DBRS Confirms Loblaw Companies Limited, Changes Trend to Positive

DBRS Limited (DBRS) has today confirmed the Issuer Rating, Medium-Term Notes and Debentures ratings of Loblaw Companies Limited (Loblaw or the Company) and the Senior Unsecured Debt rating of Shoppers Drug Mart Corporation (Shoppers) at BBB as well as Loblaw’s Short-Term Issuer Rating at R-2 (middle) and its Second Preferred Shares rating at Pfd-3. DBRS has changed the trends to Positive from Stable. DBRS has also discontinued Loblaw’s Cumulative Redeemable Second Preferred Shares, Series A rating as the preferred shares were previously repaid.

The trend change reflects the Company’s deleveraging efforts and successful integration subsequent to the acquisition of Shoppers as well as its solid operating performance in both food retail and pharmacy through the end of F2015. The ratings continue to be supported by Loblaw’s business profile which is considered very strong for the current BBB rating, featuring industry-leading size, scale and market positions in retail and pharmacy across Canada. The ratings also incorporate the intense competition in food retail in Canada and the risks associated with drug pricing and pharmacy reforms.

On March 25, 2015, DBRS confirmed Loblaw’s ratings and maintained a Stable trend. The rating actions considered Loblaw’s solid operating performance in 2014 and deleveraging efforts, which were expected to result in credit metrics that would be considered acceptable for the BBB rating by the end of 2015. DBRS also stated that, should operating performance remain solid and credit metrics continue to improve further (i.e., toward lease-adjusted debt-to-EBITDAR of 3.25 times (x)) as a result of growth in operating income and/or more debt repayment than expected, a positive rating action would likely result.

Outlook

DBRS has changed the trend to Positive in recognition of Loblaw’s strong business profile, combined with the Company’s sound operating performance relative to peers in F2015, its achievement of synergies and its deleveraging efforts. Loblaw’s efforts resulted in continuing improvement in its key credit metric (i.e., lease-adjusted debt-to-EBITDAR attributable to Retail and Choice Properties Real Estate Investment Trust (CP REIT) of 3.41x for F2015) toward a level (3.25x) that DBRS would consider appropriate for the BBB (high) rating for a company with Loblaw’s size, scale, market position and diversification.

Going forward, DBRS believes that Loblaw’s earnings profile should continue to improve, benefiting from current levels of food inflation and a rational competitive environment, partially offset by the impact of continuing drug pricing reforms. Consolidated revenues attributable to Retail and CP REIT should increase toward the $47 billion level by the end of F2017 based on low- to mid-single digit same-store sales growth and modest net square footage growth (approximately 1.0% in F2016). In addition, revenues will benefit from the consolidation of remaining franchisees (in F2016), partially offset by the disposition of certain assets of the Shoppers ancillary health-care business. Adjusted EBITDA margins attributable to Retail and CP REIT should benefit from improved operating leverage as selling, general and administrative (SG&A) rate improves with sales growth and efficiency gains from recent information technology (IT) initiatives more than offsetting rising investments in in omnichannel (i.e., Click and Collect, beautyboutique.ca) and loyalty. Adjusted gross margins should remain relatively flat as Loblaw passes on price increases to its customers, despite continuing pressure on drug retail gross margin from regulatory reforms. Adjusted EBITDA margins should also benefit from the disposition of certain assets of the Shoppers ancillary health-care business and further achievement of synergies. As such, DBRS believes that Loblaw’s adjusted EBITDA attributable to Retail and CP REIT should increase above the $3.6 billion level by the end of F2017.

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 should continue to track operating income while capital expenditures (capex) attributable to the retail operations is expected to decline moderately to approximately $1.0 billion. Retail capex will focus on improving existing stores as well as new food and drug store openings as larger supply chain and IT initiatives have been completed. DBRS believes that dividends on a per-share basis will continue to grow at a steady pace, but the cash outlay for dividends should remain near the $400 million level (as share repurchases are completed). As such, DBRS believes that free cash flow before changes in working capital should increase toward the $900 million to $1.0 billion range. Free cash flow is expected to be used to complete share repurchases. As a result, DBRS believes that balance-sheet debt should remain relatively stable and credit metrics should continue to improve as earnings grow.

If DBRS becomes confident in the next six to 12 months that Loblaw’s operating performance will remain sound and balance-sheet debt will remain fairly stable resulting in continued improvement in credit metrics, a ratings upgrade to the BBB (high) level would likely result.

Background

Since the last DBRS confirmation on March 25, 2015, Loblaw released F2015 results which delivered solid operating results in both food retail and pharmacy; further integrated Shoppers, including delivering planned synergies; and completed the Company’s debt repayment efforts. Revenues attributable to the Retail and CP REIT segments increased approximately 8.6% to $44.5 billion versus nearly $41.0 billion (excluding the 53rd week) in F2014. The increase in revenue was driven primarily by the full-year contribution from Shoppers as well as same-store sales growth in food and pharmacy, partially offset by a modest decline in net square footage consistent with the Company’s announced closures of unprofitable stores. Comparable (52-week) food retail same-store sales (e.g., gas and tobacco) increased 3.5%, driven primarily by inflation as well as increased basket size and traffic, partially offset by changes in mix. Comparable same-store pharmacy sales growth of 3.7%, caused by a 4.3% increase in the number of prescriptions dispensed, was partially offset by a modest decline in average prescription value. Same-store front-store drug retail sales continued to accelerate, growing 4.7% in F2015, benefiting from enhanced product offerings after the acquisition of Shoppers by Loblaw.

Adjusted Retail segment EBITDA margins benefited from the net impact on gross margin and SG&A expenses as a percentage of sales of the full-year contribution of Shoppers as well as the consolidation of franchisees and the modification of franchisee arrangements. Excluding such items, adjusted EBITDA margins benefited from modest adjusted gross margin expansion driven by food and drug synergies, which were partially offset by a decline in drug retail gross margin caused by the continuing impact of health-care reform. SG&A as a percentage of sales was flat as higher operating costs and changes in foreign exchange were offset by fair value changes in franchisee investments and improved efficiencies in food retail supply chain, administrative and IT. As such, adjusted consolidated EBITDA attributable to Retail and CP REIT increased to approximately $3.4 billion in F2015 versus nearly $3.0 billion for a comparable 52-week period in F2014.

Loblaw’s financial profile improved through F2015 as the Company completed its stated debt repayment plan related to the acquisition of Shoppers before shifting use of its free cash flow to completing share repurchases. Cash flow from operations as calculated by DBRS (before changes in working capital, after interest paid) was flat versus the previous year at nearly $2.4 billion in F2015 while capex increased moderately to $1.2 billion as Loblaw invested largely in its retail operations as well as IT and supply chain. Cash outlay for dividends declined, despite an increase in the per-share common dividend because of an extra dividend payment and the payment of a previously declared Shoppers dividend in the previous year (F2014). The Company used a portion of free cash flow to repay nearly $600 million of long-term debt, with the remainder used to complete share repurchases. As such, balance-sheet debt attributable to Retail and CP REIT (excluding Financial Services) declined to $9.7 billion at year-end F2015 versus nearly $10.5 billion in F2014. Combined with the growth in adjusted EBITDA, credit metrics continued its improvement to a level considered strong for the current rating (i.e., lease-adjusted debt-to-EBITDAR and lease-adjusted EBITDA coverage attributable to Retail and REIT of 3.41x and 4.76x for F2015 versus 3.90x and 4.66x, respectively, for F2014).

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

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 to the right under Related Research or by contacting us at info@dbrs.com.

This rating is endorsed by DBRS Ratings Limited for use in the European Union.

The Senior Unsecured Debt rating of Shoppers Drug Mart Corporation is guaranteed by Loblaw Companies Limited.

The applicable methodologies are Rating Companies in the Merchandising Industry, Rating Companies in the Real Estate Industry, DBRS Criteria: Guarantees and Other Forms of Explicit Support and Preferred Share and Hybrid Criteria for Corporate Issuers, which can be found on our website under Methodologies.

For more information on this credit or on this industry, visit www.dbrs.com or contact us at info@dbrs.com.