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It's hard not to like the long-term profit opportunities from the combination of Loblaw Cos. Ltd. and Shoppers Drug Mart Corp. The pharmacy chain will benefit from Loblaw's logistics capabilities, while the grocer is paying a reasonable price for a way to cash in on Canada's aging population.
The deal will not magically transform Loblaw's stock into a screaming buy for growth investors. But by creating synergies and expanding the retail reach of both firms, the combined company now appears more likely to grind out predictable growth and dividends. For long-term dividend investors, it is now a nice buy-and-forget stock that can anchor the middle of your portfolio, creep higher and spit out cash.
To be sure, these are two mature businesses that are going to walk, not sprint, ahead. Both have struggled with anemic earnings growth in recent years. Loblaw's same-store sales have expanded only 0.7 per cent over the past four quarters while Shoppers' same-store increase has been only marginally better at 2.1 per cent.
Joining forces should help on two fronts. One, management expects $300-million in savings from combining marketing, purchasing and supply chain functions. Two, both companies should benefit from increased sales of their highly profitable private label products, which will now be available in twice as many locations. Private-label products can generate gross margins of close to 40 per cent, 10 percentage points higher than national brands because of lower marketing and distribution costs.
The biggest saving for Shoppers is likely to come from adopting Loblaw's supply chain. Selling groceries is a low margin business that demands extraordinary efficiency. Produce, for instance, must be sourced across the globe then transported quickly to thousands of stores in exactly the right quantities so that customers are never confronted with either empty shelves or rotting bananas. If we assume that Galen Weston was wise enough to get assuring noises from the Competition Bureau and the deal goes through, Shoppers stores will benefit from tapping into Loblaw's massive logistics chain.
Meanwhile, the potential acquisition of Shoppers will allow Loblaw to benefit from the aging of Canada's population. The growing 65-plus population translates into increased demand for pharmaceuticals and, for Shoppers, higher revenue from fulfilling prescriptions. The U.S. Centers for Medicare & Medicaid Services found that the percentage of the U.S. population taking at least one prescription treatment was 85 per cent for the 65-and-older age group, compared to 36 per cent for the 18-to-44 year old segment.
Put it all together and the deal allows Loblaw to improve its long-term growth prospects at a reasonable price. The 27 per cent premium to Shoppers' Friday closing price looks a bit rich at first glance, but is not exorbitant relative to industry standards. The takeout prices values Shoppers at 11.3 times EBITDA (earnings before interest taxation depreciation and amortization). By comparison, U.S. drug chain Walgreen's trades at 10.2 times EBITDA.
The Canadian pharmacy chain has been hit by recent government regulation limiting profits from generic drug distribution. But the company still deserves a premium multiple. It is a well-known and widely trusted company with a brand that presents significant barriers to competition.
Importantly, both drug stores and grocers are counter-cyclical businesses. If the current global slowdown continues, the combined company's stock is likely to carry a higher price-to-earnings ratio, because investors will be willing to pay a higher stock price for dependable earnings growth .
The proposed deal looks appealing for both companies. The new bulked-up Loblaw bears all the hallmarks of a stock that bores shareholders to death right up until they realize it's up 50 per cent while paying a hefty dividend the whole time.
Scott Barlow is a contributor to ROB Insight, the business commentary service available to Globe Unlimited subscribers. Click here to read more of his Insights , and follow Scott on Twitter at @SBarlow_ROB .
Scott Barlow