Transcontinental, Inc. (TCL)

Summary

We focus on smaller companies with Ft. Knox balance sheets and large & sustainable free cash flow yields and we are typically seeking a double-digit FCF yield or higher on an unleveraged basis.  The objective is for the sustainable FCF to eventually drive up the share price to a more reasonable valuation, through share buybacks, debt reductions, dividends, or accretive acquisitions.  Obviously, it is important we have a management team that cares about shareholder value.  We focus on small-cap stocks because there is a much better chance to find an attractive investment opportunity which is under-followed or undiscovered.

Transcontinental, Inc. (TCL) engages in print, flexible packaging, publishing, and digital media operations in Canada and the U.S.  TCL is the largest printer in Canada and a key supplier of flexible packaging in North America and recently completed a transformational acquisition in flexible packaging discussed below.

All numbers are in Canadian dollars unless otherwise noted.  Years generally refer to TCL fiscal year end 10/31.

TCL has been written off over the last several years as a declining printer with no growth potential and we believe the current multiple continues to reflect this sentiment.  As one looks closer, it become evident that TCL has an excellent management team with a compelling strategy (still partially executed) to create a strong, resilient and sustainable business over the long-term. It is becoming clearer that TCL could become a major player in flexible packaging in North America over the next five years.  TCL is using the strong and steady cash flows of its unique Print Segment to position itself as a major player in flexible packaging in North America. 

Over the last few years, TCL has been shifting its business model to focus on flexible packaging, a growing industry that is well positioned for the future.  TCL recently completed a transformative acquisition of Coveris Americas for $1.7b in May 2018.  Coveris generated approximately $1.26b in revenues and approximately $165m in adjusted EBITDA for its fiscal year ended 12/31/17.  The Coveris Americas acquisition makes TCL one of the top ten flexible packaging converters in North America, among Bemis, Sealed Air, Berry, and Print Pak.  On a pro forma basis for 2017, TCL’s total revenues are about $3.3b, operating earnings are about $362m, and adjusted EBITDA is about $564m.  Packaging will represent about 48% of total revenues, 23% of operating earnings, and 37% of adjusted EBITDA.  We expect TCL to rapidly deleverage its balance sheet over the next two years.  Net debt to adjusted EBITDA is about 2.7x at closing and this is expected to decline below 2x over the next 24 months.

Over the past six years, TCL has generated cumulative cash from operations of close to $2b or about 90% of its enterprise value (EV) prior to the Coveris Americas acquisition.  TCL’s strong cash flows have been used to: (1) reduce its net debt to almost zero from $900m, (2) make six acquisitions in flexible packaging prior to Coveris Americas, (3) make strategic capital investments in its printing network, and (4) repurchase shares and pay dividends.

Pro forma for Coveris Americas, we believe TCL is attractive at current prices trading at 1.3x revenues, 7.5x 2017 EBITDA, and a 9% unleveraged FCF yield.  Pro forma for Coveris, TCL’s adjusted net earnings per share are about $3, so TCL is trading close to 10x adjusted EPS.  We believe its Print Segment is a better business than most investors realize – adjusted operating income from Print Segment have grown significantly from $185m in 2008 to $295m in 2017.  Print Segment includes a unique business model printing flyers and in-store displays for major Canadian retailers, which has enabled industry outperformance to date.  Further, we believe there could be significant long-term growth opportunities in the Packaging Segment.

TCL has about 14m Class B multiple voting shares and about 74m Class A subordinate voting shares currently trading at about $31 per share for a market cap of about $2.8b.  Class B shares are controlled by the Marcoux family of Canada.  CEO Francois Oliver is the husband of Chairwoman Isabelle Marcoux.  After the Coveris America acquisition and a follow on 10m share Class A stock offering to help finance the acquisition, TCL has about $1.5b of net debt, resulting in an enterprise value (EV) of about $4.3b.

We believe if TCL grows its Packaging Segment and Print Segment results remain relatively stable, investor perception could further improve.  We believe TCL could achieve $600m in adjusted EBITDA by 2020 and trade for 8.5x adjusted EBITDA or an EV of about $5.1b.  We believe TCL could reduce its net debt to about $1b by year end 2020.  Based on net debt of about $1b and 88m diluted shares outstanding, we believe TCL stock could trade for about $47 per share, or close to 50% higher than the current price of $32 per share.

Background

TCL undertook a transformation program starting in 2014 when Print Segment accounted for 69% of total revenues and Media Segment was 29% of total revenues and Packaging Segment was 2% of total revenues.  In 2017, Media Segment represented 11% of total revenues due to TCL’s strategic decision to divest certain activities and Packaging Segment was 15% of total revenues.

Over this period, TCL has exited local newspaper publishing activities and completed five packaging acquisitions, with its first packaging acquisition completed in 2014.  TCL chose to diversify its operations into flexible packaging, a path that leverages its manufacturing capabilities.  TCL strategy is focused on three objectives:

·         Defending and strengthening its printing platform;

·         Developing specialty media activities;

·         Accelerating the growth of operations in the packaging industry.

Printing Segment

TCL has 18 state-of-the-art printing plants across Canada and the Print Segment generated 74% of total revenues in 2017.  Despite the printing industry’s secular decline, TCL improved the profitability of its print operations for the 8^th consecutive year in 2017.  Adjusted operating earnings for print increased by almost 2% in 2017 to $295m and grew at a compound annual growth rate of about 6% since 2009.  TCL has achieved a leadership position for its print division with rigorous management of long term contracts and working on increasing its market share and focused on the most promising verticals. 

Print Segment’s key vertical is retailer related services, including flyer and in-store marketing product printing, pre-media services, and door-to-door distribution.  This business is characterized by multi-year agreements with major retailers in Canada and recurring orders, which help generate significant cash flows.  Retailer related services represented about 60% of total Print Segment revenues for TCL in 2017.  Printed flyers remain an essential and effective part of retailers’ marketing strategy for driving traffic to the store which helps stability of printing volumes.  TCL also gained market share in printing of in-store marketing products, which currently accounts for about $65m of annual sales.  TCL has relationships with all major Canadian retailers.  TCL recently entered an expanded relationship with Lowe’s Canada in addition to renewing its agreement for full range of services offered to RONA.  TCL currently prints all flyers for Lowe’s in Canada.  Print Segment adjusted operating earnings margins were 20% in 2017.

A key driver of TCL’s growth in print segment profits has been optimization of its printing platform.  From 2007 to 2010, TCL strategically invested over $800m to modernize its equipment to innovative technologies.  TCL was able to offer services to new customers, increase its productivity, and lower its cost structure, making printing less costly and more competitive compared to other forms of media, especially in the flyer printing segment.  Since then, TCL has continuously sought to maximize capacity utilization rate of its platform.  In 2008, TCL had 54 printing plants and by 2017 TCL had reduced its total plants to 18 plants.  From 2008 to 2017, TCL has significantly increased its printing division profitability, as adjusted operating earnings were $185m in 2008 and increased to $295m in 2017by continuously improving utilization of its printing plant network over time.

TCL’s non-retailer printing verticals represent the other 40% and include newspaper, magazine, mass, and personalized marketing product printing markets, which rely on advertising spending and are increasingly affected by the migration of dollars from print to digital.  However, TCL’s unique newspaper outsourcing printing model benefits from long-term contracts with publishers.  In 2017, TCL printed the Toronto Star under a five-year agreement signed in 2016.

Recently TCL announced the consolidation of its newspaper printing activities in Quebec into three plants and the closing of the Transcontinental Metropolitan plant in late January 2018.  TCL in April 2018 transferred the printing operations of its facility in Fremont, CA to Hearst and received about $55m as compensation from Hearst for early termination of its agreement to provide outsource print services for the San Francisco Chronicle.  TCL retained the plant and will rent to Hearst through 2024 but moved some of the equipment to other sites.  TCL has been moving out of the newspaper segment to focus on packaging.  It sold 12 newspapers in Quebec and shut its Metropolitan printing plant in Montreal in early 2018. 

Packaging Segment

Packaging Segment seeks to be a leader in North American flexible packaging and accelerate its growth through organic sales growth and acquisitions.  Prior to Coveris Americas, TCL had six production plants in North America for flexible packaging.  In 2017, flexible packaging represented about 15% of consolidated revenues for TCL.  In 2017, Packaging Segment achieved organic growth of about 6%.  TCL initiatives to drive organic growth included numerous capital investments made in 2015 as it increased existing capacity to meet customer needs.  Further, TCL deployed significant resources to develop its sales force which, prior to Coveris Americas acquisition, included approximately 30 sales representatives across North America.  On October 31, 2017, after the fiscal year, TCL acquired Les Industries Flexi-Pak, Inc., a flexible packaging supplier located in Montreal.  The first flexible packaging acquisition in Quebec extends TCL’s footprint to Eastern Canada by adding a facility with a state-of-the-art platform.  It allows TCL to develop further existing business relationships with retailers in Canada.

Coveris Americas

TCL’s purchase price for Coveris Americas was about 10.3x adjusted EBITDA before cost savings and about 8.9x post synergies.  Synergies are estimated at about $26m.  Coveris has 21 facilities with over 3,100 employees and has invested close to $200m to modernize its platform over the past three years.  TCL believes Coveris has a leading position across a broad range of growing end markets.  Coveris has close to 3,500 customers representing a broad portfolio with long-standing relationships.  Coveris is a leading integrated flexible packaging manufacturer of barrier films, pouches, multi-wall bags, and coatings.  Coveris positions TCL as one of the top ten flexible packaging converters in North America.  TCL had 7 existing flexible packaging facilities prior to Coveris and will have a total of 28 facilities across North America after the acquisition. 

Coveris comprehensive product offering will include Shrink Bags and Thermoforming Films, Films and Laminations, Plastic Bags and Pouches, Multi Wall Paper and Composite Bags and Sacks, Fruit Bags and Packaging, and Outdoor Films and Wraps. 

Coveris covers a broad range of growing end markets.  Markets served include Fresh meats, Processed meats, and Cheese; Beverage multi-packs, Household products, Industrial materials, and Food; Pet food, Lawn and garden, and Household and personal care; Dry Milk, Chemical ingredients, and building materials, bananas, and other fruits and vegetables, and crop protection, greenhouse covers, and waste transportation.  Coveris also has a broad customer portfolio with long-standing relationships and close to 3,500 customers.

TCL’s Packaging Segment had close to 900 employees prior to the acquisition of Coveris America and is a key supplier of flexible packaging in North America.  Its coast to coast platform comprises one pre-media studio and six production plants specializing in flexographic printing, lamination of plastic films, and converting, including bags and pouches.  The division offers an array of solutions for a variety of industries, including dairy, coffee, pet food, bakery, snacks and confectionary, supermarket fresh perimeter, frozen foods and cigars. 

Coveris Americas under TCL should also benefit from protected margins as majority of material customer contracts include structural raw materials pass-through provisions.  Further, TCL believes there are significant cost synergies in its flexible packaging plant footprint combined with Coveris plant footprint.  These include procurement of raw materials, vertical integration of film manufacturing and insourcing of pre-press and plate making operations.  TCL has a demonstrated ability to realize strong cost synergies over many years in its Print Segment.

Media Segment

TCL’s Media Segment generated about 11% of consolidated revenues in 2017.  TCL has focused on specialty brands for the business, finance, and construction sectors, and on its French language educational book publishing activities.  TCL in 2017 decided to put its local newspapers up for sale as part of its focus on the most promising segments for the media business.  All but one of TCL’s 93 local and regional newspaper properties have been exited as of today and talks are advanced about exiting the final property.

Media Segment today has a business model which generates revenues from a variety of sources, with close to 75% of its revenues being non-advertising based.  In terms of specialty publications, in December 2016, TCL acquired seven specialty brands from Rogers Media with an established multiplatform business model.  The Media Segment also continued to develop new specialty products and services to meet the needs of customers and diversify its revenues.  Educational book publishing activities generated solid results and sustained organic revenue growth in 2017. 

Seasonality

The Company’s seasonality is indicated by the chart below, which shows quarterly revenues and operating income prior to any contribution from Coveris America.

Strong Cash Generative Business Model and Attractive FCF yield

TCL has a highly cash-generative business model.  The Company’s cash from operations has represented a majority percentage of adjusted EBITDA in every year since 2008.  In 2017, TCL generated about $325m of cash from operations with about $33m of capital expenditures.  TCL has an unleveraged FCF yield of close to 9% post Coveris America acquisition.  From 2010 to 2017, TCL averaged close to $350m of cash from operations per year.

From 2012 to 2017, TCL generated cumulative cash flow from operations of close to $2b, or over 90% of the enterprise value (EV) of TCL prior to its acquisition of Coveris Americas.  TCL deployed $428m to make acquisitions in the flexible packaging industry and reinvested $274m into initiatives to sustain organic growth and increase productivity.  Further, TCL distributed $248m to shareholders through dividends and share buybacks over this time frame.  Lastly, TCL reduced its net debt from over $908m at year-end 2008 to only $101m at year-end 2017.

Solid Competitive Position in Canada Printing Industry

TCL is the largest printer in Canada and has a state-of-the-art network of printing plants and one of the lowest cost structures in the industry.  TCL cost structure and modern equipment and geographic locations enable it to provide unique service capabilities to its customers that other printers find difficult to match.  Major retailers in Canada depend heavily on flyers to drive customers into their stores and these retailers have long-term relationships with TCL.  TCL also provides unique in-store printing capabilities for these retailer customers.  TCL recently signed a major agreement with Lowe’s Canada to service all its Canadian store base and, in addition, extended for several years its relationship with Loblaw, one of the largest retailers in Canada.  About 80% of total Print Segment revenues are covered by long-term contracts.

TCL’s adjusted EBITDA and cash flows from its Print Segment and network of printing plants has grown significantly over the past six years, as TCL has reduced its cost structure by closing less efficient plants to maintain profitability.  We believe TCL can continue to successfully execute this strategy to maintain relatively stable print profits and cash flows over the next several years despite continued pressure on print revenues from the 40% of print revenues that are non-retailer related and more closely aligned with declining ad revenues.

Revenue Growth Potential Through Expansion of Flexible Packaging Segment

We believe TCL has revenue growth potential as it expands into a growing flexible packaging industry.  The flexible packaging industry is expected to grow about 5% per year over the next five years.  In 2017, TCL’s Packaging Segment had organic growth of about 6% and TCL expects a similar level of growth for 2018, excluding the Coveris Americas acquisition.  We expect packaging to become an increasingly larger share of TCL’s total revenues and adjusted EBITDA over the next five years and this gives TCL significant growth potential.

Coveris Americas has several food suppliers it provides flexible packaging for that are talking to Amazon about supplying food packaging for the ecommerce platform and this could provide a new revenue stream for TCL.  If Amazon increases its food offering via the internet, it could be a major growth opportunity for TCL.  Amazon is testing redesigned packaging with some food brands for the online world which could make it easier for Amazon to ship to urban dwellers in less than an hour.

High Margin Print Segment Generates Strong FCF to Drive Shareholder Value

Print Segment adjusted EBITDA margins have increased over the past five years and were close to 20% in 2017.  60% of Print Segment revenues are linked to retailers – flyer printing is 41%, flyer distribution is 10%, pre-media is 4%, in-store marketing is 3%, and other print revenues not retailer-related are 42%.  Demand for printed flyers has remained stable in a digital world and associated services provided to major retailer customers have growth potential.  The retailer-related print business is repetitive and contractual business and TCL recently concluded an expanded agreement with Lowe’s Canada and a major renewal of its agreement with RONA.  Major retailer customers are evidence of the importance of printed flyers in driving store traffic and Print Segment customers include the largest retailers in Canada, such as Sobey’s, Loblaws, Metro, Best Buy, Giant Tiger, Jean Coutu, Unipair, Katz Group, etc.

Ability to Consolidate Plants and Maintain High Efficiency and High Profit Margins

TCL has levers to mitigate top line challenges, as evidenced by consolidating printing plants in Canada from 54 plants in 2008 to 18 plants today.  This has enabled TCL to increase the utilization rate on its plant network in Canada and drive higher profit margins in the Print Segment, despite flattish top line growth.  We believe TCL can continue to consolidate the efficiency of its plant network to deal with top line weakness in its non-retailer portion of the Print Segment.  Print Segment profitability has increased over the past six years despite tepid top line growth as TCL has rationalized its plant network to meet demand.

Solid Q2 2018 Results (Pre Coveris Americas Acquisition)

TCL’s results for Q2 2018 continued to be solid, as adjusted operating earnings increased by $2m or 3% from $64m to $66m and adjusted net earnings increased by $3m or 6% to $45m from $42m.  Printing Segment had a stable quarter and Media segment completed sale of local publications, with only one publication in Ontario remaining to be sold.  Adjusted EBITDA was $90m for Q2 2018 which was flat with prior year and six months adjusted EBITDA was $181m vs. $178m prior year.  TCL expects revenues from print services to retailers to be relatively stable in 2018 and to benefit from the multi-year agreement with Loblaw Cos which includes the full range of retailer services.

Printed Flyers Could Have Longer-Term Staying Power

Recent studies from Brand Spark International (commissioned by TCL) have indicated the printed flyers continue to be relevant medium to drive traffic to stores in Canada.  Studies indicated close to 90% of Canadians read a grocery flyer each month and other statistics indicate up to 80% of Canadians read a grocery flyer every week.  51% of millennials prefer print flyers over other formats, compared to 24% who prefer flyer apps.  Other statistics indicated 84% of shopper read printed flyers and 73% of millennials read printed flyers, and only 9% of shoppers used digital only.  It is possible that printed flyers could have longer staying power than most investors assume.

Attractive Upside Potential

Pro forma for Coveris Americas, TCL would have had $3.3b in revenues in 2017 and $565m in adjusted EBITDA.  We believe TCL can achieve stable adjusted EBITDA in its Print Segment and its Packaging Segment can grow.  The flexible packaging industry in North America is expected to grow about 5% per annum over the next five years.  TCL’s Media Segment has almost 75% of its total revenues in non-advertising-based areas with strong niche positions in stable verticals.  TCL’s Print Segment has close to 80% of total revenues under long-term contracts and close to 60% of revenues with retailer related flyer and other critical services.

We believe TCL could achieve adjusted EBITDA of close to $600m by 2020and reduce net debt to about $1b.  As packaging operations become a larger share of total adjusted EBITDA, we believe TCL could trade for 8.5x adjusted EBITDA or more and have an enterprise value (EV) of about $5.1b and an equity market cap of about $4.1b.  Based on 88m total common shares outstanding, TCL would have a share price of about $47 per share (close to 50% higher than current price).

Balance Sheet Should Rapidly Deleverage

Pro forma for the Coveris Americas acquisition, TCL will have a reasonable a balance sheet with a net debt position of about $1.5b or about 2.7x pro forma LTM adjusted EBITDA.  We expect TCL to use its strong free cash flow to rapidly reduce net debt.  We believe TCL could generate close to$300m of FCF (defined as cash from operations less maintenance capital expenditures) per annum, which it can use to reduce its net debt.  We think TCL could end 2020 with $1b of net debt or less.

Conclusion and Target Price

Based on 8.5x our estimate of adjusted EBITDA of $600m for 2020 with about $1b net debt and about 88m diluted shares outstanding, we believe TCL could have a market cap close to $4.1b or $47 per share or more versus $32 per share today (+50%).  If TCL continues to execute and its flexible packaging and printing segments perform as we expect, we think our target price can be achieved. 

All numbers are in Canadian dollars unless otherwise noted