DBRS Confirms Transcontinental at BBB (high), Stable Trend

DBRS has today confirmed the Senior Unsecured Debt rating of Transcontinental Inc. (Transcontinental or the Company) at BBB (high). The trend remains Stable.

While DBRS acknowledges that Transcontinental could ultimately lose the benefits that keep its rating one level above the average BBB rating for the printing industry, DBRS is mindful that Transcontinental continues to use its capabilities to grow and is committed to reducing leverage to historical levels. Bolstered by new contracts, this growth will add to cash flow from operations derived from a stable base of recurring business given the Company’s long-term contracts. These factors are expected to lead to credit metrics that are more supportive of a BBB (high) rating.

The confirmation reflects four factors. Firstly, while Transcontinental’s operations have experienced some EBITDA pressure (down roughly 7.7% LTM to July 31, 2009) as a result of the downturn in the economy, the Company reacted quickly relative to its peers with its rationalization efforts, which are expected to stem EBITDA pressure for H2 F2009. This should position the Company for growth for the next couple of years both organically (as new contracts begin to generate revenue and EBITDA) and as the economy improves. While DBRS expects EBITDA to be lower in F2009 compared with F2008, DBRS notes that Transcontinental quickly implemented its rationalization plans, adjusting costs due to lower revenue as a result of the weaker economy.

As such, DBRS believes that for the most part the pressure Transcontinental has experienced in F2009 is cyclical in nature, with structural factors only impacting a small portion of its businesses (for example its direct marketing business in the United States). This approach is consistent with DBRS’s rating philosophy of rating companies through an economic cycle. However, should these or any competitive pressures become more permanent and structural in nature, DBRS could deem some impairment to Transcontinental’s current business risk profile, which is a large factor in assessing its rating.

Secondly, while the economic downturn has impacted most of its operating sectors, the Company continues to benefit from its niche-based strategy and diversification benefits that include non-printing based operations. These factors continue to differentiate Transcontinental from peers that exclusively focus on more competitive parts of the printing industry and related activities. Additionally, the Company continues to leverage its expertise and capabilities into creating new services for its customers, such as its outsourced printing solutions for newspaper publishers (notably the San Francisco Chronicle, the Globe and Mail and La Presse) and the enhancement of its Marketing Communications sector as it vertically integrates itself to handle more aspects of its customer’s changing media and marketing needs. While this sector remains small, DBRS believes that this is the direction marketing is heading in a multimedia world, and that capabilities procured in this sector could have benefits in Transcontinental’s more traditional printing and media sectors.

Thirdly, with capex levels peaking in F2009, DBRS expects capex will be reduced by a step function in F2010 and F2011 as the Company completes the investment phase of its projects and revenue and EBITDA begin to flow. This is expected to return the Company to a free cash flow position beginning in F2010 and into F2011. This free cash flow is expected to be used to reduce Transcontinental’s leverage, which was increased to fund these projects, to more historical levels. This expectation is critical from DBRS’s perspective, as leverage is currently above levels that support its rating.

DBRS notes that Transcontinental began to make these prudent investments, including sizable, multi-year printing contracts, without anticipating the downturn in the economy which concurrently impacted its existing operations. Normalizing for the cyclical nature of the economic downturn and the one-time nature of these investments, DBRS notes that Transcontinental would have continued to generate good levels of free cash flow in F2009 and going forward given the inherent free cash flow yields embedded in its operations. Furthermore, DBRS believes that investing in printing and other capabilities is critical in this business. DBRS has observed many situations where failing to make such investments has put an operator at a competitive disadvantage.

Fourthly, Transcontinental has made good progress in obtaining both necessary and opportunistic financing in F2009. This has included nearly $800 million of financing to date to refinance its F2009 maturities, cover its free cash flow deficit in F2009, extend future maturities and aid in financing investments in equipment, such as printing presses for its expanded Globe and Mail outsourced printing contracts. While DBRS notes that more refinancing is required over the medium term, some of the aforementioned financing was completed during the peak of the credit crisis, with credit conditions improving markedly in recent months.

Despite these factors, DBRS continues to remain cautious regarding Transcontinental’s largest sector, printing, as capacity continues to remain abundant and competition remains intense. However, DBRS notes that Transcontinental appears to have been relatively successful at insulating itself against some of the current structural trends affecting the industry (and particular sectors). Furthermore, DBRS will continue to monitor the Company’s results in its media and marketing communications sectors, which should benefit from a recovery in the economy in the medium term and as Transcontinental positions these businesses around new forms of media over the medium term.

Finally, should DBRS’s expectations for Transcontinental not materialize over the medium to long term, in terms of a stable business risk profile and an improved financial risk profile, these factors will be used in assessing the appropriateness of Transcontinental’s BBB (high) rating going forward. These expectations include: (a) the current economic downturn being cyclical with some form of recovery expected; (b) a stable business risk profile; and (c) free cash flow and leverage returning to more historical levels beginning in F2010, with DBRS preferring Transcontinental to be at the lower end of its 2.0 times to 2.5 times net debt-to-EBITDA target.

Notes:
All figures are in Canadian dollars unless otherwise noted.

The applicable methodology is Rating Printing and Publishing, which can be found on our website under Methodologies.

This is a Corporate (Telecom/Media/Technology) rating.