The grocery sector in Canada has proven to be a difficult market for companies to navigate and flourish in. Hampered by rapidly increasing wholesale costs and the pressure of a Canadian dollar now back well below parity margins have gotten harder to maintain. Still, amidst the turmoil Loblaw Companies Ltd. (OTCPK:LBLCF) (a division of George Weston Ltd. (OTCPK:WNGRF)) remains Canada's largest grocery retailer.
This has been no easy task with the current Canadian economy combined with increased competition from Wal-Mart (NYSE:WMT) and Costco (NASDAQ:COST) which now have a combined Canadian market share of 20%. One of the strategies that Loblaw enacted on was its blockbuster acquisition of Shoppers Drug Mart a few years ago. Now a couple of years into the merger we can clearly see the net benefit to Loblaw. Which is more than you could say about Sobeys' (division of Empire Company Ltd. (OTCPK:EMLAF)) acquisition of Safeway's (NYSE:SWY) Canadian assets, which I wrote about earlier this week.
In fact in its recently released Q2 2016 report Loblaw revealed that Shoppers Drug Mart is its fastest growing chain with an increase in same store sales of 4%. Compared to a same store sales increase of 0.7% in Loblaw's food retail segment. Much of this growth is directly from these added retail food offerings as retail same store sales rose by 4.3% and Shoppers Drug Mart's traditional pharmacy same store sales rose by 3.6%. This also proved to be the first time in years that Shoppers has been able to grow profits. One of Loblaw's biggest hopes with its acquisition of Shoppers Drug Mart was that its less expensive and smaller retail foot space would allow the company to break further into urban markets.
Since the merger Shoppers Drug Mart has been carrying an increased amount of fresh and packaged foods. Although at a generally higher price than Loblaw's more traditional big box stores, showing that customers will pay a higher price at times in exchange for convenience, think of it as the 7-Eleven effect. In the quarter Loblaw was able to achieve another one of its goals following the merger with the C$83 million it achieved in net synergies it has now reached its goal of C$300 million in annualized synergies from the merger.
When Loblaw acquired Shoppers Drug Mart it added it to its already vast portfolio of grocery chains such as Loblaw, Real Canadian Superstore, T&T, Wholesale Club, No Frills, Extra Foods as well as several other smaller grocery chains. Beyond grocery store operations Loblaw also produces its own in-house brands of Presidents Choice, No Name along with the Joe Fresh clothing brand and is financial arm PC Financial. Loblaw also has its 12 million member strong PC Plus loyalty program and its 10 million strong Shopper Optimum rewards program.
Filling the basket with financials
In all Loblaw posted increased revenues of C$10.7 billion in the quarter up from C$10.5 billion during the same period last year. This represented a 1.9% growth in revenue, which was slightly behind the 2.2% revenue growth it posted in Q2 2015. When we break down the revenues we see that the retail segment increased its revenues by 1.7% to C$10.4 billion from C$10.3 billion. Food retail saw a revenue increase to C$7.71 billion from $7.62 billion and drug store revenues climbed to C$2.77 billion from C$2.68 billion. The PC Financial division also saw revenues increase modestly by 7.5% to C$214 million from C$199 million while seeing its "average quarterly net credit card receivables" increase to C$2,717.00 from C$2,585.00. Finally Loblaw's interest in Choice Properties REIT saw its revenues rise to C$198 million from C$183 million.
Adjusted EBITDA rose in the quarter to C$924 million from C$857 million, an increase of 7.8% which surpassed analysts' expectations of 4%. However when we get to the bottom of the bag we do see some spoilage as net income (available to common shareholders) dropped in the quarter to C$158 million (diluted net EPS of C$0.39) from C$185 million (diluted net EPS of C$0.44). This drop in net income has been attributed to factors such as higher financing charges along with higher income taxes which increased to 28.4% from 27% in the quarter due to Alberta's increased corporate tax structure. The fires in Fort McMurray were another factor as they brought with it C$12 million in added inventory recovery and clean up expenses along with the closure of 10 stores.
While net earnings may be down in the quarter, year to date net earnings have increased to C$351 million from C$331 million, which leaves Loblaw in a better position than many of its Canadian based competitors.
Battle with vendors
Going forward Loblaw is trying to lure back customers through its ongoing battle with its vendors citing that they would be forbidding any type of price increase unless the vendor can prove that the increase is based on higher operating costs. Loblaw has already stated that it will reduce payments to vendors by 1.45% for any products received after September 4, 2016. This continues the long battle between the retailers and the vendors which has the general public caught in the cross fire. The higher wholesale prices have already sparked a trend in consumers to seek out discount brand alternatives or other alternatives such as Wal-Mart.
Recently Loblaw CEO Galen Weston stated that "Prices got to the point that they were too high in the Canadian market," as Loblaw stated in its recent letter to vendors that it has had to pass on more than C$1 billion in price increases to consumers since 2014.
While this may be a battle which will never end it does demonstrate some of the more negative aspects of the grocery retail sector with this constant fight over costs. I still believe Loblaw to be a positive option for investors. Loblaw's recent retail strength against its Canadian competitors has helped its stock price climb back up to its three-year high. The stock was trading at C$73.36 on July 27 following its earnings release. This puts it right at the edge of its 52-week and three-year high of C$74.59, erasing its 52-week low of C$61.25. Given the nature of this sector Loblaw isn't the best option for a major holding in your portfolio but it can act as a stabilizing force with its slower moving stock price. The dividend itself isn't outstanding with an annualized payout of C$1.04 with a yield of 1.43%, but it does add to the conversation that Loblaw could be used as a counterweight to other riskier investments.
Given the recent surge in stock price it is now trading closer to its average price target of C$78.20, with a range of C$74.00 to C$80.00. While this offers some short-term gains for investors a company like Loblaw is better as a five-year or longer hold strategy, case in point on August 1, 2011, the stock closed at C$36.00.
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