DBRS Confirms Loblaw at BBB and R-2 (middle); Trend Revised to Stable on Short-Term Rating, Trends Remain Negative on Long-Term Ratings

DBRS has today confirmed Loblaw Companies Limited’s (Loblaw or the Company) long-term ratings at BBB and its Cumulative Redeemable Second Preferred Shares, Series A issue rating at Pfd-3, while keeping the trends Negative. At the same time, DBRS has confirmed the Company’s short-term rating at R-2 (middle), but has revised the trend to Stable from Negative.

On April 30, 2008, DBRS downgraded Loblaw’s ratings and kept the trends Negative. That action reflected DBRS’s view that deteriorating operating performance, combined with the longer time period and mounting risks associated with changes to the turnaround plan and management team, resulted in a credit risk profile that was no longer consistent with the previous BBB (high) rating. At that time DBRS noted that a meaningful recovery would remain challenging, since Loblaw was expected to continue investing in pricing within an increasingly competitive environment. DBRS stated that if the Company’s plans led to stabilization in operating income and credit metrics over the course of 2008, the ratings outlook could stabilize, however, continued and meaningful deterioration would result in further rating pressure.

Along with the management changes that were made in early 2008, the Company announced some new initiatives to be included with its overall turnaround plan, including: (1) enhanced food and service offering in 20 greater Toronto area stores; (2) expansion/upgrade in western Canada; (3) increased merchandising at the local level; (4) investment in supply chain/systems; and (5) greater emphasis on President’s Choice. Since that time, Loblaw’s operating performance has displayed some signs of stabilization – particularly with the results for Q3 and Q4 of 2008. The Company was able to keep market share almost level and deliver modest revenue growth without compromising margins (for the full year 2008) for the first time in four years.
Sales grew by 4.8% (driven almost entirely by same-store sales) in 2008 as the Company completed pricing adjustments that aimed to improve its value perception with customers (note: 2008 includes 53 weeks compared with 52 weeks in 2007). In terms of margins, Loblaw improved in the second half of 2008 from the historic lows set at the beginning of the year such that adjusted EBITDA margin for the full year 2008 (5.3%) was roughly level with 2007. As such, adjusted EBITDA increased to $1,630 million in 2008 from $1,546 million in the prior year – the first time EBITDA increased year-over-year in four years. This performance contributed to an improvement in key credit metrics – 2008 lease adjusted gross debt-to-EBITDAR of 3.1x (compared with 3.3x for 2007); and lease-adjusted cash flow-to-gross debt of 22% (compared with 20% for 2007) – to levels more comfortably within the BBB rating category for Loblaw.

Although DBRS is encouraged by recent results, we are choosing to proceed with caution and are not revising the trend to Stable on the long-term ratings at this point in time. While Loblaw displayed some improvement in the second half of 2008, it still did not outperform some of its major competitors on a relative basis over the same period. In addition, DBRS believes the more stable but still competitive Canadian food retailing sector will remain intense such that Loblaw will be challenged to grow sales by more than 1% to 2% without putting recently achieved operating margins at risk. DBRS would like to see a longer than two-quarter period of stable metrics before formally revising the trend to Stable, especially given the fact this follows an exceptionally long period of deterioration (almost four years) for Loblaw.

DBRS expects Loblaw will continue to focus on cost efficiencies, control label performance and invest significant levels of capital in IT and supply chain infrastructure over the next couple of years. DBRS believes Loblaw is gaining some traction with its new management structure and initiatives. DBRS is cautiously optimistic about the Company’s ability to deliver steady credit metrics (lease-adjusted cash flow-to-debt and lease-adjusted debt-to-EBITDAR close to current levels) going forward and would consider revising the long-term trend to Stable after another two quarters of stable performance.

In terms of liquidity, DBRS has revised the trend on the short-term rating to Stable from Negative. DBRS believes Loblaw’s profile has stabilized since April 30, 2008 within a range that is comfortable for the R-2 (middle) rating category. This change in view is based on the fact that:

• On May 30, 2008, Loblaw raised US$300 million fixed-rate private placement debt (two equally sized tranches of five and seven year maturities).
• On June 20, 2008, Loblaw raised $225 million of 5.95% Cumulative Redeemable Second Preferred Shares.
• Loblaw possesses significant balances of cash, cash equivalents, short-term investments and security deposits: $1,190 million as of the end of 2008.
• The Company has a $800 million, five-year committed credit facility with a syndicate of banks that matures in 2013.
• Loblaw’s next major debt maturities are $300 million in May 2010, and $350 million in 2011.

In addition, DBRS is less concerned now than it was in 2008 about the possibility of significant deterioration in Loblaw’s cash flow generated from operations over the near term. DBRS now estimates that the Company will generate cash flow from operations (before changes in working capital) comfortably above $1 billion for 2009, while capital expenditures and dividends are expected to be consistent with 2008. DBRS believes management will use any free cash flow generated over the near term to strengthen the balance sheet (i.e., reduce net debt). As a result of all of the above, DBRS believes Loblaw should have ample liquidity to retire its next significant long-term debt maturity of $300 million in May 2010.

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

The applicable methodology is Rating Merchandisers, which can be found on the DBRS website under Methodologies.

This is a Corporate rating.