DBRS Morningstar Confirms Sobeys Inc. at BBB (low), Stable, Following Acquisition of Longo’s

DBRS Limited (DBRS Morningstar) confirmed Sobeys Inc.’s (Sobeys or the Company) Issuer Rating and Senior Unsecured Debt rating at BBB (low), both with Stable trends. The rating confirmations are based on Sobeys’ strong operating performance during the last three quarters ended January 30, 2021 (9M F2021) in the context of the Coronavirus Disease (COVID-19) pandemic, as well as a strengthening of the Company’s business risk assessment within the rating category. The Stable trend reflects DBRS Morningstar’s expectation that operating results and credit metrics will moderate as the economy reopens and debt levels, in particular operating lease liabilities, increase. 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 the intensely competitive environment and a relatively low share of discount stores.

The confirmation also incorporates Sobeys’ announcement that it has agreed to acquire 51% of Longo’s for $357 million (the Acquisition), financed through a combination of up to $125 million in equity, approximately $197 million in cash, and approximately $35 million of acquired debt. While DBRS Morningstar acknowledges the merits of the Acquisition, including Longo’s strong brand in the Greater Toronto Area (GTA) and the benefit of Longo’s well-established Grocery Gateway, the Acquisition does not have a material effect on Sobeys’ overall business risk assessment because of its relatively small size. The Acquisition is subject to customary closing conditions and is expected to close in the first quarter of F2022.

Founded in 1956, Longo’s is an Ontario-based grocer with 36 stores located in the GTA and sales of approximately $1.1 billion for the fiscal year ended February 28, 2021. Longo’s focuses on fresh, high-quality products, including a variety of prepared foods and private label products. Additionally Longo’s operates Grocery Gateway, which has approximately 70,000 online grocery customers. Longo’s will be fully consolidated under Sobeys, but will continue to be managed separately, led by President and CEO Anthony Longo and his team. DBRS Morningstar expects Sobeys to achieve synergies particularly around sourcing, logistics, and real estate. The transaction structure allows Sobeys to achieve 100% ownership of Longo’s over time.

On August 26, 2020, DBRS Morningstar confirmed Sobeys’s ratings at BBB (low) with a Stable trend. At the time, DBRS Morningstar stated that should credit metrics improve, such that debt-to-EBITDA drops below 3.5 times (x) on a normalized and sustainable basis, Sobeys’ ratings would be more appropriately placed in the BBB rating category and a positive rating action could result.

Since then, the Company has reported results for three quarters. During the 9M F2021, operating results were strong, benefitting primarily from significantly elevated volumes as a result of the coronavirus pandemic. Revenues during the 9M F2021 increased 9.1% year-over-year (YOY), growing to $21.3 billion, primarily driven by same-store sales growth. EBITDA margins improved roughly 80 basis points (bps) YOY to 7.3%, benefitting from operating leverage gains and efficiency improvements, despite increased coronavirus health and safety expenses, which had an approximately 50 bps negative impact during the 9M F2021. As such, EBITDA increased 22.3% YOY to $1.56 billion. During the 9M F2021, Sobeys continued to generate meaningful free cash flows, after working capital changes and lease principal repayments, of $254 million, which the Company in combination with cash on hand primarily used to repay $515 million in net debt. As such, despite a more than $600 million increase in lease liabilities, in part due to the addition of Voilà’s second Ocado fulfillment centre in Montréal, key credit metrics strengthened, with debt-to-EBITDA improving to 3.39x for the last 12 months ended January 30, 2021, from 3.88x at the end of F2020.

Going forward, DBRS Morningstar expects Sobeys’ operating results to moderate, but believes Sobeys’ earnings profile will continue to improve over the near to medium term, considering the benefits of Project Horizon. Sobeys’ Project Horizon commenced at the beginning of F2021 and aims to improve the Company’s EBITDA margins by 100 bps and add an incremental $500 million in annualized EBITDA by F2023 through growth in market share as well as cost and margin improvements. DBRS Morningstar forecasts Sobeys’ to end the full-year F2021 with mid-single-digit same-store sales growth, given the lapping of surge volumes during the fourth quarter. In F2022, DBRS Morningstar expects same-store sales to be negative in the low-single-digits due to strong comparable periods in F2021, but expects overall revenues, pro forma a full year of Longo’s, to increase to approximately $29.5 billion, benefitting from the acquisition of Longo’s, a 53rd week, and new store openings. DBRS Morningstar forecasts Sobeys’ EBITDA margins to weaken modestly in F2022, with benefits from merchandising initiatives related to Project Horizon more than offset by volume deleverage as well as costs associated with the roll-out of Voilà and the conversions to FreshCo. As such, DBRS Morningstar forecasts EBITDA to be approximately $2.0 billion for the full-year F2021 and increase towards $2.1 billion in F2022.

In terms of financial profile, DBRS Morningstar expects Sobeys’ credit metrics to weaken as debt levels, in particular operating lease liabilities, increase. DBRS Morningstar forecasts Sobeys’ free cash flow (FCF) after dividends and before changes in working capital and lease principal payments to be approximately $750 million in each of F2021 and F2022. This is based on operating cash flow of approximately $1.6 billion, capital expenditure of $650 to $675 million in F2021 and above $700 million in F2022, and annualized dividend payments of approximately $150 million. After changes in working capital and lease principal payments, DBRS Morningstar believes the Company will primarily use its FCF for share buybacks. As such, when considering lease liability increases and to a lesser extent the roughly $70 million of consolidated debt associated with the Acquisition, DBRS Morningstar expects debt-to-EBITDA to return to above 3.5x in F2022.

That said, DBRS Morningstar believes Sobeys’ has the ability to return debt-to-EBITDA to below 3.5x, on a normalized and sustainable basis, primarily through growth in earnings subsequent to F2022. Should the Company grow revenue and EBITDA more than expected and/or return debt-to-EBITDA to below 3.5x on a normalized and sustainable basis, DBRS Morningstar believes that Sobeys’ credit risk profile would be more reflective of the BBB rating category and a positive rating action could result. Conversely, although unlikely, should credit metrics deteriorate (i.e., debt-to-EBITDA rise above 4.00x on a sustained basis) as a result of either weaker-than-expected operating performance and/or more aggressive financial management, the ratings could be pressured.

A description of how DBRS Morningstar considers ESG factors within the DBRS Morningstar analytical framework can be found in the DBRS Morningstar Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings at https://www.dbrsmorningstar.com/research/373262.

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

The principal methodologies are Rating Companies in the Merchandising Industry (July 30, 2020; https://www.dbrsmorningstar.com/research/364692) and DBRS Morningstar Criteria: Rating Corporate Holding Companies and Parent/Subsidiary Rating Relationships (November 2, 2020; https://www.dbrsmorningstar.com/research/369167), which can be found on dbrsmorningstar.com under Methodologies & Criteria. Other applicable methodologies include the DBRS Morningstar Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings (February 3, 2021; https://www.dbrsmorningstar.com/research/373262).

For more information regarding rating methodologies and Coronavirus Disease (COVID-19), please see the following DBRS Morningstar press release: https://www.dbrsmorningstar.com/research/357883.

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.

Generally, the conditions that lead to the assignment of a Negative or Positive trend are resolved within a 12-month period. DBRS Morningstar trends and ratings are under regular surveillance.

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

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