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

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), both with Stable trends. DBRS’s confirmation of the ratings reflects the Company’s strong and stable financial profile in combination with adequate operating performance, particularly in light of continued pressure from generic drug pricing reforms across Canada. The Company’s A (low) rating continues to be based on its strong market positions and brand name, improving private-label penetration, and favourable industry trends. The rating also reflects the continued pressure from provincial drug pricing reforms, and intense competition in the front-store and the pharmacy.

Shoppers’ earnings profile remained stable through the end of 2011 and into 2012 despite the continued pressures from generic drug pricing, thanks to improved front-store performance and private-label generic drug penetration. Revenue for the last twelve months (LTM) ended Q2 2012 increased modestly to nearly $10.6 billion from approximately $10.5 billion in 2011 and $10.2 billion in 2010. Sales growth of 2.3% in H1 2012 is based on same-store sales growth of 1.9% and 20 net new store openings. Growth continues to be driven by the front-store, while the pharmacy has remained relatively flat based on growing prescription counts and declining average prescription value, attributable to provincial regulatory changes and increasing use of generic drugs as a percentage of overall prescriptions. EBITDA margins declined modestly in H1 2012, negatively affected by the pricing reforms and by higher operating expenses caused by higher levels of associate compensation, as well as the closure of two Murale stores. As such, EBITDA for the LTM ended Q2 2012 remained relatively flat versus 2011 and 2010.

In terms of financial profile, Shoppers continued to be strong in 2011 and through H1 2012, helping to support the current ratings, as a result of the Company’s strong free cash flow generating capacity and stable debt levels. Cash flow from operations declined moderately in the LTM ended Q2 2012 based on higher cash interest and taxes in H1 2012, while capex continued its recent trend of decline for the third consecutive period since peaking in 2010. Shoppers’ dividend policy remained stable, increasing consistently on an annual basis. As a result of the above factors, free cash flow before changes in working capital rose moderately, nearing the $400 million level for the LTM ended Q2 2012. The Company continued to increase returns to shareholders by repurchasing $171 million of shares in H1 2012 and $212 million in 2011. Shoppers also repaid maturing medium-term notes and announced the purchase of Paragon Pharmacies Limited in H1 2012 to be completed using cash and short-term debt (completed on August 1, 2012). Balance sheet debt increased modestly in H1 2012 to nearly $1.2 billion, as lease-adjusted debt-to-EBITDAR was modestly weaker, increasing to 2.25 times (x) for the LTM ended Q2 2012 versus 2.20x for 2011.

Going forward, DBRS expects that Shoppers’ earnings profile will remain relatively stable, despite further pressure from generic drug pricing reforms. Sales should increase modestly in the remainder of 2012 and into 2013 based on low single-digit growth in same-store front-store sales combined with relatively flat same-store pharmacy sales. EBITDA margins should remain somewhat pressured by higher front-store input costs, food in particular, and lower generic drug pricing, partially offset by the higher number of generic molecules and rising penetration of Sanis, Shoppers’ private-label generic. As such, DBRS believes EBITDA should remain relatively flat in the $1.15 billion to $1.23 billion range.

DBRS expects that Shoppers will maintain a sound financial profile, owing to its free cash flow generating capacity and stable overall debt levels. Cash flow from operations should continue to track operating income and remain relatively steady through the remainder of 2012 and into 2013, while capex should settle at a new lower equilibrium in the $300 million to $350 million range as new store openings slow and the focus shifts to renovation and expansion. Shoppers’ dividend is expected to continue to grow toward the $230 million level through 2013, in line with the Company’s goal of increasing shareholder returns. As such, free cash flow before changes in working capital should remain stable in the $325 million to $400 million range in 2012 and 2013. Shoppers is expected to continue to use cash-on-hand and free cash flow generated to complete acquisitions and additional share repurchases, while debt levels remain stable. Should credit metrics, however, deteriorate as a result of weaker-than-expected operating performance or more aggressive-than-expected financial management (i.e., lease-adjusted debt-to-EBITDAR toward 2.5x), the current ratings could be pressured.

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.