Investing In The Alcohol Sector Through This Industry Leader; 45% Upside With Liquor Stores NA

| About: Liquor Stores (LQSIF)

Summary

When considering the different industries to gain exposure to in order to prepare for a market downturn, the alcohol sector has historically proven its consistency and profitability.

Based on both a discounted cash flow model and comparable analysis, the stock is clearly undervalued relative to LIQ's earnings potential with a 45% upside opportunity.

Although the Alberta market remains impacted by the low price of oil, Liquor Stores NA continues to report increases in sales and gross margins proving the sustainability of its business.

As North America's bull market continues to see extended gains following Donald Trump's presidential victory, many investors are beginning to question current valuation levels in the face of increased global uncertainty. When attempting to rebalance one's portfolio in order to preserve capital, companies like Wal-Mart (NYSE:WMT), J&J (NYSE:JNJ), and General Mills (NYSE:GIS) are usually the suggested stocks in order to defend against recessionary pressures in the macro environment.

While not entirely "recession-proof," another important sector that is often overlooked is the alcohol industry. Studies like this New Zealand Drug Foundation review confirm that recessions are accompanied by increased demand for alcohol as people struggle to cope with stress due to increased unemployment and economic challenges. Therefore, under the correct conditions, adding a company exposed to the reduced cyclicality of alcohol sales may improve one's defensive strategy during a market downturn.

Investment Proposition - Liquor Stores NA (TSX:LIQ)

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^Sourced from Market Watch

Liquor Stores NA (OTCPK:LQSIF) is a Canadian-based operator of alcohol stores and the largest publicly traded liquor retailer in North America. Listed on the Toronto Stock Exchange under the ticker symbol (TSX:LIQ), the company was publicly listed in 2004 initially as an income trust fund before merging with Liquor Barn to form the current entity. Throughout the article, for simplicity's sake, I will refer to Liquor Stores NA by its ticker symbol, LIQ.

The company operates in both the Canadian and US market through its 253 retail stores that cover approximately 1.3 million square feet in retail space. Revenue wise, the company earns around 67% of sales from the Canadian market with the remaining amount from its US operations. Looking at the stock's performance, due to the company's operational exposure to the Alberta market (70% of store base), shares have been heavily sold in the past 18 months as the price of oil collapsed.

From a fundamental perspective, this underperformance, which saw the stock fall from $15/share in July of 2015 to $7/share in March of 2016, was largely unwarranted. While the company did report a $129.6 million impairment charge as management revised revenue projections, throughout the past six quarters, earnings has consistently grown and gross margins averaged around the 25.5% level. This strong performance in the face of current economic challenges in the Alberta market confirms the durability of sales and LIQ's business model. At the current $10.44/share level, the company pays a monthly dividend of 3 cents at an annualized rate of 3.46%.

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^Sourced from Bloomberg.com

The alcohol industry is currently experiencing several influential trends that have negatively impacted producers (Appendix A). When considering the rise of craft beer and the slowdown in consumption volumes across emerging markets, LIQ's industry position as the retailer of these beverages has insulated the company from many of these production-level threats.

The investment proposition for LIQ is based on the growth opportunities in the US alcohol market where the business continues to grow significantly in addition to the established Canadian network of stores, which could see increases in value following further provincial de-regulation. Overall, the stability of sales and gross margins provides an opportunity for investors to build a position in a company that is expected to grow in the long term while providing consistency throughout recessionary periods.

Industry Overview

The alcohol sector is one of the largest industries in the world with $1.16 trillion USD in global sales that is expected to grow by a 3%-4% CAGR through 2020. The consistent growth of consumption paired with improving margins across the beer, wine, and spirits segments has resulted in large players like Anheuser-Busch InBev (NYSE:BUD), Carlsberg (OTCPK:CABGY), Diageo (NYSE:DEO), Molson Coors (NYSE:TAP), and Kirin Holdings (OTCPK:KNBWY) all generating significant shareholder value over the past decade.

Unfortunately, in the past year, many of these producers have begun to see margins decline as changing consumer tastes has given way to the rise of craft beer, which increases competition and impacts bottom line growth. In addition, economic challenges in emerging markets have caused global consumption levels to decline by 0.7% in 2015 signaling a necessary change in strategy for many producers.

When considering the major participants of the alcohol industry, the retailing side of the sector is another component as most producers work alongside private or state-run vendors in order to distribute their products. Furthermore, unlike the producers who are influenced by changing consumer tastes, the intermediary retailers have largely been insulated from these sectoral trends. With sales increasing by 2% in dollar terms even as consumption volumes decline, retailers of alcohol have remained strong in the current market and continue to benefit from the increased demand for more premium, and expensive, craft beer.

Privatization of Alcohol Sales in Canada

When considering the opportunities and challenges facing LIQ in the Canadian market, the privatization efforts of the Canadian government remain key to long-term projections. In Canada, the sale of alcoholic beverages is within provincial jurisdiction, and as of 2016, Alberta is the only province to have fully privatized the sale and distribution of alcohol.

While the privatization debate has generated much discussion, the success seen in Alberta since moving to a private system in 1993 is undeniable as the number of liquor retailers increased by 160%, product selection expanded by 944%, and government revenue grew by 89%. In addition to generating significant government revenue, the privatization of the liquor industry has allowed companies like LIQ to invest heavily in local jobs and infrastructure.

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^Sourced from AGLC (Alberta Gaming & Liquor Commission)

In addition to Alberta, through its hybrid control network, the BC government is the only other province to acknowledge the opportunities that privatization can create. In the current system, private stores are able to sell alcohol but must purchase from the government's wholesale distribution centre, which allows the province to control the amount of alcohol-related goods sold to communities. With over 699 private stores and 197 provincial stores in British Columbia, the government's liquor branch that oversees the wholesale distribution of alcohol remains the main bottleneck that reduces the profitability potential of the BC market.

While the distribution functions overseen by these facilities were recently contracted out to improve efficiency after several complaints, the current structure falls short regarding the potential that a fully privatized industry is able to achieve.

When considering the privatization efforts beyond Alberta and BC, the two key markets that remain central to the overall performance of the Canadian alcohol industry are Quebec and Ontario. Both provinces have adopted a strategy of increasing distribution by allowing grocery stores to sell certain types of alcohol at a regulated pace. As of last month, in certain select grocery stores, Ontario now sells beer, cider, and wine with the overall plan to have wine in 300 of the province's 1,500 grocery stores and beer/cider in 450 stores by 2025.

Even with this recent change, Ontario's alcohol industry remains dominated by two players: (1) the LCBO (Liquor Control Board of Ontario), Ontario's government enterprise and (2) the Beer Store, the only privately owned retailer permitted to sell beer for off-site consumption.

When considering the possibility of the LCBO being privatized in the coming years, while the current political landscape is much more favorable, the logistics of such a move remain truly difficult. Business analyst Mark Milke of the Huffington Post writes:

"Twenty years after Alberta began to dismantle and sell off government liquor stores, no other provincial governments has exited the retail side of the liquor business. The reason for that is not economic or social, but merely political: too many government employees' union have a vested interest in the status quo."

The challenge that limits Ontario's privatization efforts are not the suggested social problems, lost revenues, or higher prices which have all been disproved repeatedly. Rather, it is the logistics of handling the closure of 651 provincial stores and transfer of 6,469 government employees that generated over $5.214 billion CAD in sales last year.

Looking to the future, while Liberal leaders may propose alternative methods, investors should not assume any significant changes to the current provincial sector. In addition to the complications of transferring these government benefits, the success of the LCBO, which has consistently increased net income by a CAGR of 5.25% over the past 10 years, lessens the incentive to change a system that remains very profitable for the government.

While LIQ would largely benefit from entering a multibillion-dollar market if Ontario does privatize, the likelihood of such a scenario is limited. Therefore, current efforts in expanding their presence in Alberta and BC while looking out for opportunities in Saskatchewan remain the key growth prospects for LIQ in the Canadian market.

US Market Potential

When considering the store breakdown for LIQ, 85% of the company's stores are located in Canada with the remaining 15% in the United States. However from a revenue perspective, the company earns just 64% of total earnings from its Canadian operations with the other 36% coming from US stores. Since joining the company as CEO, Stephen Bebis has identified this clear difference in value and underlined the importance of expanding the business into the US market in order to drive growth in long term earnings.

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^Author's Own Work

As of Q3, the company earned around $1.82 million per each US store while only reporting $0.64 million for each of their Canadian locations, a difference of 182%. Before concluding that the US market offers better opportunities, it is important to identify three factors, which augment this difference in geographic performance: (1) the FX impact, (2) type of stores, and (3) market exposure. When considering the FX impact, the devaluation of the CAD relative to the USD has clearly increased total earnings from US operations as illustrated below.

While this impact does skew results, a reliance on FX gains as US exposure continues to increase can be beneficial as it offers a hedge against any underperformance in oil, which would negatively impact Alberta and the CAD. In addition, part of the expansion strategy has been to increase sales per store by opening larger locations in regions with higher populations. Unlike these new US stores, many of LIQ's Alberta locations are convenience-format shops, which are impacted by seasonal changes and traffic volumes thus lowering overall sales per store.

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^Author's Own Work

Looking at the company's total segmented sales per region, while the Canadian market generated significantly higher revenues, over the past six years, US earnings have reported a CAGR of 18.45% versus the 10.16% CAGR for Canadian operations. With the US market offering higher returns for invested capital, LIQ's management has been heavily focused on expansion efforts, recently securing a location in Massachusetts, which will be opened in the coming year, while also expressing further interest in the Connecticut region.

Management and Shareholder Analysis

With a market cap under $300 million, LIQ is largely underfollowed by the public market with only 8 analysts covering the equity and limited institutional support. When considering the company's management team, LIQ's leadership is essential to ensuring that the correct strategic decisions are made to expand operations while preserving shareholder value.

Stephen Bebis - President & Chief Executive Officer

At the helm of LIQ's leadership team is retail veteran Stephen Bebis, whose contribution to the company's strategy since his appointment in 2014 has created significant value for shareholders. Mr. Bebis joined LIQ following his tenure as founder and CEO of Canadian golf retail giant Golf Town. He was also Vice President and Merchandise Manager of Home Depot's $6 billion mid-south division in the late 1990s eventually becoming the President of Home Depot Canada. Overall, his retail experience across several categories has proven that Mr. Bebis' contribution to LIQ cannot be undervalued from a leadership perspective.

Since his appointment, the company's strategy has shifted towards modernizing existing stores while expanding operations in the US market to diversify revenues. In addition, even with political agendas pushing back against privatization efforts, Mr. Bebis has started conversations with numerous provincial advisory panels to push for the necessary license agreements in Canadian markets like Manitoba and Saskatchewan.

Anthony Price - SVP, Advertising & Marketing

One of the core challenges for any liquor retailer is the public perception surrounding the company and the social issues facing the alcohol industry. Mr. Price's role as head of advertising and marketing is essential to distinguishing the company's brand in a competitive Alberta liquor market while also improving consumer perception. Before joining LIQ in 2015, Mr. Price was previously the VP of Digital Marketing/Media at Michaels, a wall décor and seasonal merchandise retailer, and previous to that, the Director of Advertising for Petco.

It seems that for an industry like alcohol that is both emotionally sensitive and difficult to advertise for, the relevance of floral and pet marketing experience is limited at most. If the company is to expand beyond its current market capabilities and increase brand awareness, improving the effectiveness of marketing by adding relevant industry experience is essential to driving shareholder value.

Matthew Rudd - SVP & Chief Financial Officer

As the leader in North America's publicly traded liquor industry, LIQ is in a strong position to use existing capital to make accretive acquisitions. This past September, the company raised $67.5 million through a convertible unsecured debenture offering adding to its liquidity. In light of last year's Q4 acquisition through a 51% ownership interest in Birchfield Ventures LLC, the company seems to be active in the financial markets with an intent and improved ability to make future moves.

Therefore, when considering Matthew Rudd's role as CFO and the person tasked to handle these deals, LIQ needs an experienced financial officer with previous M&A experience. Looking at Mr. Rudd's track record, his 7 year tenure at KPMG in the financial services division offers limited value for shareholders from that perspective. For a company of LIQ's size, having the in-house experience and understanding of M&A saves the company money spent on investment banking fees while also ensuring effective acquisition decisions.

Additional Shareholder Information

When evaluating LIQ's shareholder information, due to the company's size and the public's perception of alcohol-related equities, the stock is not held by many institutional investors. As of September 30, 2016, Dimensional Fund Advisors LP, Hexavest Inc., and PE firm PointNorth Capital were among the only major investors. Therefore, when considering the company's management team and shareholder breakdown, there are several concerns regarding the relevant experience of management and confidence shown by institutional investors.

While some of this risk may be inherit to the investment proposition of any alcohol-related equity, further institutional support or coverage would increase market awareness significantly. In addition, with management confirming that there will be no more changes to the C-suite level in the following quarters, investors should not expect any changes in the medium term.

Quarterly Performance

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LIQ reported its latest Q3 quarterly report on November 9th, 2016, and results were stronger than expected as net earnings grew by 10.7% yoy while total sales grew by 7.5%. When analyzing the geographic breakdown of sales, total Canadian store earnings increased by 1.3% while total US store sales increased by 22.8%. With LIQ reporting net earnings of $4.6 million following another strong quarter in Q2, it seems that the company has recovered from its disastrous Q4 in 2015 where the company reported a $129.6 million impairment charge.

The impairment was due to downward adjustments to management's forecasted sales and profitability as a result of the rapid and significant economic slowdown in the key markets of Alberta and Alaska. Although the writedown was significant to the bottom line, the company actually reported a 3.1% increase in total Canadian sales and a 8.9% increase in total segmented sales. In addition, during this recessionary period, the gross margin remained constant at the 25.5% level proving that even with these difficult market conditions, LIQ's business model is resilient from both an earnings and cost perspective.

When breaking down the company's quarter, the $15 million USD acquisition of Birchfield Ventures in Q4 of 2015 continues to impact the overall growth of sales. While total segmented revenues increased yoy, LIQ's same store sales (SSS) in both Canada and the US declined by 2.1% and 1.2% respectively. When analyzing the $2.6 million decrease in Canadian SSS, the economic slowdown in Alberta paired with poor weather during key sales weekends in many markets reduced customer traffic.

Management highlights that in the resource and rural regions of Alberta, SSS declined by 10% to 15% which illustrates how severe the economic situation is in the province. Conversely, the SSS decline of $0.5 million in the US was largely due to increased competition in the Kentucky market (15 LIQ locations) as a nearby county moved from a dry (no retail sales of alcohol) to wet (retail sale of alcohol permitted) policy.

From a cost perspective, LIQ reported a 3.6% yoy increase in operating and administrative costs, which was largely driven by the increase in sales and the related administrative costs of Birchfield. In addition, the company opened nine stores since Q3 of 2015 while closing six, which has further increased operating costs.

Fortunately, a $0.5 million expense reduction was reported due to increased efficiencies, which was largely due to the ongoing improvements made to several locations. This cost reduction sourced through improved infrastructure is a positive for investors as management has expressed their desire to continue investing into LIQ's existing store base. On Q3's earnings call, Stephen Bebis comments:

"We approximately invested about $2.5 million in renovations despite the headwinds and we continue to see strong sales growth after finishing the renovations, between 15% to 20%, for example, we just finished and re-opened one of our stores here in Alberta -- a store that's been around for maybe 15 years. And we had a 30% increase in the first two to three weeks in same-store sales. So I look forward to completing even more renovations next year because they work financially, and they provide a strong return on capital employed."

With the recent success of these renovations increasing sales and earning over 20% in ROIC, the expected completion of 10-12 more renovations in Q4 of 2016 will continue to accelerate earnings as the holiday season begins. Based on current economic conditions, management expects to invest approximately $4 to $6 million for further store refurbishments in 2017. When looking at the $2.5 million expense for an expected 13 renovations in 2016, the increased budget in 2017 is predicted to refurbish around 20 to 30 locations.

Things To Watch For In Upcoming Quarters:

Saskatchewan Government Request For Proposal (RFP)

On LIQ's Q3 earnings call, Stephen Bebis was asked about the privatization efforts in Saskatchewan as the province announced that 40 government-owned liquor stores will be sold while 12 new private stores will be allowed to operate in the province. So far, the government has not completed its evaluation of LIQ's submitted RFP, however management expects that if approved, LIQ is able to open between two to eight stores in the market.

Fort McMurray Insurance Claims

As identified in LIQ's Q2 report, on May 1st, 2016, the city of Fort McMurray, Alberta issued evacuation orders due to a massive forest fire in the area. The company has 7 convenience format stores in the region, which were closed and did not re-open until mid-June after remediation efforts were completed. Management had filed an insurance claim in Q2 to recover certain losses under their coverage plan and was expecting to see their claim go through this past quarter. In Q3, the company did not provide on update on this claim in the MD&A or conference call.

LQR NKT Store Expansion Strategy

The company opened its first, 20,000 square foot LQR MKT store in Norwalk, Connecticut. Stephen Bebis has said that expanding into the Connecticut region "is going to be a very strong market for us," which seems to represent a change in the company's strategy. With LIQ already established in Kentucky, expanding their market presence helps diversify US operations as competition across the country increases. In addition to market expansion, the new LQR MKT brand seems to focus on developing a more personal in-store experience that will "inspire customers to discover an unmatched selection of beer, wine, and spirits."

Debt Challenges

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^Author's own work

The biggest challenge for LIQ's profitability and overall valuation remains the company's long term debt load of $156.8 million and its limited cash balance of $3.9 million. With current economic conditions continuing to limit earnings potential, investors need to consider the finance costs required to service LIQ's existing debt while ensuring that upcoming maturities are able to be met. In Q3, LIQ paid $2.7 million in interest expense and when considering the company's recent actions to free up capital, including cutting the dividend in Q4 of 2015 by 67%, current quarterly EBIT of $9.4 million is more than sufficient in covering these interest payments.

In the past quarter, management responded to concerns regarding the upcoming $110.6 million bank indebtedness due in 2017. On September 29, 2016, the company issued $67.5 million in convertible unsecured subordinate debentures due in 2022, which bear a rate of 4.7% and are convertible at a conversion price of $14.6 per share. On October 4, 2016, the underwriting syndicate exercised the over-allotment option (allowing to sell up to 15% more debentures) and issued an additional $10.125 million in aggregate debentures. Proceeds from the raise were used to pay down the $110.6 million bank indebtedness due in 2017, which now stands at $30.5 million. In addition, on August 31, 2016, the company were able to extend the maturity date to 2019 and increased the funds available to $165 million CAD and $15 million USD due to the company's improved ability to pay down the remaining amount of the credit facility.

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^Sourced from LIQ Q3 Quarterly Report

When considering the company's financial obligations, the maturing 5.85% debentures with a principal value of $67.5 million in 2018 and the newly renegotiated $30.5 million bank indebtedness maturing in 2019 are the two key dates from a credit perspective. It is unlikely that LIQ will be able to cover these principal repayments even if cash flows improved due to a recovery in the Alberta market. Thus, investors should assume that based on the success of the recent debenture raise, LIQ will return to the debt market in the following years to cover these loan obligations. Not only does this provide certainty for longer term investors, the opportunity to renegotiate terms in this low interest rate environment should reduce LIQ's finance expense as seen through the newly issued 4.7% coupons that were used to pay down a large portion of the more costly $110.6 million bank indebtedness due in 2017.

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^Author's own work

When considering these developments, several positive comments can be made regarding the current debt situation for the company. Firstly, the debenture raise was telling for investors as the greater-than-expected market demand for LIQ's offering, which triggered the over-allotment option, indicates that creditors continue to believe in the growth potential of the business and its ability to pay down debt. In addition, the revolving credit facility that includes $15 million USD and $165 million CAD available to LIQ is favorable as the company now has the option to access US funds for acquisitions south of the border.

Liquor Stores NA 7-Point Strategy

Since 2013, LIQ has clearly communicated the company's strategy through its 7 point plan focused on supporting long-term profitability and driving growth across the business. The following seven points were recently updated in Q3 as the prolonged period of economic pressure in Alberta impacted projections.

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^Author's Own Work

As mentioned in the management analysis, LIQ has completed only one of the seven points outlined in this strategy by enhancing the leadership team with several new additions in 2015. Looking to the other objectives, LIQ has confirmed that both its investment in people and its store network continue to be on target with over 90% of their store managers expected to complete an industry leading training program by the end of 2016. In addition, with the continued investment in store renovations generating sales success, LIQ is expected to expand its store refurbishments budget in the coming year, which should increase annual capex expenditures and exceed previous projections.

However, the key objective for LIQ remains its expansion efforts as the company looks to diversify revenues and reduce its exposure to the Alberta market. Management comments on point seven:

"To adjust to current economic conditions, the Company expects to open four to seven new stores over the next 24 months. The Company will continue to monitor economic conditions and evaluate plans for 2017 new store constructions in due course. Management will continue to evaluate and assess potential store acquisitions for their ability to add accretive cash flow and create shareholder value."

The projection that LIQ will add between 4-7 new stores in the coming 24 months is highly probable as the company has been very strict with its expansion projections. While this is a positive for longer term growth and diversification, the capital outlay required to acquire or open new stores will impact net earnings if the Alberta market doesn't see improved sales. When considering the Birchfield acquisition that saw the company pay $15 million USD for two stores, the potential acquisition(s) required to meet this projection may increase the company's debt load, a persistent challenge for LIQ.

Liquor Stores NA Store Network

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^Author's Own Work

When considering LIQ's asset base of 253 stores, throughout the past 5 years, the company has incrementally grown its store network while also closing many unprofitable locations. Since 2010, LIQ's total store count has only increased by 7% whereas the company's total quarterly earnings have increased by 37.7% in the same five year period. The reason behind this strong growth in earnings versus the limited expansion of LIQ's store network is due to management's emphasis on strong same store performance.

Longer-term shareholders are familiar with the constant turnover seen across the company's store network as almost every quarter, numerous stores are closed down and replaced with new locations in order to ensure consistent same store sales growth.

However, the risk which continues to increase pressure on LIQ during this recessionary period in Alberta is the type of consumer market the company is exposed to. While over 58% of stores are in cities with a population of 300,000 or more people, the remaining number that operate in smaller municipalities increase the volatility of sales during these economically challenging period. Unlike bigger cities where average income and total economic activity are significantly larger, these smaller regions pose a risk to store profitability and can impact SSS performance significantly, a risk which needs to be addressed by management in the future.

Valuation

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^Author's Own Work

To provide a more model-based confirmation of the company's valuation, instead of projecting into the future, a DCF model can be built to recreate the current share price. Then, by understanding the necessary assumptions (revenue and FCF growth) reflected in today's share price, investors are able to decide whether the company is fairly valued. In the example above, a valuation spectrum is graphically presented, with the current share price, $10.64/share, illustrated by the bottom line.

When considering the growth assumptions factored into the current share price, the market expects LIQ to grow its quarterly revenues by 1% through Q4 of 2020 with a terminal value growth rate of 2.5% and a market premium of 10%, twice the historical average. Revenue projections remain essential to valuing LIQ as the company's gross and operating margins have remained consistent even during the recessionary periods seen earlier this year.

Compared to the 2.29% average quarterly growth rate of revenues in the past six years, the expected 1% growth rate is largely undervaluing LIQ's potential as the company continues to expand the business and profits. A more suitable projection that would account for the current downward pressure and future expansion efforts would be a 1.5% growth rate with a lower market premium of 8% (Appendix B). Using the updated growth rate and WACC of 4.91%, the projected DCF value is $15.39/share, a premium of 45% to current market levels.

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^Author's Own Work

When attempting to conduct a comparable analysis, it remains challenging to find direct competitors for LIQ. Rocky Mountain Liquor is the only other competitor in the retailing side of the business however with a market cap of just $4.3 million, the company offers a limited perspective of market sentiment. Instead, the analysis attempts to consider two different groups: (1) the retailers and Canadian brewers with market caps under $600 million and (2) large cap producers.

The first group provides more insight into the market sentiment surrounding the Canadian alcohol industry whereas the second group provides a more global perspective on the industry and expectations for future growth. When comparing LIQ to both groups, the company's price/sales, price/book, price/CF, and P/E are all below the market median indicating a clear undervaluation.

While both the comp and DCF analysis confirm that LIQ is undervalued, it is important to identify a key risk to these projections; the volatility of gross margins (Appendix C). Like any other retailer, the consistency of margins is important to the bottom-line of the business and when considering an incremental change to current levels, projections could differ greatly. Fortunately, the business has clearly proven that throughout different recessionary periods, its operating costs have remained in line with overall sales growth.

Investment Decision - Highlights

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^Author's Own Work

  • Industry Positioning - With the alcohol industry experiencing increased competition through the rise of craft beer and declining demand in emerging markets, producers have been hurt from an earnings perspective. As a retailer, LIQ is protected from many of these trends while actually benefiting from more expensive craft beer sales.
  • Recession Proof? - When considering the possibility of LIQ experiencing recessionary pressures, the recent collapse of oil and its implications for Alberta was the perfect case study on how the company would perform. While confidence declined which impacted the share price, margins remained consistent and profits recovered within the quarter.
  • Macro Exposure - When considering the 40% decline in the company's share price from October of 2015 to March of 2016, it remains clear that the equity was oversold based on increased concerns regarding the Alberta oil market rather than changes to company-specific conditions. Therefore, the market has pegged the performance of the equity to the price of oil which unfairly values the company but provides insight into the conditions needed to see the equity recover to 2015 levels.
  • Management Strength - While CEO Stephen Bebis brings a wealth of experience and strategy, which has been seen through LIQ's US expansion, the supporting C-suite team are questionable.
  • Activist Pressure - PointNorth Capital, a major shareholder in the company recently released a statement outlining their desire to speak with management about "operational performance and corporate strategy." Reports have already emerged that this interest could signal future activist pressure.
  • Debt Challenges - With a current long term debt load of $156.8 million CAD, the company's valuation will be limited in the long term as it continue to pay down debentures. While the company is expected to pay around $2.8 million CAD in quarterly interest, as upcoming principals come due, the financing expense is expected to decline by $0.4 million in 2018.
  • Store Strategy - In-store refurbishments have been successful from a sales perspective and while IT infrastructure upgrades have been delayed, the company values the importance of maintaining profitable stores ensuring long term stability in margins.
  • Valuation - With a projected 45% premium to market levels, LIQ is undervalued based on current valuation ratios and projected cash flows. As the company continues to expand in the US, increased profitability and more sustainable revenues will increase the fundamental value of the company.

Conclusion: Based on the SWOT analysis above, Liquor Stores NA offers an attractive long term investment opportunity with considerable upside. Buy.

Appendix

1) Current Industry Trends

Craft Brewing - As of 2015, craft brewers reported a 13% increase in volume, the eighth consecutive year of double-digit growth which now represents 12% of the total beer market. The rise of craft brewing in recent years has been fueled by changing consumer preferences as standardized brands are unable to compete with the unique tastes offered by craft beer. In the US, there are more than 4,144 breweries as of 2015 breaking the previous all-time record set in 1873. While some producers have acquired major craft brands, the increasing number of brewers in local markets continue to fuel price competition thus threatening established market share and revenue projections.

Global Consumption - In 2015, reports confirmed that the overall volume of alcohol consumed globally dropped by 0.7% yoy which was the first decline in over 15 years. While fears of market saturation and changing consumer tastes have threatened producers, in dollar terms, the industry has actually benefited from these changes as global sales saw a 2% increase yoy.

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^Sourced from Euromonitor

Emerging Markets Growth - When analyzing the 0.7% decline in global alcohol consumption levels, developed markets like the United States and Japan actually reported steady gains of 2.4%. Instead, emerging markets have been the major underperformers in the past year as volumes in China, Brazil, and Russia, declined by 3.5%, 2.5%, and 7.7% yoy respectively. This drop in consumption can largely be attributed to the difference in consumption habits between developed countries and developing markets. Unlike more developed markets where consumption remains stable throughout different business cycles, emerging markets experience increased challenges as price and income volatility limit the demand and accessibility of these beverages during recessionary periods.

Industry Consolidation - As pricing growth continues to be limited and product competition increases, producers over the past decade have consolidated to realize internal synergies and improve top line growth. In 2004, the industry's top 10 brewers controlled 51% of total market volume; however, by 2014, 47% of the market was held by just 4 companies. Looking at the $103 billion USD mega-merger between AB InBev and SABMiller, the key driver of value for both companies remains the potential cost savings generated from consolidating operations. With increased competition from local craft brewers impacting margins, consolidation remains the easiest form of improving top-line growth and driving operational savings.

E-Commerce Growth - While there are many regulatory challenges that need to be overcome in North America, the early success of online alcohol sales in the UK and France indicate an area of future growth. Gilles Bogaert, the CFO of Pernod Ricard (OTCPK:PDRDY), predicts that in the next seven to eight years, 5% of all industry sales will be through digital channels.

2) DCF Model Growth Rate Decision

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^Author's Own Work

The reason why a 1.5% quarterly growth rate in revenues was chosen for the model is based on the company's efforts to expand its US store base while continuing to invest in store refurbishment programs. From 2013 to 2015, LIQ added seven US-based stores, which helped grow revenues by a CAGR of 6.3%. With management confirming in the past quarter that LIQ is expected to open between 4-7 stores in the coming 24 months, assuming a similar growth rate to previous periods remains a fair projection. At a 1% quarterly rate, revenue would grow by a CAGR of 4%, which would result in a 2020 FCF projection of only $9.8 million, significantly lower than 2015's $30.9 million value and the projected $20.8 million for 2016.

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^Author's Own Work

Therefore, a better projection would be the quarterly 1.5% growth rate as the company, in line with its 6.3% CAGR in the past three years, would report a CAGR of 6% through 2020. At the projected $15.39/share level, the company will earn $12.3 million in FCF in 2020, which factors in a possible prolonged period of low-oil while also adjusting to the increasing store base and its revenue implications. In this scenario, total annual revenues are expected to reach $1 billion by 2020, which based on the company's current 253 store network and SSS performance would assume that in the next four years, LIQ would add around 50 stores.

In addition, when considering the difference in WACC values between the two models, the WACC was lowered from 5.27% to 4.91% due to the change in market risk premium, which fell from 10% to 8%. If the company's performance was fundamentally tied to the price of oil, the market premium of 10% would make sense as most oil stocks are valued at that level. However, when considering the consistent performance of alcohol sales and demand throughout the different business cycles, assuming a much lower 8% premium would more fairly value the company's future potential.

3) Sensitivity of Gross Margins

Click to enlarge

^Author's Own Work

While the average gross margin for LIQ in the past two years has been 25.54%, the company's valuation could differ significantly in a scenario where margins are negatively impacted either through increases in competition or price changes. Consider the current 1.5% growth model and its projected $15.39/share price. With the long-term growth rate held constant at 2.5%, a permanent 0.5% decline in long term gross margins would lower the model's projection to $9.32/share. Therefore, while the risk of a gross margin decline is limited as the company continues to prove its durability in the face of recessionary pressures, such a change is a risk that investors need to consider.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.