Our view: Against the backdrop of strong market demand and the reiteration of the F2022 outlook, we are looking through a rare margin miss in an exceptionally challenged Q1/22 with management expecting multiple operating headwinds to wane as F2022 progresses. Following a modest downward recalibration of the packaging margin trajectory, our price target decreases from $27 to $26. We reiterate our Outperform ranking.
Key points:
• Re-rating potential remains intact. At 6.0x FTM EV/EBITDA, we believe Transcontinental continues to be a cheap way to play the post-COVID theme given operating leverage to renewed YoY growth in retail flyer volumes as physical retail traffic recovers. Despite lingering resin and FX impacts, we continue to see the potential for an upward re- rating of the stock given what is accelerating organic revenue growth momentum within packaging (with the packaging revenue contribution now approaching 60%) and an improving printing narrative with one- third of printing and media revenues growing double-digits. With the stock trading at a notable discount to the ~8x average for packaging peers, Transcontinental remains one of our best ideas with each 0.5x increase in multiple equating to $3/share, management's long-standing masterclass in execution, leverage of 2.3x and ~$3/share in normalized FCF.
• Looking through a rare margin miss. The negative surprise in the quarter were packaging EBITDA margins that were well below forecast (10.1%, down -473bps YoY and versus a normalized 16%-17%). Notwithstanding known resin impacts, management attributed the additional margin pressure to an exceptionally challenged operating environment due mainly to an Omicron-driven spike in employee absences through December and January which negatively impacted efficiency and all aspects of operations (including sales and marketing). While non-resin- related inflationary pressures are expected to persist, management indicated employee absences have now normalized and along with waning resin impacts expects previous operating efficiency to kick-in beginning in Q2/22 continuing through H2/22. Importantly, management indicated that end-demand remains strong across the board (with the typical 2-week demand backlog now reaching 12 weeks) suggesting the solid underlying momentum in both packaging and printing remains unchanged.
• Other notables from the quarter. (i) despite the exceptionally challenged operating environment in Q1/22, each segment reported positive organic revenue growth including +1% volume growth for packaging; (ii) even though printing performance in the quarter was solid and in-line, Omicron negatively impacted both flyer volumes and in-store marketing suggesting further improvement is ahead; and (iii) management sees leverage falling below 2.0x in the "coming quarters" driven by improved operating performance versus Q1/22 (consistent with our forecast).