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Edited Transcript of LKSD.N earnings conference call or presentation 7-Nov-19 1:30pm GMT

Q3 2019 LSC Communications Inc Earnings Call

CHICAGO Nov 13, 2019 (Thomson StreetEvents) -- Edited Transcript of LSC Communications Inc earnings conference call or presentation Thursday, November 7, 2019 at 1:30:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Andrew B. Coxhead

LSC Communications, Inc. - CFO

* Michael King;Senior Vice President, Investor Relations & Finance

* Thomas J. Quinlan

LSC Communications, Inc. - Chairman, CEO & President

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Conference Call Participants

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* Charles S. Strauzer

CJS Securities, Inc. - Senior MD of Sales & Trading and Analyst

* William McGoldrick Mastoris

Robert W. Baird & Co. Incorporated, Research Division - High Yield Desk Analyst

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Presentation

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Operator [1]

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Welcome to the LSC Communications Third Quarter 2019 Earnings Call. My name is Elisa, and I will be your operator for today's call. We have just a few announcements before we begin. (Operator Instructions) Please note, this conference is being recorded. I will now turn the call over to Mike King. You may begin.

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Michael King;Senior Vice President, Investor Relations & Finance, [2]

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Thank you, Elisa. Good morning, everyone, and thank you for joining LSC Communications Third Quarter 2019 Results Conference Call.

This morning, we released our earnings report, a copy of which can be found in the Investors section of our website at www.lsccom.com. During this call, we'll refer to forward-looking statements that are subject to uncertainty. For a complete discussion, please refer to the cautionary statement included in our earnings release and further detailed in our Form 10-K filed on February 19, 2019, as well as in our other periodic filings with the SEC. Further, we will discuss non-GAAP financial information. We believe the presentation of non-GAAP results provides you with useful supplementary information concerning the company's ongoing operations and is an appropriate way for you to evaluate the company's performance.

They are, however, provided for informational purposes only. Please refer to the reconciliation of GAAP to non-GAAP results included in the earnings release schedules as well as in the appendix to the webcast presentation that is posted to the LSC website.

We are joined this morning by Tom Quinlan, Drew Coxhead and Kent Hansen. I will now turn the call over to Tom.

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Thomas J. Quinlan, LSC Communications, Inc. - Chairman, CEO & President [3]

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Thank you, Mike. Good morning, everyone, and I also thank you for joining us today. While I'm pleased with the very strong free cash flow performance in the quarter, sales and EBITDA results were below our expectations, driven mainly by education Book volumes. The down quarter in education Books follows 3 quarters of strong growth ahead of the 2019 school year and while we were surprised by the drop in volume, we believe it represents a shift in timing and not a structural change in demand for printed K-12 educational materials. Volume and margin trends in our other segments were in line with our expectations as reflected in our guidance issued in July. We are updating our full year guidance to reflect the lower education Book volumes, and Drew will walk you through that guidance in more detail shortly.

As we look ahead and continue to take the necessary steps to reduce cost and decrease leverage, we remain focused also on initiatives designed to improve operations and deepen our client relationships to further strengthen our leadership position in the industry. For today's call, first, I'd like to address those actions we've implemented to improve our cost structure, then I will highlight our vision for the company moving forward. The rising cost of labor, freight materials, the proposed postal rate increases and digital substitution continue to pose significant challenges for the Print industry as a whole. To offset the organic decline in sales and more closely align cost with demand, we have announced the closure of 3 major print manufacturing facilities since the beginning of the third quarter. One in California, another in Nevada and the third in Pennsylvania, which will result in the reduction of headcount by approximately 500 employees. These closures are critical steps to achieving our strategic objective of aligning LSC's operating platform with current and projected marketplace trends and demonstrate how we will continue to move rapidly to further optimize our platform and reduce cost.

The second area where we have generated operational improvement is our logistics platform. Through optimizing freight cost, systems integration and facility consolidations, we have realized significant savings and better positioned the platform for more profitable growth opportunities.

The third area where we have experienced operational improvements is in our office products platform. Our year-to-date EBITDA margin is favorable versus the prior year due to cost takeouts and tight expense management as well as realized synergies from facilities consolidations.

The fourth initiative that is underway and by far the most all-encompassing is a company-wide efficiency project to enhance our operations and better serve our clients. This employee-led initiative is focused on identifying opportunities to improve our margins by increasing efficiencies, enhancing revenue opportunities and maximizing productivity. We are well into the project and have identified and implemented hundreds of ideas that have already began to drive results. This is a comprehensive look at all aspects of our operations, so we expect the results to be significant.

Parallel to cost rationalization being critical to our plan, we are also taking strategic advantage of LSC's strength in our Book publisher services, Logistics and Office Products platforms as part of our transformation moving forward. With a specific focus on our industry-leading Book platform, we are successfully leveraging and continually enhancing our unique technologies and applying them at scale to our solutions portfolio. LSC's Book technology platform, for example, provide solutions to help publishers increase Book sales and publishing revenue, reach more readers and stay ahead of the competition. In response to the evolving trends and needs of our publishing clients, our platform provides publishers with the ability to monitor the market, review robust sales analytics and receive helpful marketing recommendations. This is more than an example of how we're leveraging technology, data and analytics to help our clients efficiently distribute content to all channels. This is an example of our vision for how we're transforming our company. We are targeting the root of our clients' needs and providing comprehensive solutions that enhance LSC's value by helping our clients improve their business.

In our Magazine division, we remain the printer of choice for niche and enthusiast publishers. With content that is hyper-targeted to the audience. This segment is investing more in the Print product as a strategy to cut through the digital noise and build their brand. We also see increasing potential for LSC's logistics, as we continue to optimize our platform with highly differentiated solutions. Plus with the USPS proposed postal rate increases, our leading postal optimization platform is well positioned to help clients offset some of the increases, as we are committed to making sure that Print remains a sustainable output option for our catalog clients.

Finally, in our Office Products segment, our strategy of diversifying into growing channels is working. Our marketing and merchandising efforts on growing our brands is paying off, as we're gaining share in a difficult online market. Our go-forward strategy is to invest in the e-tail business and grow our branded share. These areas of focus with their unique product, service and technology mixes, represent how we are changing the playing field.

And with that, I'll turn it over to Drew for the details of our third quarter results.

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Andrew B. Coxhead, LSC Communications, Inc. - CFO [4]

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Thank you, Tom. Consolidated net sales for the third quarter were $834 million, a decrease of 17.9% from the third quarter of 2018. Adjusting for the impact of acquisitions, dispositions, changes in pass-through paper sales and foreign exchange rates, our organic net sales decline was 9.3%. We reported third quarter GAAP net income of $24 million compared to a net loss of $4 million in the third quarter of 2018. The GAAP net income for this year's third quarter included pretax income of $45 million from the break fee received in connection with the termination of the merger with Quad/Graphics and related pretax costs of approximately $8 million.

Third quarter non-GAAP adjusted EBITDA was $49 million compared to $90 million in the third quarter of 2018. Non-GAAP adjusted EBITDA margin in the quarter of 5.9% was 300 basis points lower than the third quarter of last year. The decrease in non-GAAP adjusted EBITDA margin was primarily due to the significant volume declines and wage increases implemented in response to the tight labor market conditions, affecting certain of our manufacturing and distribution facilities. These factors were partially offset by cost reductions from plant closures and productivity initiatives, the impact of targeted price increases to offset higher materials and freight costs and a $6 million pretax gain realized on the previously announced sale of the co-mingle business in August.

I will now discuss net sales, income from operations and non-GAAP EBITDA performance by segment. Net sales in our Magazines, Catalogs and Logistics segment were $392 million in the third quarter of 2019, a decrease of 15.5% from last year's third quarter. After adjusting for the impact of acquisitions, dispositions and pass-through paper sales, year-over-year net sales decreased by 12.1% on an organic basis. This organic decline reflects lower volume driven by the impact of digital disruption on demand for printed materials, consistent with trends in recent quarters. For the Magazines, Catalogs and Logistics segment, GAAP loss from operations was $6 million compared to net income from operations of $1 million in the third quarter of 2018. Segment non-GAAP adjusted EBITDA in the quarter was $11 million, and non-GAAP adjusted EBITDA margin was 2.8%.

Non-GAAP adjusted EBITDA margin decreased 90 basis points compared to the third quarter of 2018. This margin decline reflects the significant drop in volume during a period where we were not able to move quickly to reduce costs due to restrictions and uncertainties related to the planned merger and an unfavorable mix of work. The impact of the lower volume on margins was partially offset by productivity across the segment, synergies from our logistics acquisitions and the gain on the sale of our co-mingle business.

In addition, we've announced the shutdowns of our manufacturing facilities in Torrance, California and Reno, Nevada, which will help us align our platform with the changes we see in the marketplace. The real estate sales proceeds of these facilities will go towards debt reduction. Expected proceeds for the Torrance facility are $35 million as announced in August, while the proceeds for the Reno facility are expected to exceed $20 million well above the expected shutdown cost of approximately $10 million.

Net sales in our Book segment were $256 million in the third quarter of 2019, a decrease of 9.6% from last year's third quarter. After adjusting for the impact of pass-through paper sales, year-over-year net sales decreased by 6.7% on an organic basis. The organic decrease was driven by lower-than-expected volume in the education market. Third quarter volumes in K-12 education Books fell after we benefited from publishers inventory buildup in the first half of the year, driven by earlier back-to-school production. Higher education volumes continued to be negatively affected by digital textbook and subscription services. While we were surprised by the early ends to this year's back-to-school peak, it is important to note that year-to-date education volumes are up and our overall year-to-date organic growth in the Book segment remains slightly positive at 0.2%. GAAP income from operations for the Book segment was $5 million, compared to income from operations of $21 million in the third quarter of 2018. Segment non-GAAP adjusted EBITDA in the quarter was $19 million and non-GAAP adjusted EBITDA margin was 7.4%. Segment non-GAAP adjusted EBITDA margin decreased 470 basis points compared with the third quarter of 2018, primarily due to the decreases in education volumes as well as wage increases we have implemented to attract and retain employees in facilities most impacted by the tight labor market.

We also announced the planned shutdown of our book manufacturing facility in Philadelphia by the end of the year, which allows us to reduce costs in our platform, while maintaining the ability to meet our customers' needs.

Net sales in the Office Products segment were $128 million, a decrease of 11.7% from the third quarter of last year. After adjusting for the impact of changes in foreign exchange rates, sales decreased by 11.6%. Reflecting the ongoing disruption and consolidation in the retail channel, along with the continuing impact of our shift away from certain low-margin commodity products. These volume impacts were partially offset by the impact of price increases to pass along higher costs for materials and freight and continued strong growth in the e-commerce channel.

Office products income from operations was $8 million as compared to $15 million in the third quarter of 2018. Non-GAAP adjusted EBITDA in the Office Products segment was $13 million for the quarter compared to $19 million in last year's third quarter. Non-GAAP adjusted EBITDA margin decreased 290 basis points to 10.2%, due primarily to volume declines and a less favorable mix of branded versus private label sales in the quarter, partially offset by price increases and synergies associated with the acquisition of Quality Park. This year, we have announced the closure of 2 facilities located in St. George, Utah and Canton, Massachusetts, as we continue to align our platform with the changing marketplace.

Free cash flow for the third quarter was a positive $75 million compared to a usage of $15 million in the third quarter of last year and free cash flow for the 12 months ended September 30, 2019 was $206 million. The improvement in free cash flow for the quarter was primarily driven by reductions in working capital, driven by the lower volumes and improved working capital management. In addition, free cash flow includes the proceeds received in connection with the termination of the merger with Quad/Graphics, net of related costs. The net free cash flow impact of these Quad-related items was a benefit of $37 million in the quarter and $24 million year-to-date. Capital spending in the quarter was $11 million, down $4 million from last year's third quarter. As of September 30, 2019, our total debt was $756 million, which is $11 million less than total debt as of year-end 2018 and a $190 million reduction since September 30, 2018.

Our gross leverage was 3.78x as of September 30, 2019, and we expect our leverage to decrease by the end of the year, as free cash flow generation and the $35 million in expected net proceeds from the Torrance sale will further reduce debt levels. At September 30, 2019, net available liquidity was $84 million, with $85 million drawn on our $300 million revolving credit facility. We estimate that our net pension liability, including both the qualified and nonqualified plans, was approximately $148 million as of September 30, 2019, an increase of $11 million from December 30 -- 31, 2018.

We estimate that our qualified pension plan funded status was 97.4% as of September 30, 2019, a decrease of 30 basis points since the beginning of the year. Also, as a reminder, there are no funding requirements related to the qualified plan for 2019, and the nonqualified pension plan obligations are paid as they become due. We expect to make cash payments of approximately $5 million related to the nonqualified plan in 2019.

Lastly, I'll share some more detail on the full year 2019 guidance, which reflects the impact of the lower-than-expected education Book volumes we are experiencing in the second half. Moving to the specifics of the guidance. First, we expect net sales between $3.35 billion and $3.4 billion for the year. We expect non-GAAP adjusted EBITDA to be between $180 million to $200 million for the year. We expect net pension income to be $35 million, excluding pension settlement charges. We expect our non-GAAP adjusted EBITDA, excluding net pension income, to be between $145 million to $165 million. Depreciation and amortization is expected to be in the range of $115 million to $125 million. We expect interest expense to be $75 million to $79 million. Our full year non-GAAP effective tax rate is not meaningful, as full year estimated non-GAAP pretax income is expected to finish in the small net income or net loss position, making the effective tax rate not reasonably estimable.

We expect capital expenditures to be in the range of $65 million to $75 million. In light of the challenging business conditions, particularly in Magazines and Catalogs, we have taken steps to limit capital spending in comparison to our previous expectations. We expect free cash flow to be between $60 million and $100 million. The free cash flow guidance includes the $45 million of gross proceeds received in connection with the merger agreement termination, less estimated transaction costs of approximately $21 million. And we expect full year average diluted shares outstanding to be 33 million to 34 million. With that, I'll return the call to Tom for some closing comments.

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Thomas J. Quinlan, LSC Communications, Inc. - Chairman, CEO & President [5]

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Thank you, Drew. In closing, I'd like to highlight an exciting milestone for LSC. As part of the company-wide initiative to enhance the well-being of our employees, this summer, LLC announced the opening of Crawfordsville, Indiana Family Health Center. This is the company's first on-site medical facility offering healthcare, wellness coaching and assessments for the nearly 1,000 on-site employees and their enrolled family members. We're committed to making quality healthcare more accessible to our employees and believe this is a very positive step in the right direction.

Thank you for your time today. And now, Elisa, let's open up the line for questions.

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Questions and Answers

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Operator [1]

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(Operator Instructions) Our first question comes to us from Charlie Strauzer from CSJ -- CJS, I apologize.

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Charles S. Strauzer, CJS Securities, Inc. - Senior MD of Sales & Trading and Analyst [2]

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Tom, can you talk a little bit more about the Book markets? And you talked about timing being kind of the impact here. What kind of drove that? And what's giving you some confidence that that's going to return again and kind of the timing of that as well?

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Thomas J. Quinlan, LSC Communications, Inc. - Chairman, CEO & President [3]

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Sure, Charlie. Thank you. So look, as we've got more long-term contracts with our Book publishers, which is great. Unfortunately, as they -- the forecasting for that or as they go through things, we're dependent upon that. So as they looked at their business going through the back half of the year, whether it was inventory or cash management on their side, the orders that we assumed or thought were coming in, hadn't come in. But with that said, I don't believe that it is structural like I do with Magazines. And I think it's timing. And I think what separates out our Book platform is that we've got different products that are on that platform. The major categories that we do are trade, education. Within education, you have -- there's higher ed and there's K-12, and then you got religious books that we do as well. So as you break those down, if you think about the -- primarily due to the political environment in United States, trade, which is one color, is going really well. I mean everyone is writing a book on what is taking place politically in the country today, no matter which side of the aisle you're on, you want to get your view out there for everyone to see. So we feel as if that has been consistent and then that's going to continue to be consistent.

When you think about religious, the religious product is under pressure. I mean as you saw by our recent announcement and closing of our national plant in Pennsylvania, we're going to move that work to Crawfordsville facility. And in this product, we believe we clearly need to focus on making sure we're matching costs to revenues, but we want to keep the flexibility to flex up again, as demands for Bibles fluctuate.

Higher ed content for a few years now has been moving towards electronic content. It's been followed by physical content, and our feeling here is that, that transition is almost complete and the physical content in the higher ed is going to be stable.

K-12, which is a big one for us, as we look at it. And why I think things bode well, over the next 3 to 5 years, we believe this -- the population -- student population is going to be flat at worst. The adoption cycle is already expected to be a tailwind for us and for the industry over the next 3 to 5 years. Public funding is in place. Obviously, if there is a recession or downturn that will be impacted, but as we see things now, public funding is in place there. As you think about the changing that higher ed has gone through from an electronic standpoint -- to electronic standpoint from a physical standpoint, K-12, there's some different, what I'll call, restraints there that are taking place. There's regulatory requirements that make it tougher to switch to new products. There's the school districts themselves, as they look at how children should learn, and that makes it difficult for things to change there.

Our estimates are there's about 53 million K-12 students in the United States today. About 93%, we believe, are in public schools. So given that, the regulatory requirements of school districts, we think that's a positive, as you look out over the next couple of years for physical content. And then finally, as I think about the -- eventually, the country will be WiFi-ed. The rural areas and the lower social economic areas, they'll all have Wi-Fi. However, the schools will be WiFi-ed. But what does that mean to bring that device home, and how's that going to play out? So there's still a lot of, what I'd say, uncertainty as it relates to that. And that's why we feel good that the Book market is going to be there in all those areas: trade; education; religious.

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Andrew B. Coxhead, LSC Communications, Inc. - CFO [4]

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Also just to remind you that we had good organic growth in the Book segment across 2018 and in the first half of 2019. We were positive 3.9% organic growth in the first half. So we had a down quarter, but when we look at how the numbers have been trending in the longer term, they have been pretty good.

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Charles S. Strauzer, CJS Securities, Inc. - Senior MD of Sales & Trading and Analyst [5]

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Great. That's helpful. And then just quickly, if you could just touch upon maybe a glimpse into the next year with free cash flow and the road map to delevering the balance sheet. Maybe a little bit more of an update there, too.

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Thomas J. Quinlan, LSC Communications, Inc. - Chairman, CEO & President [6]

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Okay. Charlie. Look, your term, the road map, we've got a clear path. We've got to continue to rationalize the facilities, we've got to continue to make sure that the work that we're bringing on to our platform fits our platform. We've got to go ahead and take a look at SG&A in all areas. And we've got to look to see -- monetize any non-core businesses that we have. We've got to go ahead and do that. We've gotten early wins and I think, as you've seen, we need to continue that success that will continue to build a more capable business for the future.

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Operator [7]

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Our next question comes to us from Bill Mastoris from Baird.

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William McGoldrick Mastoris, Robert W. Baird & Co. Incorporated, Research Division - High Yield Desk Analyst [8]

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Tom, you talked quite a bit about the digital disruption, pretty much throughout your businesses away from Books. I'm just kind of wondering with some of the sales declines, what's kind of a reasonable run rate should we expect in the future? I know that, that's a really tough question, but should we expect -- what type of adjustment, I mean, we should -- are we looking at now a $2.5 billion company, $2.75 billion? And then kind of the back half of that and you've touched on a few points here is, really on the cost side, you've mentioned a couple of additional steps. But how are you kind of approaching that rationalization, so that you can get back to those margins and so you can get back to at least a point where you can start to grow again? And then I do have a follow-up.

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Thomas J. Quinlan, LSC Communications, Inc. - Chairman, CEO & President [9]

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Sure. Thank you. Look, the sense of urgency is high across all of LSC Communications. And this sense of urgency hopefully is evident by the steps that I just indicated we're taking and requiring immediate corrective actions to make sure that this platform matches the revenue that's coming into what we have. And again, the actions that we've taken to go away from plant consolidations, to client portfolio management, to SG&A reduction, to reducing the Board size, we continue to derisk the pension plan investment portfolio, so that we can mitigate that as we look at the end of funding. But I would tell you, as we look at it now, I think, I've said, structurally, we look at Magazines as being structurally, we don't look it's Books. As we sit here today, it's been structural, we look at that as being timing. So I think some of the actions or all the actions you've seen have been related to that as we go through things. And again, for us, I said the path is clear. But we've got to go as quickly as we possibly can to make sure that we achieve everything that we continue to talk about. But do it in an orderly fashion as well, which I would -- hats off to everyone, I think, we've done that so far.

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Andrew B. Coxhead, LSC Communications, Inc. - CFO [10]

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I would just to add in terms of your question. We're obviously not providing guidance at this point for next year or beyond. But when you do look at the trends, there's clearly been an uptick in the organic decline in Magazines. And we're expecting not necessarily at the rate you've seen in the last couple of quarters, but you've-- we've expected ongoing organic declines. So as Tom outlined, continuing to reduce costs, we'll be aggressively moving to reduce costs. And there is a good profitable core in Magazine, Catalogs and Logistics that we will see drive margins and cash flows in the business.

When you look at the other 2 segments, we've already touched on Books and what we expect there. And Office Products has seen, in the last couple of quarters, some higher organic declines, but we don't think those are representative of the longer-term trends, particularly with the mix improving on the online channel and that becoming a bigger piece. We're continuing to see good growth there. And so you won't -- we don't expect you'll see -- continue to see that level of decline in Office Products.

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William McGoldrick Mastoris, Robert W. Baird & Co. Incorporated, Research Division - High Yield Desk Analyst [11]

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Okay. And Drew, maybe a question for you. Liquidity is much lower than it's been historically on a seasonal-adjusted basis. And you're coming up to your best cash flowing generating quarter in the fourth quarter. But the first quarter, historically, you've also used quite a bit of cash. And I wonder if you could kind of take us through kind of the cadence of how you kind of restore that liquidity comfort level? It looks as though it's going to be accelerating asset sales that are going to be used to pay down the revolver. But is there anything else here that is going to be used to maybe help out that liquidity front a little bit more?

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Andrew B. Coxhead, LSC Communications, Inc. - CFO [12]

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Yes. Sure. So a couple of things. The liquidity at the end of Q3 was in a comfortable spot, but tighter than what, maybe you've seen historically. But I would also say that if you look at total debt levels, they're down significantly versus kind of where they would be -- what you would expect for this part of the year to have debt levels down versus year-end of prior year reflects the strong cash flow that we've had. We've been able to, as I mentioned in some of the prepared remarks, we've been able to have really good working capital performance. On top of the working capital decline that you'd expect just driven by this -- by some of the sales and top line challenges. So we aren't going to see the kind of free cash flow in Q4 that we've seen historically because of effectively we've been able to pull some of that cash flow forward, and even-out the cash flows across the year. I think we'll also see some moderation then of the cash usage in Q1, as we go into next year. And we feel confident with where we are from a liquidity standpoint that we'll continue to make progress.

And then finally, as you mentioned, we've got proceeds coming in from some of the real estate sales, and we outlined the amounts for those. It's the $35 million that we're expecting yet in Q4 for the Torrance sale, we've got that Reno property on the market. We don't know the timing for that yet, but that will be a $20 million property or more. And we've got the other facilities that we've closed over the course of the year also on the market, and we'll see proceeds from all of those. All of those real estate proceeds are not included in our free cash flow guidance. They are in addition.

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William McGoldrick Mastoris, Robert W. Baird & Co. Incorporated, Research Division - High Yield Desk Analyst [13]

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Okay. And Tom, very last question I have for you. In the second quarter call, you indicated that there are a lot of clients that had put off certain decisions or they put them on hold because of the uncertainty of the merger, but have now begun to engage you with new opportunities. And maybe you could kind of give us a progress report of exactly where you are in that process?

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Thomas J. Quinlan, LSC Communications, Inc. - Chairman, CEO & President [14]

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Yes. I would tell you, we've made great progress in Logistics and in, what I'll call the, niche Magazine players. And we're excited about that. From a Catalog standpoint, the physical retargeting that we have talked about in the past, is starting to gain momentum and more retailers are seeing the benefit of what we're able to bring to them, as it relates to what is taking place online and then how the physical print can go ahead and follow-up to that.

So sales force is more than engaged. Everyone is going at it. I mean, look, the bottom line for us, right now, is simple, it's cost reduction, keep making the liquidity moves that we've got to make, make sure we've got the clients and serving them as we should. And everything that we're doing is incredibly time-sensitive, and we're on it. So appreciate all your questions today.

Elisa, we'll wrap it up here, but I'd like to say, in closing, I'd like to sincerely thank all of our employees for their continued commitments, their passion that they've shown over these last couple of months and the desire to serve our clients.

So with that, we wish everyone a happy Thanksgiving later this month. And thank you for joining today's call.

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Operator [15]

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Thank you, ladies and gentlemen. This concludes today's webcast. We appreciate your participation. You may now disconnect.