DBRS Morningstar Changes Trend on Loblaw Companies Limited to Positive, Confirms Ratings at BBB

DBRS Limited (DBRS Morningstar) confirmed the Issuer Rating and Medium-Term Notes and Debentures ratings of Loblaw Companies Limited (Loblaw or the Company) at BBB as well as its Short-Term Issuer Rating at R-2 (middle) and its Second Preferred Shares rating at Pfd-3. DBRS Morningstar also changed all trends to Positive from Stable. The trend change reflects the Company’s strong business profile, stable operating performance in both food retail and pharmacy as well as improved credit metrics after the spin-out of Choice Properties Real Estate Investment Trust (CHP; rated BBB with a Stable trend by DBRS Morningstar) (the Transaction).

Following the Transaction, DBRS Morningstar stated on September 5, 2018, that if Loblaw’s key credit metrics improved modestly (i.e., lease-adjusted debt-to-EBITDAR attributed to retail below 3.0 times (x)) and the Company continued to overcome ongoing headwinds (i.e., rising costs, including minimum wage increases; tariffs and transportation increases; drug-pricing reforms; impact of the bread-price fixing; and other litigation) and grow EBITDA in the near term, a positive rating action would likely result.

Since then, Loblaw’s operating performance has remained sound. In H1 F2019, retail sales increased 2.9% year over year (YOY) to $21.4 billion based on food retail same-store sales growth of 1.3%, same-store pharmacy sales growth of 3.0% and same-store front-store drug retail sales of 3.2%. Gross margins remained relatively stable and selling, general and administrative expenses increased slightly. As a result, adjusted EBITDA attributed to retail (excluding the impact of International Financial Reporting Standard (IFRS) 16) increased by 5.5% YOY to $1.5 billion in H1 F2019. The Company continued to generate significant free cash flow (FCF) after dividends, mainly applied toward share repurchases but also toward debt repayment. When combined with the growth in operating income, lease-adjusted debt-to-EBITDAR improved to 2.83x for the last 12 months ended Q2 F2019 from approximately 3.1x pro forma the spin-out of CHP.

Going forward, DBRS Morningstar expects Loblaw’s earnings profile to remain stable. Revenue is forecast to increase above $48 billion in F2020, mainly based on same-store sales growth in the low single digits. DBRS Morningstar believes that EBITDA margins will improve moderately through F2020 as efficiency initiatives and the benefit of operating leverage are partially offset by regulatory headwinds, including costs associated with drug-price reforms. As a result, DBRS Morningstar expects EBITDA (excluding the impact of IFRS 16) to grow toward $3.6 billion in F2019 and rise above $3.7 billion in F2020.

Loblaw’s financial profile should continue to improve over the medium term, benefiting from growth in earnings and cash flows as balance-sheet debt should remain relatively stable. Cash flow from operations from retail should continue to track operating income while annual net capex attributable to the retail operations is expected to remain relatively stable near $1.1 billion. Retail capex will focus on existing-store improvements, process and efficiency improvements (supply chain, front store automation, etc.) and information technology projects. DBRS Morningstar believes that dividends on a per-share basis will continue to grow at a steady pace and that the cash outlay for dividends will rise above $450 million in F2020. As such, DBRS Morningstar believes that retail FCF after dividends and before changes in working capital should increase to the $1.0 billion range, which is significant relative to the Company’s $7.7 billion of balance-sheet debt, excluding lease liabilities. DBRS Morningstar expects Loblaw to use FCF to complete share repurchases. As a result, DBRS Morningstar believes that balance-sheet debt should remain relatively stable and credit metrics should continue to improve as earnings grow.

DBRS Morningstar believes that the strength of Loblaw’s business profile should afford it higher leverage than is typical for the BBB rating categories. As a result, lease-adjusted debt-to-EBITDAR attributed to the retail business of up to 3.0x would be appropriate for a BBB (high) rating. If Loblaw’s operating performance remains sound and leverage remains relatively stable over the next two to four quarters, DBRS Morningstar could upgrade the Company’s ratings to the BBB (high) level.

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

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

The principal methodologies are Rating Companies in the Merchandising Industry and DBRS Criteria: Preferred Share and Hybrid Security Criteria for Corporate Issuers, which can be found on dbrs.com under Methodologies & Criteria.

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 under Related Documents or by contacting us at [email protected].

The rated entity or its related entities did participate in the rating process for this rating action. DBRS Morningstar had access to the accounts and other relevant internal documents of the rated entity or its related entities in connection with this rating action.

DBRS Morningstar will publish a full report shortly that will provide additional analytical detail on this rating action. If you are interested in receiving this report, contact us at [email protected].

For more information on this credit or on this industry, visit www.dbrs.com or contact us at [email protected].

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