DBRS Confirms Loblaw Companies Limited at BBB, Maintains Positive Trend

DBRS Limited (DBRS) confirmed the Issuer Rating, Medium-Term Notes rating and Debentures rating of Loblaw Companies Limited (Loblaw or the Company) at BBB; Shoppers Drug Mart Corporation’s (Shoppers) Senior Unsecured Debt rating at BBB; and Loblaw’s Short-Term Issuer Rating and Second Preferred Shares rating at R-2 (middle) and Pfd-3, respectively. DBRS maintains the Positive trends on all ratings.

The confirmations reflect the Company’s solid operating performance in a challenging competitive environment, as well as improving credit metrics based on growth in underlying earnings and relatively stable balance sheet debt. DBRS has maintained the Positive trends (rather than upgrading the ratings) because of the uncertainty surrounding the possible impact of the recently announced industry-wide investigation by the Competition Bureau, in conjunction with expected minimum wage increases and generic-drug pricing/health-care reforms.

On October 31, 2017, Loblaw and George Weston Limited (GWL; rated BBB with a Stable trend by DBRS; Loblaw’s parent company) confirmed their awareness of an industry-wide investigation by the Competition Bureau concerning a price-fixing scheme involving certain packaged bread products. Loblaw and GWL have indicated that they are cooperating fully with the investigation and expect to be able to provide further comment after the Competition Bureau court filings are unsealed. DBRS will continue to monitor the potential impact of the Competition Bureau’s investigation on Loblaw, as well as the Company’s operating performance and future financial management practices, before taking the appropriate rating actions. If DBRS becomes confident that the result of the ongoing investigation should not have a material impact on Loblaw, including any potential penalties and effects on future profitability, the Company’s operating performance will remain sound and credit metrics will remain sustainable in the range considered acceptable for a BBB (high) rating (i.e., lease-adjusted debt-to-EBITDAR below 3.25 times (x)) a rating upgrade will likely result at some point during 2018. Otherwise the trends could be changed to Stable.

The ratings continue to be supported by Loblaw’s business profile, which is considered very strong for the current BBB rating and features industry-leading size, scale and market positions in food retail and pharmacy across Canada. The ratings also incorporate the intense competition in food retail in Canada and the risks associated with changes to generic-drug pricing and pharmacy regulations.

SUMMARY
Loblaw’s earnings profile remained stable and strong for the current BBB rating through the end of 2016 and for the nine months ended October 7, 2017 (9M 2017), based on the Company’s solid operating performance in a challenging competitive environment. Revenues attributable to the Retail segment and Choice Properties REIT (CP REIT) increased modestly year over year (yoy) in 9M 2017 to approximately $45.9 billion for the last 12 months (LTM) ended 9M 2017. The increase in revenues was based primarily on the consolidation of franchisees, as well as modest same-store sales growth and a net increase in retail square footage, incorporating the impact of the disposition of the gas bar on July 17, 2017.

-- Food retail same-store sales growth, excluding the gas bar and unfavourable timing of New Year’s Day, was 0.6% for 9M 2017, driven primarily by volume growth as prices remained deflationary in Q1 2017 and Q2 2017 before shifting to very modest inflation in Q3 2017.
-- Drug retail same-store sales growth (excluding the unfavourable timing of New Year’s Day) was approximately 2.9%, driven by pharmacy same-store sales growth of 3.0% and front-store same-store sales growth of 2.9%. Pharmacy same-store sales growth continues to be driven by an increase in the number of prescriptions dispensed, partially offset by a modest decline in average prescription value.

Adjusted EBITDA margins (which excludes the gain on the sale of the gas bar operations and prior-year restructuring charges) improved by nearly 42 basis points (bps) in 9M 2017, driven primarily by higher adjusted gross margin in the Retail segment, partially offset by higher selling, general and administrative (SG&A) costs as a percentage of sales in the Retail segment.

-- Excluding the consolidation of franchisees, adjusted gross profit margin in the Retail segment improved by approximately 30 bps yoy in 9M 2017, driven primarily by the disposition of the lower-margin gas business combined with improved drug retail margins.
-- Retail segment SG&A as a percentage of sales increased by 50 bps yoy in 9M 2017; however, excluding the consolidation of franchisees, Retail segment SG&A as a percentage of sales was flat yoy.

As such, adjusted EBITDA attributable to the Retail segment and CP REIT as reported by Loblaw increased to approximately $3.8 billion for the LTM ended 9M 2017 versus $3.7 billion in 2016 and $3.4 billion in 2015.

Loblaw’s financial profile continued to improve as expected in 2016 and through 9M 2017, as growth in earnings combined with relatively stable levels of balance sheet debt resulted in improved credit metrics, despite the use of free cash flow for returns to shareholders. Cash flow from operations was negatively affected by an increase in cash taxes, while capital expenditures (capex) and the cash outlay for dividends increased only modestly yoy. The Company used free cash generated, as well as cash on hand, to complete share repurchases. As such, balance sheet debt attributable to the Retail and CP REIT segments (excluding Financial Services) remained relatively flat at approximately $9.64 billion as at the end of 9M 2017 versus $9.44 billion as at year-end 2016 and $9.73 billion as at year-end 2015. Combined with the growth in adjusted EBITDA attributable to the Retail and CP REIT segments, credit metrics continued to improve, remaining at a level considered strong for the current BBB ratings (i.e., lease-adjusted debt-to-EBITDAR and lease-adjusted EBITDA coverage attributable to Retail and CP REIT of 3.04x and 5.99x for the LTM ended 9M 2017 versus 3.12x and 5.74x in F2016 and 3.40x and 5.29x in F2015, respectively).

OUTLOOK
DBRS believes that Loblaw’s earnings profile should remain relatively stable over the near to medium term, despite ongoing intense competition (which is contributing to only modest inflation expectations), the near-term impact of minimum wage increases (estimated at approximately $190 million), and drug-pricing/health-care reforms and, to a lesser extent, the disposition of the gas bar and wind-down of the Company’s relationship with the Canadian Imperial Bank of Commerce (rated AA with a Negative trend by DBRS) for personal banking services under the President’s Choice (PC) brand. The Company has undertaken a number of initiatives to help mitigate the impact on EBITDA of the above-noted headwinds, including reducing corporate headcount by 500, closing 22 underperforming stores and charging a new supply-chain fee to suppliers, along with continuing efficiency improvements and loyalty initiatives (i.e., the combination of PC Plus and Shoppers Optimum, in addition to the partnership with Instacart for grocery delivery). DBRS believes that revenues attributable to the Retail and CP REIT segments should remain relatively flat or increase modestly in the near term based primarily on same-store sales growth, as well as a modest net increase in retail square footage. Same-store sales growth should continue to be driven primarily by volume in food retail as inflation should remain modest, while drug retail will continue to experience growth in prescription count, although the average prescription value is expected to continue to decline. EBITDA margins will be negatively pressured in the near term by factors outside of the Company’s control, as noted above. These negative factors, however, are expected to be largely offset by initiatives undertaken by the Company, as well as by the divestiture of the lower-margin gas bar. As such, DBRS expects EBITDA attributable to the Retail and CP REIT segments to remain relatively flat or increase modestly in the near term toward the $4.0 billion level.

Loblaw’s financial profile should remain relatively stable in the near term, benefiting from the Company’s cash-generating capacity, despite continued focus on completing share repurchases, as DBRS expects Loblaw to maintain relatively stable levels of balance sheet debt. Cash flow from operations should continue to track operating income, while capex is expected to stay relatively stable ($1.3 billion in total with $1.0 billion attributed to the Retail segment). Dividends on a per-share basis are expected to continue to grow, but the cash outflow for dividends should remain relatively stable as share repurchases are completed. Free cash flow is expected to continue to be used primarily to complete share repurchases. As such, balance sheet debt attributable to the Retail segment and CP REIT should remain relatively stable, and key credit metrics should remain relatively stable or improve modestly as earnings grow in the near term.

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

Shoppers’ Senior Unsecured Debt is guaranteed by Loblaw.

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, Rating Entities in the Real Estate Industry, DBRS Criteria: Guarantees and Other Forms of Support and DBRS Criteria: Preferred Share and Hybrid Security Criteria for Corporate Issuers, which can be found on dbrs.com under Methodologies.

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The rated entity or its related entities did participate initially in the rating process. DBRS had access to the accounts and other relevant internal documents of the rated entity or its related entities.