DBRS Changes Trend on Sobeys to Negative from Stable

DBRS Limited (DBRS) has today confirmed the Issuer Rating and the Senior Unsecured Debt rating of Sobeys Inc. (Sobeys or the Company) at BBB (low) and changed the trend on both Ratings to Negative from Stable. The rating action reflects deteriorating operating performance that began in early F2016 and worsened significantly over the last two quarters. As the most recent performance was meaningfully below DBRS’s expectation, the concern is heightened that a near-term recovery may be difficult to achieve.

On March 10, 2016, DBRS commented on Sobeys Q3 F2016 results. At that time, DBRS believed that Sobeys had the capacity to withstand continued pressure from the Canada Safeway (Safeway) business over several quarters in its current rating category (lease-adjusted debt-to-EBITDAR comfortably below 4.0 times (x)). At that time, lease-adjusted debt-to-EBITDAR was 3.34x. DBRS expected that F2017 EBITDA would remain near the $1.0 billion level.

Since then, Sobeys has continued to underperform its peers. Revenue increased by 0.9% in Q4 F2016 and declined by 1.0% in Q1 F2017 year over year (YOY), based on same-store sales of negative 1.8% in both periods. Adjusted EBITDA declined by 21.4%, to $243.6 million YOY in Q4 F2016 and by 26.9%, to $229.7 million YOY in Q1 F2017, respectively. The challenges continue to predominantly relate to the ongoing integration and operational issues resulting from the acquisition of Safeway, causing store-level disruptions, as well as increased promotional and merchandising strategies amid an intensifying competitive environment.

DBRS is now concerned that Sobeys could struggle to grow its revenue in F2017, particularly because of challenges in Western Canada. Margins could be further pressured due to the ongoing promotional programs in the intensely competitive environment, combined with the deceleration in food inflation. Going forward, should operations continue to track Q1 F2017 results, EBITDA would be well short of $1.0 billion and credit metrics could deteriorate to a level that is no longer satisfactory for the current rating category.

To address its weakening operations and stem market share losses, Sobeys has introduced its Simplified Buy and Sell program aimed at rebalancing store pricing, reducing the steep discounts on promotional items while lowering overall prices in stores. The program was initially launched in Québec in F2016, and expanded to Western Canada in September 2016. Also, Sobeys is expected to continue its investment in remodeling existing stores in F2017, with a focus on Western Canada, as the Company continues to roll out its new concept Sobeys extra stores. DBRS notes that execution of this strategy could take time to materialize, involves execution risk, and could incite competitors to adopt more aggressive promotional strategies.

In the next four quarters, should Sobeys be successful in stabilizing its same-store sales in Western Canada and reverse the downward trajectory in operating income toward a run-rate of approximately $1.0 billion per year, the trend could be revised to Stable. However, should operational issues persist throughout F2017 such that lease-adjusted debt-to-EBITDAR deteriorates towards 4.0x, lease-adjusted EBITDA coverage decreases towards 5.0x, and/or free cash flow (after dividends and before changes in working capital) is meaningfully negative, the ratings could be downgraded by one notch.

DBRS notes that it does not expect Sobeys to generate a material amount of free cash flow in the near future that could be applied to debt reduction. While the Company could use capital conserving or other measures to improve credit metrics through debt reduction, the revision of the trend to Stable would be more influenced by stabilization and recovery in operating income.

Sobeys’ ratings continue to be supported by its number two position in the Canadian food retailing market and its diversification across the country, balanced by intense competition and execution risks associated with its turnaround strategy in Western Canada.

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 web site under Methodologies.

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