Loblaws L S
July 04, 2012 - 9:52am EST by
ima
2012 2013
Price: 33.00 EPS $2.61 $2.00
Shares Out. (in M): 285 P/E 12.6x 16.5x
Market Cap (in $M): 9,400 P/FCF 14.0x 18.0x
Net Debt (in $M): 5,000 EBIT 1,250 1,050
TEV ($): 14,400 TEV/EBIT 11.5x 13.7x
Borrow Cost: NA

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  • Canada
  • Grocery Stores
  • Margin compression
  • Competitive Threats

Description

 Canadian Grocers – A repeat of the US Grocer decline in the face of competition from WMT and TGT

 Loblaws ($34) – SHORT – Upside (+10%) / Downside (-40% to -70%)

The market is valuing Loblaws and peers like they are mature but stable companies.

 Loblaws - $9.5B market cap, $16M DTV. 40% market share

•At 13x EPS, Loblaws (L) lost its premium valuation due to poor management and the early signs of problems competing with WMT and TGT. L used to trade at 16x-22x until 2007 (leading Canadian retailers with decent growth were all given that valuation back then).
•Consensus calls for 2% revenue growth over the next two years with stable margins and EPS.
 

Metro (MRU) – $5.5B market cap, $20M DTV. 11% market share

•EPS is forecast to grow in the high single digits, on sluggish revenue growth, small improvements in margin and some buybacks (they buyback 3% of shares annually)
•MRU trades at a PE of 13x. PE used to be 16x until 2007. Trades around 12x-14x for the past 2.5 years.
 

 Empire (EMP/A) - $4B market cap, $4M DTV. 18% market share

•Consensus is similar to that for Loblaws. 12x EPS.
 

Loblaws - Investment Thesis

1.Industry can’t grow, new supply will cause negative comps at incumbents – SSS was < 1% last year, Canadian consumer is deleveraging, retail numbers are weak. New supply is 3% of the market annually forcing incumbents to comp negative.
 
2.Repeat of the US Grocer industry– In the last ten years US grocer EBIT margins shrank 2.5% to 6.5% across peers. Canada is just beginning that cycle. They are where the US was in 2002. Multiples compressed and the declines in the stock prices are 30% to 100%.
 
3.EPS declines of 33% to 60% - 4.5% EBIT margins should decline 100-200 bps, representing a 33% to 60% hit to EPS
 
4.Valuation – Downside is 40% to 70%, mostly reflecting the decline in EPS plus a small decline in multiples. Valuation reflects 10x to 12x EPS versus the current 13x.
 
5.Loblaws – 1) they have the most to lose with 40% share. 2) they have the worst management team. 3) they are in the late innings of their private label brand which has contributed more than 100% of the growth in EBIT since 2011 (ie they mask an existing decline in margins). You can also short EMP because it has the most overlap with WMT and TGT but it is less liquid.
 
6.Risks/ Upside – 10% to 25% – if the macro and industry thesis is largely wrong, I think these are low beta stocks. Mid single digit EPS growth with stable multiples. The risk is that I am completely wrong about the impact of WMT and Loblaw returns to a premium multiple, in which case the upside is 25%.
 
 
Industry overview – A repeat of the US grocer market – margin erosion and multiple compression
•WMT is at 7% market share, the same level when US grocer margins began declining around 2002. WMT is growing their presence at a similar rate.
•TGT is entering the market. WFM is there but growing slowly
•Summary – Supply/Demand is worse in Canada now than the US in 2003. But the market structure is better. Incumbents management teams are just as bad as in the US
 
- demand growth- very low in Canada compared to the US in 2002 when WMT began impacting industry margins. SSS for the industry is running about 1%. Canadian are overlevereged, the central bank is cracking down on credit because household debt levels are on par with the US at the peak of the housing bubble. Even aside from lower commodity prices, there is very limited growth in demand. Definitely below growth in supply
- new entrant supply overwhelms demand. New entrant supply is 2.5% to 3.5% depending on how you measure the market. This means that SSS at incumbents will turn negative.
•WMT and TGT are incredibly enthusiastic about growth in Canada. Another signal that they think they can win.
- quality of management is poor. this is based on extensive interviews with suppliers, industry consultants and private competitors.
 

The US Grocery Industry since 2002 – margins collapse in order to maintain market share. Stocks collapse too, trailing the market by 70%

 
over the past 10 years WMT market share rose 16%, while incumbent EBIT margins declined 3%
 
why the bull argument that canada is different is wrong -
Industry Structure – a national oligopoly does not matter– the top 3 in Canada control 60% of the market. That is considered a key difference but it is misleading. Market concentration should be measured locally, at that level there is no difference with the US
•In Canada, L has 40% national share, EMP 18% and MRU 11%. Cities have similar concentrations.
•In the US, grocers are regional. But within a city concentration is very similar. Publix has 50% share in Florida. Kroger often has 30% share and the top 3 players often have 50%+. (Source: Grocery Distribution, Bclays)
•In the US, the bulk of Market share losses came from smaller players. In Canada, because of a national oligopoly, the large incumbents will lose more share than in the US. MRU is already shedding market share in an attempt to shield margins.
 
Industry Structure – but the presence of discounters does matter–What does help is the presence of discounters, est. at 25% of the Canadian market.
 
•Cities dominated by discounters are the last place WMT goes to in the US. So they definitely see them as the toughest competition
•But once they arrive they gain a market share at a similar pace as in other cities, now at 10%-18% in many of those markets. See the appendix for details.
•In Canada they are doing well and progressing at a good pace. They are at 7% market share in about 5 years. No sign that WMT isn’t succeeding.
•I go through a breakdown of the competitive offerings on a later slide
 
Conclusion – it’s definitely a positive for incumbents but not a big barrier. But likely does mean less margin impact. EBIT margins were down 2.5% to 6.5% in the US over 7 years, I forecast 1% to 2% in Canada over the next 4 years. The implication is that bankruptcies aren’t likely.
 
competitive analysis -

There is a clear hollowing out of the middle, just as in the US but with a lag - Each customer shops at different places for different things; sometimes they seek value (WMT, dollar stores, discounters) and sometimes they seek indulgence (WFM, specialty, ethnic). That means there are two formulas for winning:

1.Value – large scale/selection and low price are key. Customers prefer a high quality and large selection in the fresh/perishables section
2.Indulgence – very high quality perishables are key with focus on exotic products. Best in class will have a leading brand and excellent storefronts.

 Conclusion – WMT is best in class Value grocer and WFM is a best in class Indulgence Grocer. TGT is a best in class convenience grocer. Loblaws is stuck in the middle

General drivers of success

•Competitive prices – WMT wins
•Location – MRU wins (mostly urban in Ontario).  Rest on par, except discount stores which have the worst location.
•Good perishables section – WMT Canada wins. it’s the core driver of customer traffic and higher margins.
•Great service – WFM wins, WMT 2nd, TGT 3rd.
•Mgmt. is crucial here. 1) they have to be great at training their team to execute. Grocery retail is like running a “tight army”. 2) create a great storefront where people want to shop (WFM). 3) you need a culture that is focused and continuously strives to improve and execute better.
•Because of this, you want intact teams. When you see big management changes things go bad. Think Albertsons, supervalu.

 Hollowing out of the middle – it’s a definite threat. Incumbents are signaling they expect increased competition. They are following the same playbook as US peers, which did not work

•L lowered prices/margins in 2006 when WMT announced it would enter. KR did the same thing in the late 1990s. It didn’t help them.
•Both WMT and MRU acquired specialty brands and grew their discount arms because they expect a hallowing out of the market. The US experience shows that this is not enough.
•MRU and EMP are slowly trying to move upscale.  SWY tried the same and it did not save them.
L and MRU acquired ethnic/specialty stores
 

Loblaws – their traditional arm - Stuck in the middle

•Positives – 1) best in class private label brand. 2) large stores.
•Negatives – 1) Bad mgmt team. 2) bad GM department. 3) they are getting worse in perishables which is a key driver of traffic.
•Result – Stuck in the middle. Mediocre at everything.

 •Calls with independently sourced suppliers to perishables/bakery/branded goods, industry experts (Canadian Grocer Magazine). I’ve also shopped at all of these stores.

•They are like a bad WMT – big superstores with terrible Gross Merchandise (GM), they lost their advantage in fresh/perishables due to the mgmt change. They are mediocre at things that matter (price, perishables, location) and they seem to be bad managers
•Negative view of management. Their old team was great at grocery but failed at GM. They built out GM thinking that would help them compete with WMT but they stank at GM. They were let go. The new team has executed better on GM and extended gains on private label. But they have no prior grocery experience so perishables is in decline which is the biggest driver of traffic. They also tried to centralize purchasing like SWY did (disaster for both). Moreover, all the top talent in grocery is now gone, from purchasing, merchandising to marketing. The new team is focused on improving IT as L underinvested there and they have lost focus of the store.
•I was told that whenever mgmt teams leave, transitions in grocery are very tough since the business requires a tight control of operations. Most of the US bankruptcies resulted from poor mgmt and changes in mgmt.
•Private label has shielded EPS but that game is nearly over - Growth in private label sales and the expansion of its margins has contributed more than 100% of the EBIT gain at L over the past 4 years. Otherwise, margins are down.
 

WMT – Strong management, low costs, gross merchandise and strong perishables generates traffic. Best overall position: strong in value, indulgence and convenience

•Low costs – below incumbents, similar to discounters– although WMT lack’s L’s scale, they are close to MRU (7% share vs. 11%) and are growing much faster. Talks with suppliers and Canadian Grocer indicates that they won’t be undersold or underpriced. They are tough competitors. In Quebec (20% of the market), they are priced below everyone including discounters. In Ontario (40% of the market), they are priced below incumbents’ traditional stores but at a slight premium to the discounters.
•Great merchandise – their SKUs are the largest in Canada. In the US, Kroger had 60k sqft per store, but L leads with 48k and much of that is GM, compared to WMT’s 40k of grocery. MRU and EMP have much smaller stores. Their perishables are considered great – because they have the best management, with a lot of experience in Canada, their offering is much better than WMT’s US grocery arm and comping much higher. They got perishables right; better selection and quality. This is key since it drives traffic, particularly the higher income demographic.
Conclusions – they are a leading choice, whatever the consumers’ reason to shop. If it’s value, they offer similar prices to discounters with better selection, quality, storefronts, service and location. If it’s indulgence, they do better than discounters and seem to be better than incumbents.
 

TGT – moving aggressively. They will begin with smaller stores than in the US; they will win on convenience and branding. But the actual product will not include a great selection of perishables until 2014.

•What is clear is that TGT will generate a ton of traffic. Canadian consumers want an aspirational brand. TGT enjoys strong brand awareness and large differentiation. They will definitely be successful. They are trying to recruit the best employees. They are very serious/ambitious
•However, TGT is entering by remodeling their acquired Zellers stores. These stores are smaller. So they will not be as strong in perishables and hence in indulgence grocery shopping as they are in the US.
•In the long run, it seems clear they intend to open large supercenters with a strong perishables section. However, until 2014 and 2015 they will likely win on convenience shopping but not on indulgence nor value (small selection).

 WFM – They dominate the indulgence shopping experience. While they often say they will grow heavily in Canada, they don’t deliver. they say this time will be different, but I don't factor that into my forecasts

At some point they will be a very large threat. Right now they have 7 stores. They often say they will focus on Canada but those plans get delayed. So I assume the delays continue.
 
 
forecasts & valuation
 
EBIT margin forecasts – Imply an EPS cut of 33% to 60%
•US margins declined by 2.5% to 6.5% over the past ten years across US grocers
•Canadian peers stand at 4.5% EBIT margin.
•Target: stable margins if they are lucky, 3.5% margins in a case where there is no macro shock, 2.5% with a macro shock
•I feel the presence of discounters will limit the downside but there will be downside
•Suppliers have been squeezed for years. My impression is they have less to give than before.
•Loblaws – their private label has shielded their margins but that game is in late innings
•Implications for EPS – Range from Stable EPS, a 33% cut if margins are hit 1% and a 60% cut if EBIT margins fall to 2.5%
 

Valuation and target price – upside is 10%, down side is 40% to 70%

•Upside – slow growth, stable margins, stable multiple. 10% upside
•Downside – 33% cut to EPS and 12x multiple, -40% downside.
•Applying a 10x multiple results in a 50% downside
•Downside – 60% cut to EPS and 12x multiple, -63% downside
•applying a 10x multiple result in a 70% downside

Catalyst

1) slowing demand as canadian household debt levels are capped. 1% demand growth. You can watch monthly retail sales in Canada, GDP, monthly credit metrics.
 
2) increased supply. WMT accelerating expansion plans, TGT entering and WFM accelerating expansion plans. new supply to add 2.5% to 3.5%. Implies negative SSS comps for incumbents
 
3) Loblaws is in the late innings of its private label brand which has masked a deteriorating in their margins.

Their private label brand, “president’s choice”, is the #3 brand in Canada and a big driver of traffic and margins. It is a great brand and the food is high quality. It’s success has masked the deterioration in the rest of the business. They have targets for profit margins on private label and sales as % of total. They are very close to reaching those long term targets. Given their disclosure you can accurately estimate what margins are in the rest of their business. You can see that all the growth in EBIT comes from private label. What you can see is that excluding private label, margins are down 50 bps and SSS barely rises, definitely less than inflation. The biz is already under a lot of pressure.  total EBIT increased $430M over the last 4 years but private label EBIT increased $525M implying a nearly $100M EBIT decline in the rest of their business despite growing their store count. EBIT margins in the rest of their business is already down 50 bps. They had margin pressure in H2 2011 and I wouldn’t be surprised if this slowdown in the private label story is now exposing the deterioration in the rest of their business.

the quality of earnings is also deteriorating. lots of one time items etc that the sell side is ignoring but point to a continued deterioration in margins.

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