DBRS Confirms Transcontinental Inc. at BBB (high), Trend Now Negative

DBRS has today confirmed its long-term and preferred share ratings on Transcontinental Inc. (Transcontinental or the Company) at BBB (high) and Pfd-3 (high), respectively. The trends have been changed to Negative. While the Company’s business risk profile and financial profile continue to support a rating above the BB (high) business risk rating for the printing industry, DBRS expects the structural factors that Transcontinental is facing (such as declining demand for print and pricing pressure), along with increased competitive forces (both factors contributed to lower revenue and EBITDA for the two most recent quarters), to persist and potentially accelerate further for Transcontinental over the medium term. As such, these challenges could reduce the Company’s rating differential relative to the printing industry.

The Negative trend reflects DBRS’s expectation that structural forces in both Transcontinental’s Printing and Media segments will persist and could accelerate with excess capacity in the printing industry and a structural shift to digital forms of media affecting both segments. In fact, DBRS notes that, from an industry perspective, digital advertising in the United States surpassed newspaper print advertising for the first time in 2011 (likely just below this level in Canada at the end of 2011), with digital advertising in the United States expected to surpass combined newspaper and magazine print advertising spending in 2012.

In the Printing segment, excess capacity and competition for traditional printing contracts are expected to remain ongoing, while new forms of advertising that Transcontinental is increasingly offering to its printing customers remain in their infancy. In terms of the Media segment (which, as of November 1, 2011, includes the former Interactive segment), these sectors continue to remain competitive from a national perspective, while local media (largely community newspapers) has also faced a heightened degree of competition. The Company’s digital and interactive businesses, while a growth area in advertising and media as a whole, are highly competitive (from both new and traditional competitors) and unproven in terms of profitability. In fact, this business (currently roughly 10% of total revenue) was operating below the Company’s expectations in F2011, with only modest growth of 5.8%, while core Printing revenue declined by roughly 3% in F2011 on a reported basis, which included some small divestitures (Mexico and black and white book printing – a highly commoditized business facing significant structural pressures).

As a result, DBRS expects the Company to experience modest pressure on EBITDA in F2012, with ongoing structural and competitive forces and the delay in integrating Quad/Graphics Canada, Inc. likely to offset further efficiency efforts and growth from new contracts. Adding to this pressure has been two successive quarters (Q4 F2011 and Q1 F2012) that have been below expectations and shown pressure on revenue and EBITDA (EBITDA down 1.7% and 10%, respectively). While the economic uncertainty in terms of near-term advertising spending has led to lower printing volumes and national advertising revenue over this period, DBRS is concerned that there are also underlying structural and competitive forces driving some of this pressure that could accelerate over the medium term.

In terms of its business risk profile, DBRS expects Transcontinental to continue to benefit from its position as the largest printer in Canada and the fourth largest in North America, in addition to having the benefit of its niche-oriented strategy and diversification in its Printing segment (by geography, product and customer). The Company continues its focused strategy in its Printing segment (78% of EBITDA), which, combined with an advanced and efficient printing network, allows it to generate EBITDA margins well above its printing peers (20.1% in the last 12-month period to January 31, 2012). Furthermore, the focus on leading in five key Printing verticals (also five verticals in Media) and the stability that these multi-year printing contracts provide (between 50% and 60% of printing revenue is under multi-year contracts), offers greater stability than traditional commercial printers, which offer a greater breadth of printing services and shorter contracts. Despite this, the recent acquisition of Quad/Graphics Canada, Inc. (in exchange for Transcontinental’s Mexican and certain other operations in F2011), while adding to the Company’s customer base and printing network, will pressure EBITDA in the near term and will require concerted effort to achieve the planned synergies in order to improve this business to the Company’s typical EBITDA margins.

From a financial risk perspective, Transcontinental has demonstrated healthy free cash flow conversion, leverage and credit metrics that are above the industry average. This includes EBITDA interest coverage of over 9.0 times, cash flow-to-debt of 0.40 times and gross debt-to-EBITDA of 1.76 times. However, with organic revenue and EBITDA growth under pressure, DBRS believes free cash flow will be directed to small-to-medium acquisitions and increasingly toward shareholder-friendly initiatives. In fact, DBRS notes that inorganic growth must be undertaken by Transcontinental in order to support the dividend growth model that the Company strives to maintain.

DBRS believes Transcontinental’s business risk profile continues to weaken due to a structural shift from traditional forms of media to new forms of media. Competitive forces in the traditional printing industry should continue to intensify with ongoing excess capacity, while the new forms of media are also highly competitive with lower barriers to entry and a less-proven profit model.

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

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