"While 2017 was, overall, a transitional and challenging year, we are particularly pleased with our stronger trading performance in H2 - our Children's and Foreign Rights businesses showing significant growth once again, when many others in our industry struggled.

"Quarto is now fully focused on what we do best - creating a variety of books and intellectual property products that inspire life's experiences for the whole family, and selling them globally through diversified sales channels and partnerships.

"Our strategy remains to grow organically, through innovation and, where applicable, by acquisition, and to continue to drive c. 60% annual recurring revenue through our enduring backlist and to leverage our rich IP catalogue.

"We have moved into 2018 with clear objectives about continuing to realign our portfolio with the broader market and consumer trends, and making the financial and operational improvements required to fulfil our ambitions - including strengthening our balance sheet as a platform for growth.

"Since the year end, the Group has been trading in line with the Board's expectations."

For further information, please contact:

About The Quarto Group

The Quarto Group (LSE: QRT) creates a wide variety of books and intellectual property products for global distribution, with a mission to inspire life's experiences. Produced in many formats for adults, children and the whole family, our products are visually appealing, information rich and kinesthetically stimulating.

The Group encompasses a diverse portfolio of imprints and businesses that are creatively independent and expert in developing long-lasting content across specific niches of interest.

Quarto sells its products globally in over 50 countries and 40 languages, through a variety of sales channels and partnerships, and five main routes to market - US, UK, International English language, Foreign language and other Partnerships.

Quarto employs c. 400 talented people in the US, UK and Hong Kong. The group was founded in London in 1976. It is domiciled in the US and listed on the London Stock Exchange. 

For more information, visit quarto.com or follow us on Twitter at @TheQuartoGroup.

Strategic overview

2017 was a transitional year. It encompassed difficult and volatile trading conditions, the disposal of our last non-core businesses, the integration of a sizeable acquisition, the restructuring of the finance team and the handling of an unsolicited offer for the Group.

A poor H1 performance, with continued softness from H2 2016, was followed by a stronger performance in H2 2017, with revenue up 5.8% year-on-year. The business showed resilience in a year when many others in the industry struggled.

Overall, adjusted operating profit is down 58% while revenue only declined marginally by 1.4%.

The Group's operating margin was impacted by a combination of factors including high levels of returns, rising cost of goods and royalty expenses as trade sales become a larger part of the product mix, and higher product development costs owing to the integration of becker&mayer.

Industry shifts such as the changing product mix and the lack of any notable growth in the mature Adults publishing market are unlikely to change, and we continue to restructure a number of our Adults imprints to realign our portfolio with broader market trends.

Children's publishing revenues grew 19% year-on-year, both organically and through acquisition with the first full year contribution from becker&mayer. They have increased by 165% since 2012.

Our Foreign Rights sales team achieved another year of revenue growth, up 6% year-on-year. As we continually seek to further expand our scale and reach across the globe, our new Spanish language imprint in North and South America, in partnership with Catapulta Editores, was also a major highlight.

The Group ended the year with net debt of $64.0m (2016: $61.9m) down from $75.8m at 30 June 2017. Net debt is down 21% since 2012 but is still sizeable. It has become clear that the competing pressures of servicing debt, paying dividends, and investing in the core business currently inhibit Quarto's ability to grow by acquisition. The Group is therefore looking at all options to strengthen the balance sheet and will keep all stakeholders updated with its progress.

Quarto is now firmly looking to the future as a pure play intellectual property business creating a wide variety of books and intellectual property products for global distribution. Produced in many formats for both Adults and Children's, they are visually appealing, information rich or kinesthetically stimulating. All of them inspire life's experiences for the whole family.

The Group, now one third Children's products and two thirds Adults products has been transformed as the English language co-edition market declines further. The acquisitions made since 2014 have renewed the portfolio and content pipeline, and the shape of the Group today is largely a solid platform from which to grow.

Our model remains effective and agile: talented people making high quality and long-lasting products across a balanced portfolio of creative businesses, with efficient processes, supported by a scalable operating platform that adapts to market conditions.

Quarto sells its products globally, in 50 countries in 40 languages, through a variety of sales channels and partnerships and five main routes to market - US, UK, International English language, Foreign language and other Partnerships.

The Group's strategy remains to grow organically as we continually examine and manage our portfolio; through innovation, be it product, communication, business or process transformation; and where applicable, by acquisition, within a fragmented and artisan business landscape that can offer attractive opportunities.

Outlook

Quarto is now fully focused as a pure-play intellectual property business with a refocused vision and a clear growth strategy.

The Group's strategy addresses the trends observed in its core publishing market, which in the US and the UK combined is worth an estimated $14.4bn*. Children's books have grown ahead of other categories in recent years, while eBook sales have been flat-lining with limited success outside of Adult fiction. In the retail space, the market share of physical book specialists continues to decrease vs online retailers and physical non-book specialists.

Quarto expects the volatile trading environment to continue in 2018, with ongoing softness in specific channels. Its primary focus this year will be on strengthening the balance sheet and growing margins.

The Group expects a steady recovery with some organic growth in Children's, softer foreign language markets, and continuing remedial action in the Adults portfolio, to drive improved cash generation.

As expected, 2018 full year results will be once again dependent on the second half year performance. The Board has decided to change the year end from 31 December to 31 March, which will better align with the operational needs of a seasonal business. It will enable the business to fully focus on the critical fourth quarter sales period and effect a more balanced spread of revenue between the reported fiscal half years.

In the medium to long term, our strategy remains to grow organically, through innovation and, where applicable, by acquisition and to continue to drive c. 60% annual recurring revenue through the Group's enduring backlist and innovative use of its rich IP catalogue.

Since the period end, the Group has been trading in line with the Board's expectations.

* Report commissioned by and produced for The Quarto Group in November 2017 by Pragma Consulting Limited as part of a strategic market and channel review.

Operating review

As previously announced, following the Group's refocus on our core publishing activities and a new organisational structure, we have changed our segmental reporting. Revenue is reported by the geography in which the product is sold, with five main routes to market - US, UK, International English language, Foreign language and other Partnerships. Adjusted Operating Profit is reported by IP portfolio, where the product is generated - US Publishing, UK Publishing and Q Partners.

Note: Revenue is shown by destination; Adjusted Operating Profit is shown by portfolio.

Routes to market

In the US, revenue was $81.8m, down 2.0% year-on-year (2016: $83.5m) as a result of several factors including a softer retail environment, especially in H1 - lower initial order quantities, fewer reprints, and higher than usual returns from a few key customers. In addition, there were still significant sales of Adult colouring books in H1 2016 which did not repeat in H1 2017. However, US reported revenues did benefit from the first full-year results of becker&mayer. Without these, the US revenue decline was 9.2%.

UK revenue was $20.4m, down 2.4% year-on-year (2016: $20.9m). Besides the soft retail environment and unusually high level of returns, also observed in the US, the UK has been facing a more structural industry shift characterised by an increase in trade sales, partially offsetting a decline in English Language co-edition sales.

Within the UK and the US, we are seeing a continuing shift away from traditional channels, including trade retail, towards online trade and other non-traditional channels.

Foreign Language sales achieved another record year with revenues of $34.4m, up 6% year-on-year, through a mix of co-edition, license and royalty deals sold to over 550 customers in 50 territories and 40 languages. This performance is particularly commendable given the currency fluctuations in some of the markets in which we conduct business, and demonstrates the solid, enduring relationships the team have built with co-edition partners all over the world. The largest part of the revenue comes from continental Europe, including France, Germany, the Netherlands, the Nordics and Eastern & Central European countries, with growing contributions from Asia and South America, as well as an increased success in Children's Publishing.

In its first full year, our publishing partnerships and distribution business, Q Partners, performed in line with expectations. Revenue was down 11% to $5.6m (2016: $6.3m). We launched a new Spanish language imprint, Quarto Iberoamericana, in November 2017 across North and South America and to date its progress has been encouraging. Our distribution partner has shown an impressive ability to distribute significant quantities of adult titles into the market place. The key title of our launch list, Frida Kahlo at Home, has sold out throughout all territories within four months of publication.

In Brazil, Quarto Editora strengthened its presence with 85 titles published in 2017, including two titles that made it into best-selling lists. Revenue has continued to increase. In the Middle East and North Africa, Kalimat Quarto operates with high margins although volumes remain low.

Intellectual property portfolio

The heart of the business is its creative and development capabilities where the intellectual property products of Quarto are produced. Each one of our imprints and businesses within our portfolio is creatively independent and caters for different audiences and markets.

Our most profitable imprints were Quarto Children's Books/QED Publishing (UK, founded in 1990), Lincoln Children's Books (UK, acquired in 2011, relaunched in 2014), Walter Foster Publishing (US, acquired 1996), becker&mayer (US, acquired in 2016) and Ivy Press (UK, acquired in 2015).

Portfolio highlights

The highlights of our top-selling titles in 2017 demonstrate what Quarto does best: a wide variety of books and products, each with a different vision and a specific market in mind, and the view to sell over a long period of time.

The overall portfolio is extremely well diversified with no single title or series accounting for more than 0.7% of our total revenue (TR).

Adults

- Creative Lettering and Beyond - Walter Foster, published 2014: $691k revenue (0.5% of TR)

- Star Wars: Stormtroopers - becker&mayer books, published 2017: $627k (0.4% of TR)

- 1001 Movies You Must See Before You Die (2017 Edition) - Quintessence, first Published 2001: $441k (0.3% of TR)

- Wonder Woman Ambassador of Truth - becker&mayer books, published 2017: $389k (0.3% of TR)

- 1001 Photographs You Must See Before You Die - Quintessence, published 2017: $381k (0.3% of TR)

- New Views - Aurum Press, published 2017: $367k (0.2% of TR)

Children's

- Little People, Big Dreams series (nine titles) - Lincoln Children's Books, first published 2016: $1.1m revenue (0.7% of TR)

- Build The Human Body, Build The T.Rex and Build A Rocket - Quarto Children's Books, first published 2013: $857k (0.6% of TR)

- Etch Art series (two titles) - Wide Eyed Editions, both published 2017: $738k (0.5% of TR)

- Smart Circuit: Electronics Lab - SmartLab Toys, published 2016: $650k revenue (0.4% of TR)

- Imagine - Lincoln Children's Books, published 2017: $606k (0.4% of TR)

- Ultimate Secret Formula Lab - SmartLab Toys, published 2016: $523k (0.3% of TR)

Overall, Adults publishing revenues declined 9.2% while Children's publishing revenues grew 19% - by acquisition through becker&mayer's first full year but also organically, with a solid performance throughout the year despite areas of softness, for example in the educational market.

Children's publishing continues to remain an area of strong focus and growth. Revenues now represent one third of the Group's overall revenue and have grown by 165% since 2012 organically, by innovative reorganisation of existing assets and by acquisition.

Parts of our Adults portfolio under-performed expectations in both US and UK markets, but more significantly in the UK. We continue to review a number of our imprints to realign our portfolio with broader market trends and give the Group more flexibility to re-allocate assets towards faster-growing parts of the business. We have consolidated seven of our UK-based Adults imprints into two new entities: White Lion Publishing in London and The Bright Press in Brighton.

The revenue split between frontlist titles (published in 2017) and backlist titles (published before 2017) was comparable year-on-year, with 60.3% of publishing revenues generated from backlist titles vs 58.3% in 2016. This is consistent with Quarto's strategy to generate c. 60% annual recurring revenues from the Group's rich IP catalogue and reflects its expertise in creating long-lasting content.

Adults titles represented 67% of backlist revenues (2016: 79%) and 67% of frontlist revenues (2016: 73%), while Children's titles represented 33% of backlist revenues (2016: 21%) and 33% of frontlist revenues (2016: 27%). Even though Children's is more naturally frontlist-led, the increased proportion of Children's titles in the backlist can be explained as some of the Group's imprints, only started a couple of years ago, are now becoming established businesses.

US Publishing

US Publishing adjusted operating profit was down 51% to $4.6m (2016: $9.4m).

There were some significant one-time factors to this decline:

1. The 2016 US adjusted operating profit included a gain of $0.8m relating to the change in the Useful Economic Life of capitalised pre-publication investment. A far smaller gain also arose in 2017 as the change phased in.

2. Far higher than expected returns of adults colouring books were taken in 2017 with impacts on net revenue, inventory obsolescence and on distribution costs due to the related processing costs.

3. Distribution costs were also higher in 2017 as a result of running two warehouses for SmartLab for most of the year. These have now been consolidated into one.

Some of the elements of the 2017 margin decline are ongoing challenges which the Group will address in 2018 and the following years. Product development costs have increased following the acquisition of becker&mayer as some of their products, including SmartLab products, require higher initial investments. Price increases for raw materials and printing are being mitigated by operational efficiency gains but this is an ongoing challenge and area of focus. Royalty costs are increasing due to changes in product mix as the proportion of co-edition sales declines relative to trade sales. Sales and Marketing expenses increase as the proportion of sales to online channels grows, although returns rates reduce.

UK Publishing

UK Publishing adjusted operating profit was $7.1m, down 43% (2016: $12.4m), due to a combination of factors noted below.

The 2016 UK adjusted operating profit included a gain of $1.3m relating to the change in the Useful Economic Life of capitalised pre-publication investment. A far smaller gain also arose in 2017 as the change phased in.

2017 saw unusually high levels of returns due to the volatile retail environment. Returns at this level are not expected to recur in 2018.

As mentioned above, we have also observed a significant decline in English Language co-edition sales, which we believe is structural and will continue, although at a lower rate than the sharp drop experienced in 2017.

Finally, increased royalty costs have impacted profitability, due to the increasing mix of sales to the trade. This trend is expected to continue.

Q Partners

Q Partners made a small loss of $0.4m in 2017 (2016: loss $0.1m) due to the investment needed to set up our third partnership - the new Spanish language imprint, Quarto Iberoamericana.

Overall, this business is performing in line with the Group's expectations as we recognise that it will take a few years to generate more substantial volumes.

Financial review

Revenue

Group revenue declined marginally by 1.4% to $152.5m (2016: $154.6m). A poor H1 performance, with continued softness from H2 2016, was followed by a stronger performance in H2 2017, with revenue up 5.8% year-on-year.

Margin

Adjusted Operating Margin has declined in 2017 from 11.0% to 4.7%. As noted in the comments about the US and UK divisions above, the overall $2.1m benefit booked in 2016 for the change in the Useful Economic Life (UEL) of capitalised pre-publication costs contributes to this, albeit offset by a far smaller gain in 2017. Also, as noted in the divisional comments above, other impacts have been the high levels of returns experienced in 2017, particularly of Adults Colouring Books, but also rising cost of goods and royalty expenses. Additionally, the amortization of pre-publication costs has increased as becker&mayer is phased in. Sales and marketing expenses have increased slightly and the group has incurred higher IT costs as core systems implementations have been undertaken for the first time in over a decade. The UEL and returns-related elements of the 2017 cost increase are not expected to recur at anything like the same level in subsequent years.

Exceptional Items

These total $24.2m and comprise the following elements:

1. $17.4m of goodwill impairment. This is principally an adjustment to reflect a reduction in the value-in-use of the U.S. cash-generating unit of $17.1m. The reduced operating income result noted above reduced the carrying value both in itself and as a lower base for future growth. Further details are in Note 9.

2. $5.8m of restructuring costs actioned in 2017. Of this $5.4m is the write-down of intangible and current assets in respect of six closed imprints.

3. $0.6m are the costs related to the implementation of a security package for the group's lenders.

4. $0.4m are costs associated with the unsolicited offer for the group and an unrelated acquisition which did not complete.

Discontinued Operations

The disposal of the Group's 75% interest in Regent Publishing Services Limited was completed on 31 March 2017; the disposal of Books & Gifts Direct Pty Limited (BGD Australia) on 31 March 2017; and the disposal of Books & Gifts Direct Limited (BGD New Zealand) on 7 July 2017.

The results from discontinued operations include the trading results of Regent Publishing Services and BGD Australia to 31 March 2017 and BGD New Zealand to 7 July 2017 and the gains or losses on the respective disposals.

Further details are included in note 8.

Earnings

The adjusted basic earnings per share for the Group's continuing operations of 18.3c shows an annual decrease of 63% on the comparative figure for 2016 of 49.8c and reflects the decrease in the pre-exceptional profit before tax.

Dividend

The Directors are not recommending a final dividend for the year, bringing the total dividend for the year to nil per share (2016: 15.0c per share). 

Balance Sheet

Goodwill has been reduced from $36.1m at 31 December 2016 to $19.3m due principally to the impairment charges noted in 'Exceptional Items' above.

The intangible asset for pre-publication costs has reduced from $61.1m in 2016 to $60.3m. The key movements comprise $35.6m of additions, $32.2m of amortisation, and $4.9m of impairments in respect of six imprints closed in 2017. These closure costs have been treated as exceptional items.

Inventory at $22.6m is down from $24.0m in 2016. This has been closely managed during 2017.

Accounts Receivable at $43.1m is up $0.8m on the prior year.

Accounts Payable at $46.5m is $3.2m higher than 2016.

Other payables have decreased by $4.0m since 2016 which includes the settlement within 2017 of $7.0m of deferred consideration liabilities, principally related to the acquisition of becker&mayer and Harvard Common Press in 2016.

Finance costs of $3.3m (2016: $3.1m) represent the interest costs on the Group's borrowings together with the amortisation of the debt issuance costs. The increase in net finance costs reflects a slightly higher average gross debt in 2017 compared to 2016 and an increase in the interest margin.

The tax credit for the year of $1.5m (2016: charge of $3.8m) arises on the loss before tax. The effective tax rate for the Group is 7.0% (2016: 28.8%). A significant proportion of the Group's taxable profit arises in the US where the federal tax rate was 34% in 2017. More information is in note 5.

Cash Flow

Free cash flow (see table below) was $7.7m in 2017 which represents an increase of $4.1m compared to 2016 ($3.6m). The main reasons for the increase in 2017 over 2016 were an improvement in working capital movements of $12.1m and a reduction in pre-publication costs of $1.6m, which were offset by a decrease in the operating profit before amortisation of acquired intangibles and exceptional items in 2017 compared to 2016 of $9.8m.

Going Concern

The Board has assessed the Group's ability to operate as a going concern based on a financial model which was prepared as part of the process of considering and approving the 2018 budget. The Group engaged Pragma Consulting to perform a review of the market over a similar timeframe. The financial model and the underlying assumptions have been reviewed by a firm of independent consultants, against the background of this market review.

Supported by the findings of both the Pragma and the other independent consulting project, 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 for the three years ending 31 December 2020, which comprise a detailed cash forecast for the year ending 31 December 2018, based on the budget for that year, and the growth assumptions for revenue and costs, together with cash forecasts, for the years ending 31 December 2019 and 2020, to satisfy themselves of the appropriateness of the going concern basis used in preparing the financial statements.

In carrying out their analysis of viability, the Directors took account of the Group's projected profits and cash flows and its banking covenants and these have been subjected to sensitivity analysis over the three-year period using a range of downside scenarios. The scenarios tested include:

· A reduction in revenue for the second half of 2018.

· A reduction in revenue for full year 2019.

· 10% of receivables collections are delayed by one quarter at the projected period with least headroom.

If these scenarios were to materialise the Group would still satisfy the banking covenants in its facility agreement as recently amended. We also have a range of options that enable us to maintain our financial strength including reduction in pre-publication costs, reduction in capital expenditure and managing debt.

The level of profitability of the Group reduced significantly in 2017. This has inevitably put more pressure on the banking covenants and the ability of the group to service its debts. The Directors are in discussion with the loan facility providers to mitigate the risk and the following steps have either already been implemented or are in progress:

· A standard security package was put in place in December 2017 as indicated in the group's November trading update.

· Spot amendments to individual covenants have been put in place as required.

· Further amendments for each of the loan covenants, to increase the headroom available during 2018 and early 2019, have been agreed, along with additional oversight and reporting arrangements.

As we indicated last year, whilst we have successfully transformed the business in the last few years, the competing pressures of servicing our debt, paying dividends, and investing in the core business were inhibiting our ability to grow. The Board's decision not to pay a dividend in respect of 2017, its ongoing detailed review of creative investment, and its stated intention to look at all options to strengthen the balance sheet, are major initiatives which are expected to support future growth in revenue and margins.

The Board will keep all stakeholders updated with developments of our thinking.

Based on our assessment, the Directors have a reasonable expectation that the Group will be able to continue in operation and meet all of its liabilities as they fall due up to 31 December 2020.

For these reasons, the Directors continue to adopt the going concern basis in preparing the financial statements. In doing so, it is recognised that such future assessments are subject to a level of uncertainty that increases with time and, therefore, future outcomes cannot be guaranteed or predicted with certainty.

Change in Financial Year-End

The financial year-end date of the Company will be changed from 31 December to 31 March. Accordingly, the next financial year-end date of the Company will be 31 March 2019 and 2018/19 will be a 15-month period. The Group will still report Interim results to 30 June 2018 and 31 December 2018.

The proposed change will better align with the operational needs of a seasonal business such as Quarto's.

It will enable the business to be fully focused on delivering sales targets in the critical calendar Q4 sales period without a budget process at the same time. It will allow year-end and budgeting reviews to be based on a known fall season out-turn. Interims will be issued with a better understanding of the upcoming fall season. It will also result in a more evenly balanced spread of revenues and profits between the two fiscal half-years and so aid understanding of the group's performance.

The Board of Directors are satisfied that this change will be beneficial for the group and the users of its financial statements.

The Company will hold its next Annual General Meeting for the financial period from 1 January 2018 to 31 March 2019 before 31 August 2019.

The Group's primary focus for 2018 will be on strengthening the balance sheet, supporting a steady recovery in margins, with some organic growth in Children's, while continuing remedial action in the Adults portfolio, with a backdrop of changing US and UK retail and flat Foreign Language markets with a re-balance of territories.

Marcus E. Leaver

Chief Executive

THE QUARTO GROUP, INC.

Condensed Consolidated Income Statement

For the year ended 31 December 2017

The results of the discontinued businesses of BGD and Regent have been classified separately in the consolidated income statement for the current and previous years.

THE QUARTO GROUP, INC.

Condensed Consolidated Statement of Comprehensive Income

For the year ended 31 December 2017

THE QUARTO GROUP, INC.

Condensed Consolidated Balance Sheet

At 31 December 2017

THE QUARTO GROUP, INC.

Condensed Consolidated Statement of Changes in Equity

For the year ended 31 December 2017

THE QUARTO GROUP, INC. 

Condensed Consolidated Cash Flow Statement

For the year ended 31 December 2017

THE QUARTO GROUP, INC.

Notes to the condensed financial statements

1. Basis of preparation

The financial information set out in this statement does not constitute the Group's Annual Report for the year ended 31 December 2017 prepared in accordance with the Companies Act 2006 as applicable to overseas companies. The auditors have reported on the Group's statutory accounts for the year ended 31 December 2017 which are unqualified. The financial information set out in this statement has been extracted from those statutory financial statements. The financial information contained within this preliminary announcement was approved by the Board on 28 March 2018. The statutory financial statements for the year ended 31 December 2016, including an unmodified auditor's report, have been delivered to the Registrar of Companies. The financial statements for the year ended 31 December 2017 will be delivered to the Registrar of Companies following the Company's annual meeting.

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. The accounting policies used have been applied consistently and are described in full in the statutory financial statements for the year ended 31 December 2017.

Going Concern

The Board has assessed the Group's ability to operate as a going concern on a financial model which was prepared as part of the process of considering and approving the 2018 budget. The Group engaged Pragma Consulting to perform a review of the market over a similar timeframe. The financial model and the underlying assumptions have been reviewed by a firm of independent consultants, against the background of this market review.

Supported by the findings of both the Pragma and the other independent consulting project reports, 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 for the three years ending 31 December 2020, which comprise a detailed cash forecast for the year ending 31 December 2018, based on the budget for that year, and the growth assumptions for revenue and costs, together with cash forecasts, for the years ending 31 December 2019 and 2020, to satisfy themselves of the appropriateness of the going concern basis used in preparing the financial statements.

In carrying out their analysis of viability, the Directors took account of the Group's projected profits and cash flows and its banking covenants and these have been subjected to sensitivity analysis over the three-year period using a range of downside scenarios. The scenarios tested include:

· A reduction in revenue for the second half of 2018.

· A reduction in revenue for full year 2019.

· 10% of receivables collections are delayed by one quarter at the projected period with least headroom.

If these scenarios were to materialise the Group would still satisfy the banking covenants in its facility agreement as recently amended. We also have a range of options that enable us to maintain our financial strength including reduction in pre-publication costs, reduction in capital expenditure and managing debt.

The level of profitability of the Group reduced significantly in 2017. This has inevitably put more pressure on the banking covenants and the ability of the group to service its debts. The Directors are in discussion with the loan facility providers to mitigate the risk and the following steps have either already been implemented or are in progress:

· A standard security package was put in place in December 2017 as indicated in the group's November trading update.

· Spot amendments to individual covenants have been put in place as required.

· Further amendments for each of the loan covenants, to increase the headroom available during 2018 and early 2019, have been agreed, along with additional oversight and reporting arrangements.

As we indicated last year, whilst we have successfully transformed the business in the last few years, the competing pressures of servicing our debt, paying dividends, and investing in the core business were inhibiting our ability to grow. The Board's decision not to pay a dividend in respect of 2017, its ongoing detailed review of creative investment, and its stated intention to look at all options to strengthen the balance sheet, are major initiatives which are expected to support future growth in revenue and margins.

The Board will keep all stakeholders updated with developments of our thinking.

Based on our assessment, the Directors have a reasonable expectation that the Group will be able to continue in operation and meet all of its liabilities as they fall due up to 31 December 2020.

For these reasons, the Directors continue to adopt the going concern basis in preparing the financial statements. In doing so, it is recognised that such future assessments are subject to a level of uncertainty that increases with time and, therefore, future outcomes cannot be guaranteed or predicted with certainty.

THE QUARTO GROUP, INC.

Notes to the condensed financial statements

2. Operating segments

The analysis by segment is presented below. This is based upon the operating results reviewed by the Chief Executive Officer.

THE QUARTO GROUP, INC.

Notes to the condensed financial statements

2. Segmental analysis (continued)

Segmental balance sheet

3 Exceptional items

4. Finance costs

5. Taxation

Corporation tax on UK profits is calculated at 19% (2016: 20%), 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. The table below explains the difference between the expected expense at the UK statutory rate of 19% (2016: 20%) and the total tax expense.

6. Earnings per share

7. Dividends

The Quarto Group, Inc., as a US incorporated company, is required to collect US dividend withholding taxes on dividend distributions made to its non-US shareholders. The US dividend withholding tax is generally 30% of any dividends paid to Quarto's non-US shareholders, but this amount can potentially be reduced pursuant to an applicable income tax treaty between the US and the country of residence of the non-US shareholder.

For example, under the US/UK income tax treaty, the US dividend withholding tax rate can range from nil (applicable to certain UK resident pension trusts and tax exempt entities) to 15% (applicable to UK resident individual shareholders and certain UK corporate shareholders). For US shareholders, no US dividend withholding tax is generally applicable. It should be noted that certain documentation requirements must be met by all shareholders prior to the payment of any dividends to certify their status as a US or non-US shareholder, and, if a non-US shareholder to claim any applicable benefits under the US/ UK or other applicable income tax treaty. Each shareholder should consult their own tax adviser to determine whether and to what extent they may be entitled to claim a reduced amount of US dividend withholding taxes under a US income tax treaty.

THE QUARTO GROUP, INC.

Notes to the condensed financial statements

8. Discontinued operations

On 31 March 2017, the Group completed the disposal of its 75% interest in Regent Publishing Services Limited ("Regent"), its Hong Kong based publishing services business.

On 31 March 2017, the Group completed the disposal of its 100% share of Books & Gifts Direct Pty Limited ("BGD Australia"), its direct sales business in Australia.

On 7 July 2017, the Group completed the disposal of the trade and selected net assets of Books & Gifts Direct Limited ("BGD New Zealand"), its direct sales business in New Zealand.

These disposals were completed in line with the Group's strategy of disposing of non-core businesses. Proceeds from the disposals will be used to manage the Group's net debt position as received. The results of the discontinued operations which have been included in the consolidated income statement were:

THE QUARTO GROUP, INC.

Notes to the condensed financial statements

9. Goodwill

The Group performs its annual impairment review at the end of each financial year. The impairment charge in 2017 comprised charges of $17.1m in respect of Quarto Publishing Group USA and $0.3m in respect of a closed imprint within Quarto Publishing Group UK. The impairment charge in 2016 of $6.0m related to Books & Gift Direct ANZ.

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 the growth rates applicable to each CGU. The cashflows are then discounted using a country specific WACC. The growth rates used are ones consistent with the growth expectations for the sector in which the company operates.

The discount rate has been calculated using Weighted Average Cost of Capital analysis.

Goodwill, specific to the US Publishing Group, was impaired by $17.1m at 31 December 2017 reducing its carrying value to $12.9m. The impairment principally arose due to the decrease in profitability experienced in 2017.

One imprint in the UK was closed in the year and the previous carrying value of its goodwill of $0.3m was impaired to nil.

10. Intangible assets: Pre-publication costs

THE QUARTO GROUP, INC.

Notes to the condensed financial statements

11. Alternative performance measures

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

Adjusted operating profit excluding amortisation 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 10).

Inventory % of sales is the book value of inventory divided by total revenue for the year. Inventory turn is cost of sales divided by book value of inventory and measures the number of times inventory is sold through the business in a year.

12. Principal risks and uncertainties facing the Group

a. Economic conditions. The Group operates across many of the major world economies including the USA, United Kingdom, Europe, Australia, New Zealand and Hong Kong and our revenues and profits depend on the general state of the economies in these territories. Another recessionary environment in our key USA and UK markets could have a significant impact on the financial status of some of our key customers and their ability to pay their debts to us. We monitor debts closely and maintain close relationships with all major customers that may provide prior warning of likely failure.

b. Currency risk. The Group's businesses operate in a number of different currencies giving rise to a risk of exchange loss due to fluctuating exchange rates. We have 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. Borrowings have been taken out in different currencies to mitigate risk of currency movements impacting our net assets.

c. Loss of intellectual property. As we are an owner of intellectual property, a lot of which is digitally stored and accessed, the security and strength of our information technology systems is very important. Because of its importance, we regularly review our storage and back-up routines and disciplines. During 2017 we commenced a project to introduce a new title management system for our publishers in order to improve the security of and access to our intellectual property. This system is already being used by QUS and is being rolled out into QUK during 2018. During 2017 we also commenced a project to install a cloud storage solution which has been integrated into production workflow for storage, back-up and recovery services for product files in development. Two archive data arrays that will be a replication of each other have been purchased and are being installed across the first half of 2018. There is one in the UK and one in the US with each hosting a complete set of backlist archives.

d. Economic risk. A sudden downturn in revenues or profits caused by a global recession or through the impact of currency movements could reduce consumer discretionary spending which might result in a reduction in profitability and operating cashflow. The group has up to $80m and £5m (approx. $7m) in debt facilities available but in addition, in the event of such a reduction in profits and/or cashflow, the Directors have the ability to take a number of mitigating actions including the reduction of discretionary spend on pre-publication costs.

e. Supply chain risk. The Group uses a number of print suppliers to print its books, many of whom are based in Southern China. There is a risk that an interruption in the availability of printing services in Southern China could result in an interruption in the printing and distribution of new books to customers. The group maintain relationships with printers in other South East Asian countries, Eastern Europe, the UK and the USA and are confident that printing could be carried out by an alternative range of printers if supply from China were to be interrupted.

f. Cyber security risk. Like many organisations, the group is at risk from cyber attack. This presents a potentially serious risk disruption to production process and could have a significant impact on the probability of the business and the security of intellectual property assets. The Group uses firewalls and IT controls to prevent attack as well as maintaining offsite backup of intellectual property. Computerised files of the Group's books are also retained by printers.

THE QUARTO GROUP, INC.

Notes to the condensed financial statements

1. Directors responsibilities statement

The Directors confirm that to the best of their knowledge: 

1. The condensed financial statements, prepared in accordance with the applicable set of accounting standards give a true and fair view of the assets, liabilities, financial position and profit or loss of the company and the undertakings included in the consolidation taken as a whole; and

2. The Business Review, which will be incorporated into the Directors' Report of the financial statements, will include a fair review of the development and performance of the business and the position of the company and the undertakings included in the consolidation taken as a whole, together with a description of the principal risks and uncertainties they face.

By the order of the board