DBRS Downgrades Sobeys Inc. to BB (high), Trend Remains Negative

DBRS Limited (DBRS) has today downgraded the Issuer Rating and Senior Unsecured Debt rating of Sobeys Inc. (Sobeys or the Company) to BB (high) from BBB (low), maintaining the Negative trend. DBRS has also assigned a recovery rating of RR3 to the Company’s Senior Unsecured Debt. The rating actions reflect Sobeys’ continued underperformance relative to its peers, resulting in lost market share. Declining operating performance began in early 2016 and has deteriorated significantly in each subsequent quarter thereafter.

On September 15, 2016, following Sobeys’ Q1 F2017 results, DBRS confirmed the Company’s Issuer Rating and Senior Unsecured Debt rating at BBB (low) and changed the trend to Negative. At that time, DBRS stated that, if Sobeys successfully stabilized its same-store sales in Western Canada and reversed the downward trajectory in operating income toward a run rate of approximately $1.0 billion per year, the trend could be revised to Stable. On December 14, 2016, DBRS commented on Sobeys’ Q2 F2017 results. DBRS believed that the likelihood of the Company stabilizing and then improving run-rate EBITDA to an acceptable level in F2017 had diminished and that credit metrics could deteriorate to a level that is no longer satisfactory for the BBB (low) rating category (lease-adjusted debt-to-EBITDAR comfortably below 4.0 times (x)).

In Q3 F2017, revenue declined 2.3% year over year (YOY) based on same-store sales of negative 3.7% (excluding fuel). In the Western Canada business unit, same-store sales were negative 5.5% (excluding fuel). Adjusted EBITDA decreased to $151.8 million, a decline of 30.4% YOY and a decline of 3.9% from Q2 F2017. The challenges continue to relate to (1) customer reaction to integration issues and store-level disruption at Canada Safeway, (2) intensified competition in food retail, (3) price-sensitive consumers and their shift toward discount grocery retailers as well as (4) food deflation. As a result, the Company’s lease-adjusted debt-to-EBITDAR and lease-adjusted EBITDAR coverage for the last 12 months (LTM) ended February 4, 2017, deteriorated to 3.80x and 4.97x, respectively, from 3.27x and 5.31x, respectively, for the LTM ended August 6, 2016.

DBRS believes that the continued deterioration in operating performance, which has widened relative to the Company’s peers, has resulted in a credit risk profile that is no longer consistent with an investment-grade rating. DBRS believes that the food retail environment will remain challenging in the near to medium term as competition intensifies and food deflation/low food inflation persists.

DBRS has maintained the Negative trend as it expects that a meaningful recovery will be challenging and will take time to achieve, and credit metrics will worsen before they improve (using Q3 F2017 EBITDA on a run-rate basis results in lease-adjusted debt-to-EBITDAR of 4.37x). Sobeys is expected to face ongoing intense competition in a highly promotional environment. Although DBRS recognizes the merits of the Company’s Simplified Buy & Sell Program and its roll-out of new concept stores, Sobeys extra, DBRS expects that a significant improvement in operating performance will be difficult to realize over the near to medium term as this strategy could take time to materialize, involves execution risk and could incite competitors to adopt more aggressive promotional strategies.

Over the next four quarters, if Sobeys is successful in narrowing and/or reversing the gap in same-store sales relative to peers and/or reversing the downward trajectory in operating income above a run rate of approximately $600 million per year, the trend could be revised to Stable. However, if same-stores sales and/or operating income continue to deteriorate such that lease-adjusted debt-to-EBITDAR increases above 4.5x, lease-adjusted EBITDAR coverage decreases below 4.5x and/or free cash flow (after dividends and before changes in working capital) is meaningfully negative, the ratings could be downgraded to BB. 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 a trend to Stable continues to 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 across Canada.

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 principal methodologies are Rating Companies in the Merchandising Industry and DBRS Criteria: Recovery Ratings for Non-Investment Grade Corporate Issuers, which can be found on dbrs.com under Methodologies.