DBRS Confirms Sobeys at BBB (low) with a Stable Trend

DBRS has today confirmed the Issuer Rating and the Senior Unsecured Debt rating of Sobeys Inc. (Sobeys or the Company) at BBB (low), with Stable trends. The confirmation is based on Sobeys’ rapid deleveraging since the acquisition of Canada Safeway Limited (Canada Safeway) relative to DBRS’s original expectations, while acknowledging the Company’s weaker than expected operating performance in the last year. The ratings continue to be supported by Sobeys’ market position as Canada’s second-largest grocer, combined with its size, scale and geographic diversification. The ratings also consider the intensely competitive environment in food retailing and its effect on the Company’s margins and profitability.

At the time of the Canada Safeway acquisition, DBRS noted that Sobeys’ earnings profile improved due to the Company’s increased size, scale and geographic diversification. However, operational results have been weaker than expected as the competitive environment has remained intense, resulting in high levels of promotional activity. Revenues grew by 20.8% to $21 billion in F2014, largely attributed to the inclusion of Canada Safeway’s results for two quarters (excluding Canada Safeway, revenues were up 2.4%). Same-store sales were flat in F2014 due to virtually non-existent food inflation and relatively stable volumes and traffic. EBITDA margins declined 20 basis points to 4.7% in F2014, despite the inclusion of the higher-margin Canada Safeway business and the achievement of $29 million in cost saving synergies. Competitive pressures resulted in high levels of investment in pricing in order to retain market share. As a result, EBITDA increased 17.6% to $979 million in F2014 (excluding Canada Safeway, EBITDA declined by 2.5%).

Sobeys’ financial leverage is declining to a level that is consistent with the current rating category, based on more rapid than expected debt reduction since the acquisition of Canada Safeway. Free cash flow before changes in working capital increased to $312 million in F2014 from $176 million a year earlier, due to the contribution of Canada Safeway’s operating cash flow and relatively minor increases to capex and dividends. Free cash flow, along with $454 million in proceeds from the sale of 30 store locations in Western Canada in H2 F2014 was used to reduce balance sheet debt. DBRS estimates that on a pro forma basis, which includes approximately $405 million of debt reduction subsequent to F2014, Sobeys’ lease-adjusted debt-to-EBITDAR stands at approximately 3.65x. DBRS expects $356 million from the sale of its dairy manufacturing assets will be used for further debt reduction when the transaction closes. DBRS continues to believe that the Company is on track to achieve DBRS’s target at the time of the Canada Safeway acquisition of lease-adjusted debt-to-EBITDAR below 3.50x and lease-adjusted EBIT coverage close to 3.0x by F2015.

DBRS believes that Sobeys’ earnings profile remains strong for the current rating category, but will continue to be pressured by the intensely competitive environment. DBRS expects Sobeys’ revenue to increase to more than $23 billion in F2015, based on a full year of Canada Safeway contribution and modest same-store sales growth, partially offset by store network rationalization. DBRS anticipates same-store sales to increase in the range of 1%, due mainly to food inflation. EBITDA margins are expected to improve slightly in F2015, due to the full-year contribution of the higher-margin Safeway stores, additional synergy realization and the closing of underperforming stores. However, DBRS believes the highly promotional environment is expected to continue to limit pricing increases above inflation. As a result of these factors, DBRS expects Sobeys’ EBITDA to increase to more than $1.1 billion in F2015.

DBRS expects that Sobeys will continue to apply free cash flow toward debt reduction such that credit metrics are well placed within the BBB (low) rating category by the end of F2015. Cash flow from operations should continue to track operating income and could increase to approximately $1 billion in F2015. Capex is expected to be between $700 million and $800 million in F2015, reflecting hightened costs of the larger store base and infrastructure. Dividends are expected to grow in line with earnings. As such, DBRS forecasts that Sobeys will generate approximately $150 million free cash flow in F2015. DBRS anticipates total balance sheet debt of approximately $2.7 billion at the end of F2015 (versus ~$3.9 billion at the closing of the Canada Safeway acquisition and ~$3.4 billion ending F2014). This debt reduction, rather than growth in earnings, should result in credit metrics that are better placed within the BBB (low) rating category.

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.

This rating is endorsed by DBRS Ratings Limited for use in the European Union.

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