Description

Canadian Tire is a short. Canadian retail faces the same challenges as US retail, though they are only a few years behind. With the name trading at a 3% FCF yield, 2x book value and 13.5% ROE I view shares as expensive. Excluding the company’s stake in CT REIT (CRT-U CN) and assuming 1.5bn CAD for the financial services business, the retail business is trading at 7.3x 2018 EBITDA vs Macy’s at 4.7x. While Macy’s owns their real estate Canadian Tire has monetized it via their REIT. I see 20%+ downside to shares with a few near term potential catalysts (NAFTA, Min wage) and some free options (housing slowdown/bust).  

Price Action: Despite missing 3Q estimates by 5% the stock traded up 3% on announcement of a dividend increase from 65cents to 90cents and increase in the payout ratio. I expect more misses going forward, which will weigh on valuation and eventually pressure the company’s ability to continue levering up to pay dividends and buyback stock (cash flow pre-financing, post divs/buybacks has been negative for 5 of past 7 quarters; net debt to ebitda at 3.4x).

Background: There have been a number of VIC writeups on the name which provide background on the company. Canadian Tire is today one of the largest retailers in Canada, selling automotive, living, fixing, sporting goods and apparel. They also have a bank which provides credit cards to Canadian consumers via partnership with Mastercard.

Background (cont’d): The company has 3 retail banners - Canadian Tire, FGL Sports and Mark’s. Canadian Tire is 100% franchised, owned by what the company calls ‘dealers,’ while Mark’s is nearly all company owned and FGL Sports is 60/40 company owned vs franchised, though the franchised portion has been decreasing every year. They also have gas bars at many of their locations which are also franchised, and are one of the larger retailers of gasoline in Canada.

Industry: The e-commerce market in Canada trails that of other advanced countries, such as the US and the UK, but it has been picking up speed for the last five years. Annual Canadian e-commerce consumer revenues are now estimated at more than $20 billion, or about 7% of the nation’s $352 billion in total retail spending in 2016. (By comparison, e-commerce makes up more than 10% and 15% of retail spending in the US and UK, respectively.)

BCG expects online channels to deliver more than 35% of all Canadian retail sales growth in the coming decade, as consumers dramatically increase their e-commerce activity. BCG argues that if retailers do not move aggressively for online and mobile sales, they will face stagnant and even falling revenues and a loss of consumer relevance.

Hypothesis:

1. EARNINGS MISSES: I am 20%+ below on 2018 EPS driven by weakness in the company’s retail segment driven by minimum wage hikes, weaker SSS due to NAFTA renegotiations/ ecommerce, and lower interchange fees on premium cards. I expect the stock to trade lower on negative earnings revisions throughout the year.

2. POTENTIAL CHANGES TO IMPORT DUTY THRESHOLDS: NAFTA negotiations could be a near term negative catalyst

1. NAFTA discussions could raise the import duty threshold for goods purchased by canadian consumers online

2. The threshold could go from $20 to $800. Currently Canadian consumers do not have to pay import duties on goods purchased online from the US that cost less than $20. Trump has asked for an increase to the threshold, with rumored levels going to $800. Clearly this would be a significant negative for incumbent retailers in Canada

https://globalnews.ca/news/3605878/trump-asked-canada-to-drop-duties-on-internet-imports-under-nafta-canadians-should-cheer-say-experts/

3. DEALER ECONOMICS CHALLENGED AND LIKELY TO GET WORSE

1. While the company provides no disclosure on unit economics and dealer health - and no FDD’s in Canada unfortunately- they have said dealers don’t earn back their capital on their investment in inventory until their 2nd or 3rd store. With changeovers at 10% of total CTC stores this year that could be 20+ years. This is one of the worst payback periods I have ever seen in a franchise model. Dealers are clearly motivated by the prospects of eventually running a big store in a big city - if they do well in their current locations CTC bumps them up to progressively bigger and bigger locations. It is for this reason dealers keep a tight lip - I’ve reached out to 20 dealers and heard back from zero. I believe the company sells into the dealer channel at inflated margins, pressuring dealer health. In addition, the company finances the dealers investment in inventory at high rates. (...and the company finances end customers purchases).

2. The company has had a record # of store changeovers this year (a changeover is when a dealer leaves one store to go to a new one) which has driven a short term improvement in retail sales. IR noted 2017 changeovers are running at 10% of total stores. 1 dealer exit drives 7-8 changeovers. Outgoing dealers will sell their inventory to the incoming dealers, which will then discount the items to clear them and replace shelves with inventory of their choice. Because the company sells in to the dealer, they realize increased revenues due to dealer turnover.    

3. Important to remember the company no longer owns the real estate under the franchised stores, as it is leased to CT Reit. Interestingly, CT Reit has noted they arbitrarily set the lease expiry’s when doing the CT Reit IPO to have dates that were staggered/prolonged. This means decremental margins could be bad if CTC was to have to close more locations than initially planned given their lease costs are fixed.  

Below are my estimates for dealer unit economics. Again, these are only going to get worse with minimum wage hikes, potential changes to NAFTA and/or increasing competition with Amazon et al. A housing collapse or slowing in expansion would not help.

4. MINIMUM WAGE HIKES A SIGNIFICANT HEADWIND: Minimum wage hikes are going to pressure earnings and dealer health in 2018

1. Ontario min wages going from 11.6/hr to 14/hr (+21%)on 1/1/2018 and 15/hr in 2019. Ontario makes up 40% of store count.

2. Alberta minimum wages going to $15/hr in Oct 2018 from 13.6 (+10%). Alberta makes up 13% of store count.

3. B.C. minimum wage set to rise to 15/hr by 2021. BC makes up 12% of stores.

4. A big negative here is the timing - there was not a lot of warning in the Ontario hike, and the implementation is coming all at once. As the company notes, this is going to make it particularly challenging to deal with.  

5. HOME DELIVERY GOING TO FAIL.. AGAIN: The company previously tried in-home delivery and failed. They shut it down in 2009. They are trying again but it will fail, again. Their supply chain cycle time is too long - already seasonal fluctuations are a challenge - Canadians regularly complain the stores are constantly stocked horribly. Fulfilling online from dealer locations is going to be a disaster.

https://www.theglobeandmail.com/report-on-business/canadian-tire-to-cancel-website-order-deliveries/article20443452/

https://www.canadiantiresucks.net/forum/

https://www.reddit.com/r/canada/comments/538vbh/its_begining_to_look_a_lot_like

6. RESEGMENTATION MASKING FGL WEAKNESS: FGL SSS are overstated due to resegmentation of B2B business from FGL Sports to other

6. LOWER INTERCHANGE FEES ON PREMIUM CARDS: There are pending changes on interchange rules for premium cards that could have a negative impact on the financial services business, though I don’t have a great sense for liklihood, timing or potential impact to #s.

7. INTENSIFICATIONS BOOSTING SALES GROWTH: Intensifications have boosted SSS and revenue growth by increasing sq footage at dealer stores and then selling into the channel. I estimate this has boosted retail revenue growth by 10% over the past 4 years, or 2.5%/year.

8. VENDOR FINANCING: Retail sales weakness masked by vendor financing; sales growth outpaced by growth in receivables

10. EXPOSURE TO CANADIAN HOUSING: The company has undoubtedly benefitted from the Canadian housing boom - a downturn will clearly pressure sales. There have been a number of good writeups discussing the outlook for Canadian housing on VIC.

11. STORE COUNTS SATURATED: More than 90% of the Canadian population lives within 15 mins of a Canadian Tire. The company tried to expand into the US previously and it failed horribly.

Valuation: On an aggregate basis the company is trading at 2x book value for a low teens ROE. I show 20%+ downside for CTC shares using a 4x multiple for the retail business. This says nothing of the REIT exposed to an overlevered, unsustainable franchise model or the finl services business levered to a housing boom/bust. While bulls argue the company could sell the finance business, the company’s body language suggests otherwise. On P/E the company is trading for 17.2x 2018 and a 3%/2.7% levered/unlevered FCF yield. The 2018 dividend yield is 2.2%.

Catalyst

negative earnings revisions weigh on valuation/ share price, nafta negotiations drive increase in ecommerce penetration, minimum wage hikes pressure corp expense and dealer health, interchange fees on premium cards come down, ecommerce penetration increases over time, online direct-to-home takes longer and costs more than expected, housing bust pressures retail sales.