DBRS Downgrades Sobeys Inc. and Removes Ratings from Under Review with Negative Implications

DBRS has today downgraded the Issuer Rating and the Senior Unsecured Debt rating of Sobeys Inc. (Sobeys or the Company) to BBB (low) from BBB, with Stable trends. This action removes the Company’s ratings from Under Review with Negative Implications, where they were placed on June 12, 2013, when Sobeys announced that it had reached a definitive agreement to acquire substantially all of the assets of Canada Safeway Limited (Canada Safeway) for approximately $5.8 billion in cash (the Acquisition).

DBRS believes sufficient progress has been made to resolve the Under Review with Negative Implications status of Sobeys’ ratings as certain key elements with respect to the funding of the Acquisition are well underway, including Empire Company Limited’s (Empire) proposed equity offering and its sale of Empire Theatres Limited and the upcoming $800 million bond offering.

The downgrade reflects DBRS’s view that the initial increase in financial leverage outweighs the benefits to the business profile from increased scale, enhanced geographic diversification and potential efficiency improvements.

In its review, DBRS focused on the following: (1) the business risk profile of the combined entity within the context of an intensifying competitive environment; (2) risks associated with integration and achievement of synergies; and (3) pro forma financial leverage and financial management intentions going forward.

(1) Business Risk Profile

The acquisition of Canada Safeway, one of the leading western Canadian food retailers, provides Sobeys with improved scale and geographic diversification. The addition of 213 full-service grocery retail locations (as well as ten liquor stores and 62 fuel stations co-located with retail stores) to the Company’s existing portfolio of 746 corporate stores solidifies Sobeys’ position as the number two Canadian grocer. DBRS estimates pro forma market share at approximately 19%, with F2013 revenue of approximately $24 billion and EBITDA of $1.3 billion. The Acquisition also provides further potential for growth by strengthening the Company’s position in western Canada, the fastest growing region in the country. On the other hand, DBRS recognizes there are risks associated with the combination of Canada Safeway and Sobeys, particularly within the context of an intensifying competitive environment.

(2) Achieving Synergy Potential and Integration

DBRS believes Sobeys’ synergy goal is ambitious and that the realization of the full $200 million target may be difficult to achieve within the given three-year timeframe. This view is based on the amount of synergies relative to the size of the combined company, as well as the limited degree of overlapping footprints. That said, DBRS notes the full achievement of the synergy target is not integral to maintain a BBB (low) rating.

(3) Financial Risk Profile

The Acquisition and its corresponding financing result in a significant increase in leverage, which DBRS considers to be aggressive for an investment-grade rating. DBRS estimates that Sobeys’ balance-sheet debt will increase from approximately $765 million in F2013 to approximately $3.9 billion pro forma the Acquisition, assuming proceeds of $1 billion from the sale/leaseback of certain real estate assets. This would result in lease-adjusted debt-to-EBITDAR in the 3.75 times (x) to 4.0x range (versus 2.49x for F2013) and lease-adjusted EBIT coverage of approximately 2.75x (versus 3.32x for F2013) at the time of closing.

Sobeys has stated that it intends to apply free cash flow toward debt reduction going forward. DBRS expects debt to be reduced in the first year following the Acquisition, with potential proceeds from asset sales of up to $800 million (from Sobeys and Empire combined) and free cash flow of approximately $400 million. This, combined with moderate growth in operating income, should result in credit metrics that are better placed within the BBB (low) rating category (i.e., lease-adjusted debt-to-EBITDAR of 3.25x to 3.50x and lease-adjusted EBIT coverage of approximately 3.0x).

Should Sobeys maintain steady growth in operating income and continue to apply a significant portion of its free cash flow to debt reduction that leads to lease-adjusted debt-to-EBITDAR toward 3.0x or lower in F2015 and beyond, a positive rating action could result. However, due to the risks associated with the integration, achievement of synergies and the magnitude of deleveraging, DBRS believes Sobeys is currently best positioned in the BBB (low) rating category with a Stable trend.

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

The related regulatory disclosures pursuant to the National Instrument 25-101 Designated Rating Organizations are hereby incorporated by reference and can be found by clicking on the link to the right under Related Research or by contacting us at info@dbrs.com.

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