Bulked up buys: As the grocery business consolidates, better earnings await patient investors

Canadian investors had mixed emotions after Loblaw Cos. Ltd. announced its $12.4-billion takeover of Shoppers Drug Mart on July 15. On one hand, it was a great day for people who owned these companies. Loblaw’s stock climbed by nearly 5.5% that day, while Shoppers jumped 24%. But it also meant that another domestic retailer would soon be taken off the market.

That leaves fewer options for investors to choose from, but there are still plenty of opportunities in consumer staples. The reasons for owning a grocer remain the same: they’re stable operations that produce attractive total returns. The good ones perform well in every economic environment. However, to find a good buy in today’s depleted field, you may need to look beyond Canada’s borders and in some different retail niches.

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In some ways, having fewer players is actually a good thing, says Greg Dean, a portfolio manager with Cambridge Global Asset Management. Less competition has resulted in more rational pricing. Plus a lot of key categories, such as dairy and meat, are regulated in Canada. As a result, margins here are higher than they are in the United States.

While a stable industry is a good thing, it has an impact on valuations and growth. Dean points out that the grocery sector is about 50% more expensive on a price-to-earnings basis here than it is in America, and earnings are growing about 2% slower.

The recent consolidation in the sector—in addition to Loblaw’s Shoppers buy, Empire Co. bought Canada Safeway in June—is a bid to fuel growth, says Bobby Hagedorn, an equity research analyst at Edward Jones. The sector, he says, is dealing with a slow economy, a heavily indebted consumer and increasing competition from the likes of Target and Walmart. “That leads itself to an industry where companies are searching for growth, and they can improve their buying power through acquisition,” he explains.

There could be more consolidation too—there are rumours that Empire, which owns Sobeys supermarkets, might be interested in drugstore chain Jean Coutu Group—but Hagedorn says the pickings are getting slimmer. “There are always more acquisition opportunities,” he says, “but there aren’t a ton of assets left.”

The U.S. grocery landscape, by contrast, is looking up. American grocery chains didn’t handle Walmart’s foray into the food business well, and that hurt the sector, says Dean. Panicked companies tried to compete by cutting prices and by building larger stores. Margins contracted, growth stalled and many investors got burned. The recession didn’t help either. Many grocers saw dramatic drops in stock prices; Kroger Co.’s shares fell 32% despite posting positive results during the downturn. By comparison, Loblaw was up about 3% over the same time period.

The sector has been dealing with these issues for nearly a decade stateside, but things are starting to turn around. The U.S. consumer is shopping again, Walmart’s growth has slowed and other stores have finally realized that price wars aren’t doing anyone any good. The result? Margins are improving, and sales are growing at about 3% compared to 1% in Canada. “That trickles all the way through the income statement,” says Dean.

While valuations aren’t as low as they once were, the sector is still more attractive in the U.S., especially considering the better earnings growth there. That’s why Dean moved money out of Metro and into Kroger over the past year, and why he still thinks that America offers better investment opportunities.

Despite the broad-stroke limitations on consumer staples, there is a sub-sector that has been providing gangbuster growth on both sides of the border: dollar stores. Many of these operations are seeing double-digit earnings growth and are opening a plethora of new locations every year. Dollarama is expanding its square footage by nearly 10% a year, compared to about 1% per year for Canadian grocers as a whole. It has also added 85 new stores—it already had about 800—over the past 12 months. “That’s unmatched in the rest of Canadian retail,” says Hagedorn.

The discount sector, both in Canada and the U.S., has benefited from a more spendthrift consumer, adds Izabel Flis, a research analyst with Bissett Investment Management, but the stores have also been able to sell quality goods at below average prices. “In some cases, you’re buying something for $3 that you can get elsewhere for $10,” she says.

The space has seen dramatic stock price increases—Dollarama is up 287% over the past five years—but Flis thinks the Canadian market is still under-served and that share prices will keep rising. Companies in this space are also becoming more consistent in their performance. Products like groceries and seasonal items keep bringing people back. “Dollar stores have evolved over time,” says Flis. “It’s not just people who can’t afford to shop somewhere else. They now have a whole array of customers.”

When it comes to the grocery sector, Dean says to look at the balance sheet first. Because margins are fairly tight, investors have to be sure a company’s debt is manageable. He likes to see debt-to-EBITDA numbers of less than two times, while EBITDA (earnings before interest, taxes, depreciation and amortization) should be expanding.

He then wants to see gross margin dollars growing, but people have to figure out what’s behind that growth. Are companies just raising prices or has there been an improvement in same-store sales? He wants to see the latter. Also look for companies with a 10% to 15% return on invested capital, he says.

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Price-to-earnings ratios are also important in this sector, says Hagedorn. He compares a stock’s P/E to other companies on the market, to peers in the industry and in relation to his own growth outlook. In general, U.S. grocers are trading around 13 times earnings, while some Canadian ones are trading around 16 times. A dollar store will have a much higher P/E—Dollarama’s is close to 25 times—but that’s because of its faster growth.

Just because the sector’s consolidating doesn’t mean you should stop shopping for opportunities. Says Hagedorn: “Look for the business with the best long-term outlook.”

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