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A Metro store in Mississauga. (J.P. MOCZULSKI For The Globe and Mail)
A Metro store in Mississauga. (J.P. MOCZULSKI For The Globe and Mail)

Beware false complacency on Loblaw, Empire stock Add to ...

It was just over a year ago that the Canadian grocery landscape shifted dramatically with the announcement of two large deals: Sobeys Inc. acquiring Safeway’s operations in Canada, and Loblaw Cos. Ltd. following with a deal to buy Shoppers Drug Mart Corp.

That came just a few months after I suggested a wave of M&A in the sector – and that investor excitement about the transactions could lead to gains for the grocers’ shares in 2013. That prediction was dead-on, but the latter half of my forecast – that heavy competition in the grocery space would lead “the story to turn stale” in 2014 – hasn’t yet materialized.

A big part of that has been the shocking incompetence of Target Corp. and its disastrous Canadian expansion. Rather than providing tough new competition for Canadian retailers, Target has created a money-sucking white elephant that some analysts say is easier scrapped than fixed.

That means that the major Canadian grocers have posted better results than some expected, and the share prices have followed. While none of the companies has returned to their merger-induced peaks of mid-2013, all have posted at least small gains, year-to-date. Loblaw, the largest, which reports its first full quarter of Shoppers Drug Mart ownership next week, is the big winner, having gained more than 17 per cent this year as its numbers have impressed.

It’s possible more of the same is in store for the remainder of 2014. But we’ll stick to our original forecast: Competition from Wal-Mart Stores Inc., and perhaps Target, means the very real possibility of eroding profit margins – and share prices – for Canada’s major grocers over the long term.

As Target has amply demonstrated, Canada is not the United States. But our thesis is based on what happened south of the border as Wal-Mart and Target built out their network of grocery-selling stores.

A decade or so ago, U.S. grocery giants Kroger Co. and Safeway had EBITDA (earnings before interest, taxes, depreciation and amortization) margins of 7 per cent or more. In those 10 years, however, Wal-Mart tripled the number of its “super centres” to more than 3,000, and Target added more than 1,000 stores that had a full line of groceries. Kroger and Safeway now regularly post EBITDA margins below 5 per cent (and sometimes below 4 per cent).

The rising tide in U.S. markets has lifted Kroger and Safeway’s multiples above the levels seen in our first analysis in February 2013. But they have enterprise values – market capitalization plus net debt – of less than seven times EBITDA. The three major Canadian grocers’ EV/EBITDA multiples all check in at 7.5 to 8.5, per Standard & Poor’s Capital IQ. If their margins decline, their multiples will likely follow quickly.

Target’s botched Canadian arrival in 2013 didn’t send the legacy grocers’ traffic of profit numbers into freefall – Loblaw, in particular, impressed with its combination of sales and margin results – and many investors concluded that competition wasn’t dealing the grocers a crushing blow.

“It’s easy when Target’s messing up to say, ‘We’ve done everything right, and improved our proposition, and customers are happy with us,’” says Morningstar analyst Ken Perkins, who covers Loblaw and Metro Inc. “So the market said ‘Maybe this is absorbable. Maybe it’s not a big deal for these guys.’”

Mr. Perkins, however, fears it’s a false sense of complacency, and he estimates both companies’ fair values a few dollars below their current levels. “It’s sort of out-of-sight, out-of-mind for the long-term perspective of what’s going to happen in the next three to five years,” he says.

But what if you don’t believe that Canada will ever see the U.S. level of competition? Given what’s happened so far, and how our original forecast is at least deferred, it’s worth examining the views of those who see a path to profits for investors in the grocers’ shares.

Analyst Irene Nattel at RBC Dominion Securities says 2013, with Target’s entry and 39 former Zellers turning into Wal-Marts, saw Canadian grocery square footage grow 3.5 per cent, twice as fast as the historical norm. After the second half of this year, that number should normalize, “which should help ease pressure on the incumbents.”

To Ms. Nattel, who has an “outperform” rating on Loblaw stock, one of the big stories at the retailer is the completion of its multiyear effort to modernize its information technology and supply chain. She believes it will create efficiency gains that will not only improve margins but also free up cash to invest in driving sales.

The acquisition of Shoppers Drug Mart, she says, “should result in accelerated underlying earnings growth, enhance Loblaw’s exposure to health and wellness, provide increased penetration to Loblaws in urban areas, and create an even larger gap relative to competitors in terms of both revenue and EBITDA,” she says. Her target price is $55, versus Friday’s close of $49.44.

Perry Caicco of CIBC upgraded Empire Co. Ltd., the parent of Sobeys and Canada’s second-largest grocer, to “sector outperformer” in late June after its fourth-quarter earnings report and its decision to close about 50 stores in its newly expanded network. With EBITDA that beat Mr. Caicco’s forecast, and the prospect of the worst-performing stores culled from the network (and reducing overall grocery industry square footage growth in 2014), Mr. Caicco added $2 to his price target, raising it to $82, versus Friday’s close of $72.85. “As we have detailed in previous reports, 2015 looks like it could be a better year for the industry, and Sobeys’ closure announcements make that more probable,” he says.

It’s understandable if investors agree, and decide to try to ride the grocers’ gains further. But we warn, again, that this story has a limited shelf life.

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