DBRS Confirms Loblaw at BBB, R-2 (middle); Trend Stable

DBRS has today confirmed Loblaw Companies Limited’s (Loblaw or the Company) Issuer Rating, Medium-Term Notes and Debentures ratings at BBB, its Cumulative Redeemable Second Preferred Shares, Series A rating at Pfd-3, and its Commercial Paper rating at R-2 (middle). All trends remain Stable. The confirmation of the ratings is based on Loblaw’s stable financial profile, while recognizing that the Company’s earnings profile will remain under pressure in the near to medium term due to intensifying competition combined with a difficult consumer environment. The ratings continue to be supported by Loblaw’s strong market position, large scale, national diversification, and industry-leading private labels. The ratings also reflect the high level of and intensifying competition in food retailing, particularly with the emergence of new non-traditional players (i.e., Wal-Mart Stores, Inc. (Wal-Mart) and Target Corporation (Target)), and high levels of union penetration.

Loblaw’s revenues increased modestly in the last twelve months (LTM) ended Q2 2012, based on new square footage in discount and conventional banners and Joe Fresh and inconsistent same-store sales performance. EBITDA margins declined modestly in H1 2012 as intensifying competition made it difficult for Loblaw to pass on rising input costs to consumers while investment in infrastructure remained high. As such, EBITDA declined by 8.4% in H1 2012 to approximately $878 million, and is $2 billion for the LTM ended Q2 2012.

In terms of financial profile, Loblaw’s performance remained relatively stable in the LTM ended Q2 2012. Cash flow from operations continued to track operating income, while capex remained at elevated levels as investments in infrastructure continued (IT and supply chain). The Company’s dividend policy remained consistent, although cash dividends increased due to the discontinuation of the dividend reinvestment program in April 2011.

As such, Loblaw continued to generate free cash flow, albeit at a lower level than in 2011 and 2010. Balance-sheet debt increased modestly (excluding securitization and GICs), which, combined with the decline in EBITDA, resulted in a moderate weakening of credit metrics (i.e., lease-adjusted debt-to-EBITDAR of 2.82 times (x) for the LTM ended Q2 2012 versus 2.69x at the end of 2011), although was still stronger than at year-end 2010.

Going forward, DBRS believes that Loblaw’s earnings profile should remain in the range acceptable for the current rating category, despite intensifying competition and a difficult consumer environment. DBRS expects top-line revenue will remain relatively flat in the near term, based on a modest increase in square footage and flat-to-negative same-store sales. EBITDA margins should remain under pressure as Loblaw could be forced to increase its use of promotional pricing to help drive traffic as competition intensifies (particularly with new openings of Wal-Mart Supercenters and Target stores) and the Company continues to invest in infrastructure upgrades. As such, DBRS expects EBITDA will decline moderately or at best remain flat in the near term.

DBRS believes that Loblaw will maintain a financial profile commensurate with the current rating based on the Company’s free cash flow generating capacity and moderate debt levels. Cash flow from operations should continue to track operating income and decline modestly to the $1.3 billion to $1.4 billion range in 2012 and 2013, while capex requirements should remain at elevated levels through 2013 and begin to moderate somewhat thereafter. Dividend policy is expected to remain consistent with recent practice, which DBRS expects should result in free cash flow before changes in working capital in the range of breakeven to $150 million. Therefore, while the Company has the potential to improve its credit metrics by applying free cash flow and cash-on-hand to debt reduction, DBRS believes that Loblaw may use these sources of cash to invest in growth and/or return value to shareholders over the longer term. As such, DBRS expects that balance sheet-debt levels and key credit metrics should remain in a range acceptable for the current rating category.

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.