DBRS Morningstar Upgrades Loblaw Companies Limited to BBB (high), Changes Trend to Stable

DBRS Limited (DBRS Morningstar) upgraded the Issuer Rating, Medium-Term Notes, and Debentures ratings of Loblaw Companies Limited (Loblaw or the Company) to BBB (high) from BBB. DBRS Morningstar also upgraded Loblaw’s Short-Term Issuer Rating to R-2 (high) from R-2 (middle) and its Second Preferred Shares rating to Pfd-3 (high) from Pfd-3. DBRS Morningstar changed all trends to Stable from Positive. The upgrades reflect Loblaw’s sound operating performance over the last number of years, independent of the Coronavirus Disease (COVID19) pandemic-related effects on operating results, combined with improved credit metrics following the spin-out of Choice Properties Real Estate Investment Trust (Choice; rated BBB (high) with a Stable trend by DBRS Morningstar). While uncertainties related to the intensity and duration of the coronavirus pandemic as well as the macroeconomic aftereffects remain, the Stable trends reflect DBRS Morningstar’s view that Loblaw is well positioned to navigate the current environment within the new BBB (high) rating category. The BBB (high) ratings also reflect the Company’s strong business risk profile, including its position as Canada’s largest food and drug retailer, and continue to consider the intense competition in Canadian food retail.

On October 8, 2019, DBRS Morningstar changed all trends to Positive from Stable, based on the Company’s strong business risk profile, stable operating performance, and improved credit metrics following the spin-out of Choice at the end of 2018. At the time, DBRS Morningstar stated that, if Loblaw’s operating performance and leverage remained relatively stable over the next two to four quarters, DBRS Morningstar could upgrade the Company’s ratings to the BBB (high) level.

Since then, Loblaw has reported results for four quarters (H2 2019 and H1 2020), during which operating performance remained sound, independent of the temporary effects related to the coronavirus pandemic, which include a significant increase in retail sales volumes and meaningfully higher operating costs.

During H2 2019, operating performance remained relatively stable, benefitting from sound sales growth and relatively stable EBITDA margins. Revenues during H2 2019 increased 2.8% year-over-year (YOY), rising to $26.2 billion, primarily driven by approximately 1.2% food retail same-store sales growth and approximately 4.0% drug same-store sales growth. EBITDA margins excluding IFRS 16 remained flat at approximately 7.7% (10.3% including IFRS 16), underpinned by stable food retail margins. As such, EBITDA excluding IFRS 16 grew by approximately 3.8% to above $2.0 billion ($2.7 billion including IFRS 16) YOY during H2 2019.

Operating performance during H1 2020 was heavily affected by the outbreak of the coronavirus pandemic. Revenues increased 9.0% YOY, rising to $23.8 billion, driven by 9.8% food retail same-store sales growth and 4.7% drug same-store sales growth. EBITDA margins including IFRS 16, however, declined by approximately 100 basis points YOY to 9.2%, primarily as a result of increased coronavirus-related costs around the health and safety of customers and employees, including a temporary pay premium and one-time bonus. As such, EBITDA including IFRS 16 declined by 1.4% to $2.2 billion YOY during H1 2020. That said, DBRS Morningstar notes that EBITDA excluding the temporary pay premium and one-time bonus would have increased almost 7.0% to approximately $2.4 billion YOY during H1 2020.

Loblaw continued to generate significant levels of free cash flow (FCF) in the last twelve months ended June 30, 2020, which the Company primarily used to build its cash balance and for share repurchases. As such, key credit metrics (excluding Financial Services) remained relatively stable, that is, debt-to-EBITDA including IFRS 16 (net of $350 million of notes repaid subsequent to H1 2020) of 2.96 times (x) at the end of H1 2020 versus 2.97x at the end of H2 2019. Excluding IFRS16, debt-to-EBITDA was approximately 2.62x at the end of H2 2019 versus 2.64x at the end of H1 2019. DBRS Morningstar notes that the implementation of IFRS 16 and the resulting effect on certain metrics does not have a material impact on DBRS Morningstar’s view of the overall credit risk profile of Loblaw.

Going forward, DBRS Morningstar expects Loblaw’s earnings profile to remain relatively stable, benefitting from modest revenue growth and relatively stable EBITDA margins over the medium term, as most of the effects related to the coronavirus pandemic are expected to largely normalize. Revenues are expected to increase to approximately $52 billion in 2020 (benefitting from the 53rd week) and be above $51 billion in 2021 (52 weeks). DBRS Morningstar believes food retail same-store sales growth for H2 2020 will continue to benefit from social distancing and be in the high single-digit range for the full year while drug retail same-store sales growth is expected to be in the mid-single-digits. DBRS Morningstar expects EBITDA margins to return toward more normalized levels in H2 2020, following the end of the temporary pay premium, but remain pressured on a full-year basis as a result of pandemic-related health and safety costs as well as costs related the acceleration of Loblaw's e-commerce initiatives, despite cost-saving initiatives and operating leverage gains. As such, DBRS Morningstar forecasts EBITDA to grow to approximately $5.0 billion in 2020 and approximately $5.2 billion in 2021.

DBRS Morningstar expects Loblaw’s financial profile to improve modestly over the medium term, benefitting from growth in earnings, while the Company’s debt balance is projected to remain relatively flat. DBRS Morningstar believes cash flow from operations will continue to track operating income, while capital expenditures (capex) are forecast to remain in the $1.1 billion range in 2020 and 2021. Capex is expected to primarily focus on existing store improvements and process and efficiency improvements as well as e-commerce and information technology projects. DBRS Morningstar believes dividends on a per-share basis will continue to grow but not exceed $500 million in 2020 and 2021 (normalized for timing). As such, DBRS Morningstar forecasts Loblaw’s FCF (before working capital changes) to be well above $2.0 billion in 2020 and 2021. DBRS Morningstar believes the Company will continue to use its FCF to buy back approximately $0.8 billion and $1.0 billion of shares in 2020 and 2021, respectively, with the majority of the balance accounting for lease principal payments. Consequently, credit metrics should improve marginally within the rating category in line with earnings growth and remain acceptable for the new BBB (high) rating (i.e., adjusted debt-to-EBITDA of approximately 3.25x).

A description of how DBRS Morningstar considers ESG factors within the DBRS Morningstar analytical framework and its methodologies can be found at: https://www.dbrsmorningstar.com/research/357792.

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

The principal methodologies are Rating Companies in the Merchandising Industry (July 30, 2020), DBRS Morningstar Criteria: Rating Corporate Holding Companies and Parent/Subsidiary Rating Relationships (November 25, 2019), and DBRS Morningstar Criteria: Preferred Share and Hybrid Security Criteria for Corporate Issuers (November 1, 2019), which can be found on dbrsmorningstar.com under Methodologies & Criteria.

For more information regarding rating methodologies and Coronavirus Disease (COVID-19), please see the following DBRS Morningstar press release: https://www.dbrsmorningstar.com/research/357883.

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 under Related Documents or by contacting us at info@dbrsmorningstar.com.

The rated entity or its related entities did participate in the rating process for this rating action. DBRS Morningstar had access to the accounts and other relevant internal documents of the rated entity or its related entities in connection with this rating action.

Generally, the conditions that lead to the assignment of a Negative or Positive trend are resolved within a 12-month period. DBRS Morningstar trends and ratings are under regular surveillance.

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

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