DBRS Morningstar Changes the Trend on Sobeys Inc. to Positive from Stable, Confirms Ratings

DBRS Limited (DBRS Morningstar) changed the trends on the Issuer Rating and Senior Unsecured Debt rating of Sobeys Inc. (Sobeys or the Company) to Positive from Stable and confirmed both ratings at BBB (low). The trend changes reflect the ongoing improvement in Sobeys’ business risk profile through efficiency and profitability gains as well as the strengthening of its position as Canada’s second-largest nationally diversified grocer through organic execution, including the expansion of FreshCo and Voilà and the successful integration of its acquisitions, including Farm Boy and Longo’s. Furthermore, the trend changes also reflect DBRS Morningstar’s expectation that Sobeys’ leverage will improve through growth in earnings and that the Company will be able to maintain its credit metrics at a level appropriate for a BBB rating on a normalized and sustained basis.

On March 19, 2021, following Sobeys’ acquisition of Longo’s, DBRS Morningstar confirmed the Company’s ratings at BBB (low) with Stable trends. At the time, DBRS Morningstar stated that, while leverage was expected to increase during the fiscal year ending May 7, 2022 (F2022), should Sobeys’ return its debt-to-EBITDA to below 3.5x on a normalized and sustainable basis through growth in earnings thereafter, its credit risk profile would be more reflective of the BBB rating category and a positive rating action could result.

Since then, Sobeys has reported results for the first two quarters of F2022 (6M F2022). Same-store sales during the 6M F2022 were -1.8%, excluding fuel, given the economy reopening and strong comparable growth of 9.8% during the corresponding 6M F2021. That said, revenues during the 6M F2022 still increased 4.3% year-over-year (YOY), growing to above $14.9 billion, driven by the acquisition of Longo’s, higher fuel sales, and new store openings, including the expansions of Farm Boy in Ontario and FreshCo in Western Canada, as well as the expansion of Voilà in Ontario. EBITDA margins increased marginally by 3.6 basis points (bps) to approximately 7.4%, following a 61-bps expansion in F2021, with cost saving and efficiency improvement initiatives, and lower coronavirus-related health and safety expenses offsetting higher fuel sales and the front-loaded costs related to the expansions of Farm Boy, Voilà, and FreshCo. As such, EBITDA increased 4.8% YOY to $1.10 billion during the 6M F2022. During the last 12 months ended October 30, 2021 (LTM F2022), despite significantly increased capital expenditures (capex) and dividends, Sobeys continued to generate a meaningful level of free cash flow (after working capital changes and lease principal repayments) of $102 million, which the Company used, in combination with cash on hand, to repay $173 million in net debt and for the acquisition of Longo’s. As such, despite a more than $200 million increase in lease liabilities during the 6M F2022, key credit metrics remained relatively stable, with debt-to-EBITDA of 3.46 times (x) for the LTM F2022 versus 3.41x for the fiscal year ended May 1, 2021 (F2021).

DBRS Morningstar believes that Sobeys’ earnings profile will continue to improve over the near to medium term, considering the benefits of Project Horizon and notwithstanding some near-term headwinds related to volumes moderating from their elevated pandemic levels and inflationary pressures as a result of input costs and wage increases. Project Horizon, introduced at the beginning of F2021 to add an incremental $500 million in annualized EBITDA and improve the Company’s EBITDA margins by 100 bps by the end of F2023 through growth in market share and cost saving and efficiency improvement initiatives, is tracking in line with management’s expectations. DBRS Morningstar forecasts Sobeys’ same-store sales to be in the low negative single digits for the full-year F2022, given strong comparable periods in F2021 and the expectation of a continued economic reopening, despite the renewed restrictions as a result of the omicron variant. However, DBRS Morningstar expects overall revenues to increase to just below $30.0 billion from $28.3 billion in F2021, benefitting from the acquisition of Longo’s, a 53rd week, and the expansions of Farm Boy, Voilà, and FreshCo. DBRS Morningstar further forecasts same-store sales growth to stabilize in the low single digits in F2023 and, combined with the continuation of the aforementioned expansions, expects revenues to grow toward $30.5 billion, despite the lapping of the 53rd week. DBRS Morningstar anticipates that Sobeys’ EBITDA margins will weaken moderately in F2022, with the benefits from merchandising initiatives related to Project Horizon more than offset by volume deleverage, front-loaded costs associated with the roll-out of Voilà, and store remodeling efforts, including the FreshCo conversions, as well as inflationary pressures, before recovering in F2023. As such, DBRS Morningstar forecasts EBITDA to be approximately $2.10 billion in F2022 versus $2.06 billion in F2021 and to increase to approximately $2.20 billion in F2023.

In terms of the Company’s financial profile, DBRS Morningstar forecasts Sobeys’ financial leverage to temporarily increase as operating lease liabilities, including additional lease liabilities associated with the Q4 F2022 addition of the third Voilà customer fulfilment centre in Calgary, continue to grow, but expects credit metrics to improve thereafter in line with earnings growth. Based on operating cash flows of approximately $1.7 billion in F2022 and F2023, capex above $750 million in F2022 and above $800 million in F2023, and annualized dividend payments of approximately $160 million, DBRS Morningstar forecasts Sobeys’ free cash flow (before changes in working capital and lease principal payments) to be approximately $700 million in F2022 and F2023. After changes in working capital and lease principal payments, DBRS Morningstar believes the Company will use a meaningful portion of its free cash flow for share buybacks. As such, while DBRS Morningstar forecasts debt-to-EBITDA to increase to modestly above 3.5x for F2022, leverage is expected to return to below 3.5x in F2023 and remain below 3.5x on a normalized and sustainable basis thereafter.

Should Sobeys continue to deliver an operating performance in line with DBRS Morningstar’s expectations while maintaining relatively stable credit metrics, an upgrade of the ratings to BBB could occur over the course of the next year. Conversely, should credit metrics deteriorate (i.e., debt-to-EBITDA rise meaningfully above 3.5x on a sustained basis) as a result of either weaker-than-expected operating performance and/or more aggressive financial management, the trend could be reversed to Stable.

ESG CONSIDERATIONS
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 is Rating Companies in the Merchandising Industry (July 26, 2021; https://www.dbrsmorningstar.com/research/382073), 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).

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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