DBRS Confirms Shoppers Drug Mart, Removes from Under Review with Negative Implications

DBRS has today confirmed the Senior Unsecured Debt and Commercial Paper ratings of Shoppers Drug Mart Corporation (Shoppers or the Company) at A (low) and R-1 (low), respectively. The trends are Stable. This removes the ratings from Under Review with Negative Implications, where they were placed on April 8, 2010, after the Province of Ontario (Ontario) announced proposed changes to the Ontario Drug Benefit Act and the Drug Interchangeability and Dispensing Fee Act. The changes were enacted and became effective on July 1, 2010. These types of changes are being enacted in most other provinces, but the changes in Ontario are the most far reaching, including a reduction in the price paid for generic drugs in the public and private sectors, along with the elimination of professional allowances from vendors.

While DBRS recognizes that these regulatory changes will bring meaningful challenges for Shoppers in the coming years, the outcome of our review is more favourable than originally expected, for a number of reasons. As outlined below, these reasons include a thorough understanding of the mitigating actions to be taken by the Company and the impact of such, a degree of comfort that these actions can be implemented without triggering additional new challenges, and Shoppers’ commitment to addressing the new business risks with a more conservative financial risk profile, which relates specifically to meaningful debt reduction in the future. However, while Shoppers’ ratings have been confirmed, DBRS does note that the ratings are now less robust to withstand any new challenges or changes to the Company’s present plans, particularly in areas such as expense cutting, future capital expenditures and debt.

DBRS has reviewed the adverse effect that these changes are expected to have on the Company’s future profitability and confirmed how the impact could be significant. Indeed, it was this concern that led DBRS to place the ratings under review. Since then, DBRS has met with the Company to evaluate its plans and notes the following: First, the Company was able to clearly show that underlying demand for prescriptions will continue to grow for many years. Second, the extensive changes in the provincial plans will be phased in over a three-year period, giving Shoppers sufficient time to implement its own counter-measures. Third, the Company was able to demonstrate how, over this three-year period, the impact on earnings and cash flow could be mitigated through cost reductions, system growth, increased demand for prescriptions, additional pharmacy services, increased front-store sales, capex reductions and de-leveraging. Fourth, these changes will have little effect on Shoppers’ successful front-store business, which remains a profitable and growing part of the Company’s overall operations. Lastly, these changes will not affect Shoppers’ leading market position and brands, retail expansion and support operations. DBRS has concluded that the foregoing factors, if implemented as planned, could offset much of the negative effect of the revised regulations.

The rating confirmations reflect DBRS’s view that Shoppers has the time, ability and commitment to address regulatory changes to the provincial health-care system in a way that the key metrics that support present ratings can be maintained. In light of the longer-term outlook for the structure of the pharmacy industry across Canada, the Company will need to maintain this commitment. DBRS expects that all provinces will continue or increase regulatory pressure to contain the cost of prescription drugs in the public and private sectors. Hence, the outlook over the longer term for the pharmacy industry remains challenging and the pharmacy business across most of Canada is expected to be under pressure for some time. As the pharmacy segment makes up about half of the Company’s business, with generic drugs expected to grow well beyond half of the pharmacy segment, Shoppers will need to be ready to deal with the consequences of any new regulations. However, most of the provincial amendments made this year are expected to be in place for several years thereafter, and it seems reasonable to assume that it would be four or five years before Ontario would consider tightening them further, if at all. In the meantime, many smaller independent pharmacies may prove less able to withstand the changes and this could lead to some industry consolidation that would benefit the larger operators, such as Shoppers.

During the first half of 2010, leading up to the July 1 start-date of the new regulations, Shoppers’ financial performance remained on track – profitability, liquidity and leverage ratios held or improved. The outlook for the rest of the year is for continued growth, albeit at reduced levels with the profitability, liquidity and leverage ratios holding. By the end of 2010, the Company will have put in place the needed changes at the store and corporate levels necessary to cope with the full annualized impact of the new regulations. Hence, the outlook for 2011 shows the Company holding earnings and cash flow, avoiding an overall decline to a new base level. This assumes: (i) the successful implementation of a number of mitigating initiatives that appear manageable but are by no means certain; (ii) overall system growth continues and is more than able to offset the negative differential between the lost revenue and the expense reductions; (iii) there are no further major unexpected drug reforms; and (iv) Shoppers reduces debt levels as planned. The plans have been reviewed at a fairly granular level and the overall plan was given to the Company’s Board of Directors with a commitment that it is very achievable.

Accordingly, over the next few years, DBRS expects continued EBITDA growth, positive cash flow and lower debt levels. As a result, lease adjusted debt-to-EBITDAR should remain below 2.5 times. If the Company’s plans did not materialize as expected and performance suffered, with reduced cash flow and liquidity, leading to higher leverage, the ratings would again come under pressure. This would also be the case if an aggressive acquisition program drove up leverage.

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

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

This is a Corporate Rating.