DBRS Confirms Shoppers Drug Mart at A (low) and R-1 (low)

DBRS has today confirmed the Senior Unsecured Debt rating of Shoppers Drug Mart Corporation (Shoppers or the Company) at A (low) and its Commercial Paper rating at R-1 (low), with Stable trends. Shoppers continues to benefit from its position as the largest pharmaceutical retailer in Canada. Despite ongoing provincial generic-drug pricing reforms and intense competition, net sales increased by 2.1% in the first half of 2011, raising revenue moderately to nearly $10.5 billion for the last 12 months (LTM) ended Q2 2011 as the Company focused on improving efficiency and front-store sales. During H1 2011, same-store front-store sales increased 3.4%, while same-store prescription sales declined 0.6% from lower pricing brought in through drug reforms. EBITDA margins declined moderately through H1 2011, primarily as a result of decreased generic prescription-drug pricing, despite benefits from increased penetration of the Shoppers generic-drug private label, Sanis. As such, EBITDA for the LTM ended Q2 2011 remained relatively flat at approximately $1.2 billion.

The Company’s financial profile remained stable through the end of 2010 and into 2011 as a result of its capacity to generate free cash flow and its stable debt levels. Operating cash flow for the LTM ended Q2 2011 increased to nearly $954 million from $913 million the previous year as a result of a decrease in taxes paid as Shoppers benefited from lower statutory tax rates. As such, combined with lower capex and a moderate increase in dividends, free cash flow before changes in working capital was $375 million. Total balance-sheet debt declined moderately in H1 2011 as free cash generated was used to reduce short-term debt. As a result, lease-adjusted debt at the end of Q2 2011 was approximately $3.5 billion and lease-adjusted debt-to-EBITDAR improved slightly to 2.23 times (x) from 2.29x at the end of 2010.

Going forward, DBRS expects the Company’s earnings profile to remain relatively stable on the strength of its strong market position and improving front-store performance. DBRS forecasts net sales to increase moderately in the second half of 2011 and into 2012 on the basis of low single-digit same-store sales growth in front-store sales and a moderate decline in pharmacy sales, which will continue to be affected by new phases of the provincial reforms.

EBITDA margins are expected to remain flat to slightly lower as generic-drug prices are reduced further and certain front-store segments experience rising costs, especially in food and convenience. Further penetration of the Sanis private label could benefit Shoppers, particularly if the Ontario Court of Appeal allows its introduction in Ontario. As such, DBRS expects EBITDA in the range of $1.15 billion to $1.23 billion for 2011 and 2012. In terms of the Company’s financial profile, cash flow from operations should track operating income and remain steady in the range of $925 million to $975 million in 2011 and 2012. Capex is expected to continue to decline as the Company focuses on refreshing older stores, while dividends should continue to increase as Shoppers remains focused on returning value to shareholders. As such, DBRS expects Shoppers will generate free cash flow in the range of $325 million to $400 million in 2011 and 2012. DBRS believes that as Shoppers adjusts to its new operating environment, the Company will use free cash flow to increase returns to shareholders and, to a lesser extent, invest in growth, while maintaining leverage. Deterioration in credit metrics (e.g., lease adjusted debt-to-EBITDAR approaching 2.5x) as a result of weaker-than-expected performance or more-aggressive-than-expected financial management could result in pressure on the current rating.

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

The applicable methodology is Rating Companies in the Merchandising Industry, which can be found on our website under Methodologies.