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Transcontinental Inc TCL-A
December 18, 2019 - 2:36pm EST by
diamond123
2019 2020
Price: 15.50 EPS 1.9 0
Shares Out. (in M): 87 P/E 8.2 0
Market Cap (in $M): 1,355 P/FCF 4.4 0
Net Debt (in $M): 931 EBIT 310 0
TEV (in $M): 2,286 TEV/EBIT 7.4 0

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Description

Please note that all figures are in $CAD
 
Investment Opportunity
 
Transcontinental (TSX.TCL-A) presents the opportunity to invest in a family controlled business going through structural transformation. As noted in the previous write up by andreas947, TC was predominantly a printer in Canada that has made significant strides toward diversification in the packaging sector. Although we expect the printing business to continue to decline and acknowledge the 2x net leverage, our forecasts and financial stress testing point to TC being an attractive risk reward for value investors. TC generated a 21% FCF yield (adjusting out the benefit of working capital) in 2019. Taking a conservative view on the next few years, we believe TC will have a 2021 FCF yield of 16%. At that point we’d be left with a strong and growing niche packaging business, a smaller and declining print business but a company with overall profitability growth – a combination that we think will be worth closer to a 12% FCF yield or $23 stock. There are a few paths for even higher estimates.
 
Business History
 
Transcontinental is headquartered in Montreal, Quebec and was founded as a flyer printing business in 1976 by Rémi Marcoux, the family’s patriarch. Over time, TCL grew to be Canada’s largest printing company and magazine publisher. Rémi Marcoux made strategic acquisitions to bolster TC's competitive advantage in Canada. In 2012, Rémi stepped down as Chair of the Board and was succeeded by his daughter, Isabelle Marcoux.
 
In 2014, TC made its initial foray into flexible packaging in a strategic decision to diversify away from a declining print and advertising business and transition into packaging which offered a promising new area for growth. TCL continued to divest small pockets of non-core assets to focus its strategic execution and finally arrived as a major packaging player in April 2018 with the leveraged acquisition of Coveris Americas for $1.8b CAD. At the time of the Coveris acquisition announcement TC stock was trading near $32 at the time of acquisition and it has since fallen to below $16.
 
The Marcoux family owns a 14.5% economic and a 71% voting stake in the company through B shares. Additionally, CEO Francois Olivier is a son-in-law of TC’s founder. While both factors would typically raise investors’ eyebrows, we believe they are actually positives for the company. The family is conservative and prudent with capital allocation (although not without missteps) and Francois has done a great job managing a declining business and so far operating a new segment, packaging. We concur with our primary research that described the family as lucky to have Francois leading the business.
 
What is Different Over the Last 18 Months?
 
The market responded poorly to TC overpaying for Coveris (the purchase price is the capital allocation misstep we mentioned) and the first few quarters after the acquisition performance were less than stellar. However, more recently, we’ve seen a material acceleration of margin expansion in packaging which we think will continue. Organic growth in packaging has been challenged, but we believe 1H 2020 will be a bottom for growth as the company has made progress on new sales efforts to fill excess capacity. Additionally, TC is staying focused – they just
announced the sale of its paper packaging business for $240m, which represents about a 10x EBITDA multiple, helping to reach their leverage target goals a year early. Compared to 18 months ago, we see more synergies ahead, a better business mix with high margins and lower leverage. With packaging
finally on firm footing, we believe the headlines surrounding the printing business are weighing on TC shares.
 
Printing Business
 
Andreas947 did a great job of explaining the printing business and its segments so we defer to his write-up on this front. One of the biggest questions for TCL is how fast the printing business will decline.
 
This segment has very high customer concentration – the top 5 customers comprise about80% of the revenues on the printing side so losing a customer would be painful. We don’t know for sure who is on the top 5 list, but our impression is that the largest customers are Shoppers Drug Mart, Jean Coutu, Sobeys, Walmart, Canadian Tire, Loblaws, Home Depot and Lowe’s.
 
There are a couple headwinds in this business. The first involves digital flyers taking share from print flyers. We’ve spoken to people managing both digital and print flyer orders and it is a little hard to estimate how quickly print flyers will decline. The advantages of digital flyers are that they offer more targeted opportunities will the ability to more accurately measure the effectiveness of your ads. Still, Canadian consumers have been conditioned to check for physical flyers for coupons before making routine purchases at the hardware store, pharmacy, or grocery stores. Many of our industry calls pointed to this conditioning as a reason for retailers to be careful when weaning customers from print to digital. Of course, we expect print flyers will decline, and to deal with the uncertainty we build in heavier declines than we would normally expect. Even with what we believe to be bearish forecasts, TCL still appears to offer an attractive opportunity.
 
Over the past few quarters, the company talked about somewhere between 1 and 3 print customers that began testing dark weeks. This resulted in those retailers moving from weekly to bi-monthly flyering. This had a material impact on profits in 2019. Our understanding is that printing fewer pages consistently isn’t a huge margin problem for the company, but the on/off nature of dark weeks was challenging. Much of this has been resolved as we head into 2020 – the company claims 2 customers have returned to normal weekly output (although perhaps with fewer pages). We expect print pages to decline, but are encouraged by these retailers moving back into a normal schedule, which also meshes with the thesis that Canadian retailers will only move away from print slowly. TC has done a great job of maintaining margins on its business by closing facilities as sales have declined. The company already has a plan in place to close certain facilities if the printing volumes continue to decline.
 
The largest overhang in printing is due to Publisac, a weekly bag that is delivered to homes in Quebec with coupons from TC’s customers. The City of Montreal is in the process of considering to make the Publisac an opt-in delivery method versus an opt-out. Last week, the local environmental committee recommended to make it an opt-in procedure and there is still uncertainty around this. While we believe it is possible Publisac will be forced to go opt-in in Montreal, the market appears to be pricing in the larger risk; the wider province of Quebec will follow Montreal. Our estimates (below) factor in the complete loss of Publisac in Montreal, as well as an allocation for Montreal flyer printer (despite there being other distribution outlets). This whole policy process will still take years to unfold and while it may provide somewhat of an overhang, it is likely the company will continue seeing cash flows from this business for the next few years.
 
Packaging Business
 
The packaging business was fully built out after the 2018 acquisition of Coveris Americas. TC has significant assets in flexible packaging and some interesting niche products like shrink and forming films. We believe TC has excess capacity but has struggled to grow organically. While we have no evidence yet, the company seems to be calling 1H 2020 as the bottom for organic growth. We aren’t baking in growth to our forecasts but believe this is a reasonable area of upside. We are more optimistic on margins. Pro-forma for the recently announced sale of paper packaging, the company had 13.8% EBITDA margins in Q4 2019. They are targeting 15% EBITDA margins by 2021 which seems achievable based on realizing synergies and a bit of cost realignment. Considering the success this team has achieved by growing margins over the past few years and their long time success on the print side, we expect them achieve their 15% target. We suspect that sometime next year the company will rollout a new margin target, likely closer to 16% or 17% (although with a later target date). We’ve spoken with a few industry experts and former employees to learn about TC’s assets and general packaging environment. We were encouraged to hear that TC has some high quality assets, including some facilities that Coveris had upgraded right before the transaction. We did hear that overall supply demand remains imbalanced with excess supply, but also that the kind of packaging TC manufacturers tends to be relatively sticky. This may partially explain why organic growth has been weak.
While not in our numbers, we suspect TC will make another acquisition in packaging, likely a bolt-on to accelerate growth. A further acquisition will likely drive packaging profits well ahead of print, transforming the company ahead of our timeline.
 
Valuation
 
Our model assumes that packaging will have no growth going forward,but can achieve the targeted 15% EBITDA margin. On print, we assume a 7.5% organic decline. Since we are less certain about the fate of the Publisac situation, we conservatively assume that TC immediately loses all of their Publisac distribution revenue as well as their printing revenue in the city of Quebec. Realistically, the Publisac will not disappear immediately in a worst case scenario, not all of the printing revenue would be impacted, and some of the lost Publisac revenue may be distributed through new channels. Still, even with these draconian assumptions with respect to Publisac, TC presents 47% upside over 2 years. We do assume the company continues to close printing facilities, allowing for some margin recapture.
 
Packaging Sector
  2018 2019 2020 2021 Multiple EV
             
Revenues 977 1,618 1,332 1,332    
Adj EBITDA 117 207 190 200 8.0x 1,599
             
Printing Sector            
Revenues 1,443 1,337 1,180 1,062    
Adj EBITDA 332 268 225 192 4.5x 865
             
Other            
Revenues 102 84 84 84    
Adj EBITDA 10 1 1 1 6.3x 7
             
Total            
Revenues 2,521 3,039 2,597 2,479    
Adj EBITDA 459 476 417 393 6.3x 2,470
Capex + Intangibles -80 -126 -88 -83    
Levered FCF 261 306 220 219    
FCF Yield 19.4% 22.8% 16.3% 16.3%    

 

  Valuation
Enterprise Value $2,470
Current Net Debt 931
2 Yrs of FCF 439
Market Cap $1,978
   
Current Mkt Cap $1,355
   
Diluted Shrs 87.4
Price Target $22.6
Upside 46%
 
Risks
 
We believe the biggest risk to TC is if a large customer stops printing physical flyers with TCL. But since consumers are so conditioned to use the flyers to shop, we think printed flyers still represent an important channel to market to consumers. Certain customers have been experimenting with “dark weeks” in certain areas to measure the value of printed flyers but we’ve been told that after each dark week, TCL’s customers have always returned. The print flyers
business represents ~40% of printing revenues.
 
It would hurt TC if the City of Montreal requires Publisac customers to opt-in to the Publisac in order to receive the flyers. But Montreal Publisac only represents single digit percent of printing revenues and this would only apply to the city of Montreal. A bigger risk is that this decision spills over to other
jurisdictions which may impact TCL materially but over a many year time horizon since the policy process is slow.
 
An economic recession in Canada would obviously harm both the printing and packaging businesses.
 
Management has indicated an appetite for smaller non-transformational acquisitions which concerns us a little since they overpaid for Coveris. But this concern is somewhat tempered by the fact that the family prioritizing maintaining a healthy balance sheet at 2x leverage.
 
Conclusions
 
Although TC overpaid for Coveris Americas, we think the decision made strategic sense in order to diversify away from printing. The stock has already been punished for the high price the company paid and it seems like now is a good opportunity to invest in the company. TCL seems focused on the right things right now like executing on packaging operations, pulling out the synergies, and managing the cost structure of the printing business. The risks around Publisac seem well established and overplayed considering the likely timeline until a final decision is implemented.
 
We find the FCF yield to be very attractive relative to our forecasts which expect the printing business to decline at 7.5% per year and for the packaging business to remain flat. The TCL Media business/Other segment is much smaller and we haven’t focused on it so we’re expecting it to be flat.
 
Even though the printing business is facing declines, we believe it will be partially offset by reducing the print facility footprint. The company is attractive on a levered FCF basis, but also on an unlevered basis. They should be able to deleverage which will unlock value as debt is converted to equity.

 

I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise hold a material investment in the issuer's securities.

Catalyst

  • Strong execution and realization of synergies
  • Continued paydown of debt
  • Publisac gets sorted out in a way that isn't as bad as the market expects
  • Printing volume declines offset by reductions in the facility footprint
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