Description

Canadian Tire has been posted in the past on VIC, most recently in 2017. We recommend reading those pieces for more background. As a quick summary, the company operates three retail banners, of which the namesake Canadian Tire is by far the largest with ~500 branded locations. Despite the name, the boxes are not entirely auto related. They are a bit like an old school Sears Roebuck, or in more modern parlance a mash up of a Walmart (sans groceries), Macys, Costco (sans memberships) and Autozone. 

While the retail concept gets most of the attention, it is only a (small) portion of the entire enterprise value of the company. The company’s financial services (credit card) business and real estate (via a publicly traded REIT in Canada) are more meaningful portions of the entire value. More on this in our SOTP section below.

One of the things we like about the Canadian Tire short is that there is a great deal of “reflexivity” in the different pieces of the value pie. Declining retail sales mean the REIT has a weaker tenant; attempts to improve credit quality will impact retail sales (conversely, credit quality may be sacrificed to stimulate sales); rent increases that would benefit the REIT hurt the retail operation; and so on. The entire structure wreaks of bull market optimism. Additionally, the fact that the company has already taken the “value enhancing” step of spinning the property into a REIT takes that off the table as a positive catalyst for the shares.

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Since the last VIC writeup on the name, the major change to the situation has been Amazon’s increased and aggressive presence in the Canadian market. Since the prior writeup, Amazon Canada has:

• Launched amazon prime membership at $79/year

• Significantly increased Prime free shipments

• Increased presence to more than a dozen fulfillment centers (for reference, Canadian Tire has 4 fulfillment centers)

• Bought one of the largest office building in downtown Toronto in preparation for scaling the business

We can go into more detail in the comments section should people wish to know more, but for brevity’s sake, suffice it to say the convoluted dealer structure that Canadian Tire employs for its retail operations is very ill-suited to transitioning to omni-channel operations. 

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An oft-repeated thought throughout the Covid-19 era is that it will simply accelerate trends already in place. We agree with that in a general sense and very much agree with it in the specific case of Canadian Tire. 

Our channel checks during the shutdown have indicated the company is struggling mightily in this environment. While the stock is down considerably from it’s recent highs (from ~150CAD to ~95CAD), we remain short as we believe the “stress case” for the company uncovers significant incremental downside to the stock. Our favorite, and most succinct, summation of the current situation came from an ex-Canadian Tire dealer who referred to it as “the worst sh*tshow I’ve ever seen.” Several contacts estimated retail sales would be down between 15 and 30%, due to weakness across the board, but especially in home goods, apparel, and auto. We expect a good portion of these to be lost to e-commerce competitors and never re-gained. In our checks over the last several weeks, we have frequently found the Canadian Tire website inoperable and incapable of taking new orders. Management touted being "over capacity" as a positive for their e-commerce business in the month of April, but we suspect it meant lost sales (and perhaps customers) that will never return.

As mentioned above, there is reflexivity to this business model, and we expect to see issues mount in the company’s credit portfolio in coming months. While we have seen delinquencies and agings tick up a bit in the last couple of months, this will be a key factor doing forward as employment losses and the cratering of oil prices ripple through the Canadian economy. 

On to the sum of the parts:

Retail segment (85% apparel/sports/home goods, 15% gas) is worth $18. We are assuming 5% SSS declines and a 9% margin and a 5x unlevered multiple representative of a troubled, secularly declining, B&M department store in the US.

• Financial Services segment we get to $17 of value on assumptions we feel are fairly generous. The company has a really odd put option to sell 29% of the business to Bank of Nova Scotia based on an NPV value, last valuing the business at $2.5bn. We don’t think the business is worth nearly that much, but giving them credit for the ability to offload 29% of the equity to Bank of Nova Scotia at a 25% discount to the last implied value form the annual report. The rest of the portfolio we value at 3.3x after-tax earnings in a scenario where loans fall 3% and the PTX RoA falls to 5.5% from 6.6% in 2019 on higher credit losses. This is not a doomsday scenario – the RoA fell to 3.6% last recession. Credit delinquencies and charge offs can be monitored monthly (chart below).

• REIT value of $25. This is pretty straightforward. They own part of a publicly traded company that owns real estate and leases it back to CTC.A. We use a 20% holdco/liquidity discount factor. 

Put it all together and we get total value of ~60CAD per share. Still significant downside from today’s prices closer to 100CAD. 

There are no doubt risks to any short that is down ~40% off recent highs, especially one with leverage. Management points to an increase in website orders during the Covid-19 shutdown as evidence that e-commerce is growing at a dramatic pace. Purchasing on the website to pick up curbside while the store is closed to customers, however, is a dramatically different proposition than at home delivery. We would worry more about a dramatic improvement in the economy and consumer spending as a cyclical positive for the company more than any notion that their structural and secular position has improved.

Catalyst

Further declines in B&M traffic and sales

Problems in credit book

Relexivity in credit-REIT-retail related entities