Retail: Shelf life

Spending in Canada will more than likely continue as consumers keep tapping the equity in their homes. That, retail watchers say, combined with a generally robust economy, should be a good sign for investors in the merchandising sector. However, interest rates, inflation and energy prices could affect future optimism.

Adam Clark, a retail analyst at BMO Capital Markets, said in a recent report that the healthy real estate market has seen Canadians spend more than they earn. “Housing prices have been strong in the past and have helped to fuel spending through equity extraction,” he says.

But will 2007 be the year that the market slows enough to curtail home refinancing? A good part of the answer to that question, says Clark, will depend on whether the Bank of Canada moves its key rate. He points out that debt-service costs currently represent about 15% of personal disposable income, “so smaller moves in this variable can potentially have a greater impact on spending than bigger moves in energy.” As well, higher commodity prices, fuelled by international demand, could provoke inflation — but Clark points out that the strength of the dollar, now hovering around 90¢ against the greenback, has helped offset risk, as businesses and retailers, especially those in apparel, have been able to source goods more cheaply, and “pass the savings on to consumers through lower prices and/or better value.”

Clark says that while much has been made of the rising cost of energy, increasing oil and gas prices would more likely have more of an impact on psychology than spending, given wealth levels and the fact that energy costs represent only 5% to 7% of personal disposable income.

The Bank of Canada stated in its semi-annual monetary report in April that “strong gains in consumer spending are expected to continue, supported by further increases in real disposable income and household net worth.” It presents a mostly rosy picture over the next three years, predicting Canadians will continue to enjoy robust job prospects and that GDP should edge up to 2.7% in both 2008 and 2009. Rising prices and a lack of spare production capacity will push inflation close to the bank's upper limit of 3%, but it should decline to about 2% in 2008.

One trend Clark observes among Canadian merchandisers, especially those in discretionary areas such as apparel and furniture, is that they are improving how they approach inventory management. “Lately, we have noticed improved inventory positions,” he says, noting retailers are selling through more merchandise.

Clark leans toward small-cap discretionary retailers, based on his view that Canadian consumers are fiscally healthy and spending remains robust. BMO Capital Markets forecasts consumer spending growth of 3.1% and 2.7% in 2007 and 2008, respectively, which compares favourably with the five-year historical average of 3.3%. “The small-capitalization retailers are well positioned with improved merchandising and store bases to capitalize on this growth in spending,” Clark says.

Clark's strongest preference is for Montreal-based clothing retailer Reitmans (Canada) Ltd. (TSX: RET.A), which he gives an Outperform rating and a target of $26 compared with its current price of about $24. “We like it for its strong track record, dominant position on the market, leading brands, appealing growth opportunities, strong balance sheet and cash- flow generation.” Clark says he also believes that Reitmans can grow its bottom line by 16% annually over the next two years, and that is “complemented by an attractive valuation and 3% dividend yield.”

Other apparel retailers that Clark likes include Le Château Inc. of Montreal (TSX: CTV) and Danier Leather Inc. (TSX: DL), with its headquarters in Toronto. He has Outperform ratings on both stocks. In the case of Le Château, Clark says it's clear that the company is “back on track” after a setback; as for Danier, it is in the early stages of a turnaround. “Its strong market position and peak earnings potential suggest there is significant upside potential.” Clark is also recommending Calgary-based sporting goods retailer The Forzani Group (TSX: FGL). Same-store sales at its corporately owned stores, he notes, have been trending upward for the past several quarters, and margins are improving. “We believe that the earnings power of the company is higher than it was at [its] last peak [in fiscal 2003],” he says.

Canaccord Adams analyst Benoit Caron, based in Montreal, notes that in the convenience store sector, the “blurring of channels” (with more retailers trying to move onto each other's turf) has had an impact on companies such as Alimentation CoucheTard Inc. (TSX: ATD.B). However, he believes that Couche-Tard, one of the largest C-store operators in North America, is “well-positioned to weather these competitive threats.” He has a target price of $30 on the stock, which now trades in the $24 range.

In the home improvement arena, Caron likes Rona Inc. (TSX: RON), which is trading “at depressed multiples not seen in nearly a decade.” That is thanks in part to concerns regarding the strength of the housing industry and the future of rates. Caron has a Buy rating on the stock, which trades at about $24, and a target of $30.

When it comes to non-discretionary retailers, such as food merchandisers, the recent decision by Nova Scotia–based Empire Co. Ltd. (TSX: EMP.A) to take its Sobeys Inc. (TSX: SBY) grocery unit private has unleashed expectations among investors that there may be more acquisition deals in the offing. Shares of rivals Loblaw Cos. Ltd. (TSX: L) and Metro Inc. (TSX: MRU.A) jumped in late April on the news that Empire would pay $58 a share for the 28% stake in Sobeys that it doesn't already own, an offer more than 50% higher than what the grocer's shares were fetching before the announcement.

Some analysts, including Jim Durran at National Bank Financial, suggest Empire's move to take Sobeys private was simply a capital-allocation decision, as thecompany intends to place a greater emphasis on its real estate and grocery operations. “We believe that Empire is simply acquiring the minority of its primary asset because they believe it is cheap, making it a compelling use of capital,” he said in a research note. Durran added that Empire might be thinking that once competitive pressures on pricing and margins have settled, Sobeys earning power will improve, more than justifying the price it's paying to take it private. (Wal-Mart's full-scale incursion into food retailing in Canada has set off a price war, especially in Ontario, which has impacted Sobeys and other grocers, such as Loblaw and Metro. Loblaw has had the additional issue of trying to restructure itself in light of poor earnings and inventory problems.)

As for whether Sobeys' actions mean other food retailers are now in play, analyst Michael Van Aelst at TD Securities suggests that Loblaw shares are “being supported by hopes for a value-creating transaction,” whether it is selling off a real-estate asset or a buyout of the company. “We place low probabilities on either of these events,” he says.

In the end, any bump in the stock of grocers such as Metro and Loblaw will more likely have to depend on duking it out, and surviving, in an increasingly competitive retail world.