| Loblaw Companies Limited (L, Toronto) |
| RESEARCH
SUMMARY |
| Report Author(s): |
InvestorsFriend Inc. Analyst(s) |
| Author(s)' disclosure of share ownership: |
Author(s) hold no shares |
| Based on financials from: |
2005 Y.E. +Q2 '06 |
| Last updated: |
3-Aug-06 |
| Share Price At Date of Last Update: |
$49.01 |
| Currency: |
$ Canadian |
| Current Rating (Company Rating does not consider the
circumstances of any individual investor and is therefore not a
recommendation and is not Investment Advice): |
Speculative (lower) Buy |
| DESCRIPTION OF BUSINESS: Largest
grocery store operator in Canada. Has expanded into general
merchandise and financial services in conjunction with groceries. As of
December 2005, operates 670 corporate stores and has 402 franchised stores
and 472 associated stores. |
| RATING: This is a great company with outstanding past growth and
excellent management, although it has some "supply chain"
restructuring problems in 2005 and well into 2006, but management is
projecting a return to earnings growth in the remainder of 2006. Does reasonably well on Buffett's tenets.
In paying about $49.01 for these shares, investors are paying for an implicit
growth rate of about 7% which is much lower than the historic growth. There
is very little insider trading which gives a moderately positive signal as
insiders are not selling. The value ratios indicate a strong company but are
difficult to interpret due to the recent earnings drop. The possibility of competition from
Wal-Mart looms. Overall, we rate this a Speculative (lower) Buy. However
there is some likelihood of further downside until earnings growth is again
demonstrated. A reasonable strategy might be to take a partial position and
then wait for Q3 results before adding to it. |
| RISKS: Competition from Costco and Wal-Mart could intensify.
Other grocery chains could initiate price wars. The supply chain management
system could see additional delays in its implementation schedule. The strategy to add emphasis on general
merchandise in addition to groceries may not be as successful as
anticipated. See annual report for an
in depth discussion of many potential risks. |
| INSIDER TRADING / INSIDER HOLDING: Looking at transactions since
January 1, 2006 to July 31, 2006, 1 insider bought 5000 shares at
$54.87. In terms of insider holdings
there is a fair amount of insider holdings although most insiders hold Stock
appreciation rights rather than common shares. Overall, the insider trading /
insider holding signal is moderately positive. |
| WARREN
BUFFETT's TENETS: (see Robert Hagstrom's book) - simple to understand (pass),
very good profit history, although profit fell in 2005 (pass, subject to
review after Q3), the growth outlook is moderately favourable in the longer
term as the company has some ability to create brand loyalty but still must
compete on price (marginal pass) , has a
high ROE at 12.1% (pass), but has low profits on sales (fail, although
we don't think that this is an important factor because of volume), little chance of permanent loss of capital
(pass) probably a low level of maintenance type capital spending required to
maintain existing operations excluding growth, due to store renovations (pass)
does not have a high debt ratio (pass) and finally it's probably selling at a
moderate discount to intrinsic value (marginal pass). |
| RECENT
EARNINGS TREND: Q2 2006 earnings per share declined 8% from $0.77 to $0.71
compared to the same quarter in 2005. Q1 2006 earnings per share declined 19%
from $0.67 to $0.54 compared to the same quarter in 2005. The 2005 fiscal
earnings per share of $2.72 declined by 22% from the earnings in the prior
fiscal year. The decline is primarily
attributed to the new supply chain management systems being implemented
causing inventory not to be delivered as needed. Sales in the Q2 increased by
4.6% over the prior year's quarter.
This increase was attributed in part by the timing of Easter (1%)
which occurred in the second quarter of 2006 but in the first quarter of
2005. Same store sales increased by
1.6% and inflation accounted for approximately 1%. The balance of the increase in sales was
attributable to opening of new stores. |
| VALUE AND GROWTH RATIOS: This is a very large cap stock at about
$16.5 billion. At a recent share price of $49.01, the price to book value
ratio is a reasonable 2.2, given the type of assets, and a reasonable ROE of
12.4%, despite the earnings decline. The dividend yield is relatively
moderate at 1.7%. The trailing year price earnings ratio is somewhat high at
18.5 and the adjusted P/E is still moderately high at 17.1. The historic
growth rate in revenue per share is uninspiring at 6.8%. The earnings per
share growth had been consistently well over 20% for many years prior to
2005. However earnings have fallen in 2005 and into 2006. We calculate an intrinsic value per share
of $48 to $63 based on growth of 7% and 12% respectively and assuming a
terminal P/E of 16 or 18 respectively. The shares are pricing in lower than
historic growth in the 7% annually range assuming the P/E does not fall below
16. Overall these ratios indicate a strong company, but are difficult to
interpret because of the uncertain current direction of earnings. |
| SUPPORTING RESEARCH AND ANALYSIS |
| Symbol and Exchange: |
L, Toronto |
| Currency: |
Canadian $ |
| Category: |
Growth with modest income |
| Contact: |
investor@weston.ca |
| Web-site: |
www.loblaw.com |
| INCOME AND
PRICE / EARNINGS RATIO ANALYSIS |
| Latest four quarters annual sales $ millions: |
$28,087.0 |
| Latest four quarters annual earnings $ millions: |
$727.0 |
| P/E ratio based on latest four quarters earnings: |
18.5 |
| Latest
four quarters annual earnings, adjusted, $ millions: |
$788.2 |
| BASIS OR SOURCE OF ADJUSTED EARNINGS: Removed goodwill
amortization prior to 2001, it no longer is amortized under GAAP. Added back restructuring charges(after tax)
identified by management of $35.8 million in Q1 and $5.2 million in Q2, $52
million in Q3 and $3.9 million in Q4 for a total of $97 million in 2005. Added back restructuring charges of $2
million and $3.25 million in Q1 and Q2 of 2006 respectively. |
| Quality of Earnings Measurement and Persistence: In this
business, earnings are quite reliable and subject to relatively few
estimations (cash business). However, there are estimations for depreciation
and for the value of inventories. Overall, the accounting earnings are the
best available estimate of the "true" economic earnings. The
company has very strong operating cash flows. But the great bulk of that is
being poured into new and renovated store investments. It's not clear to us
how much of the investment relates to replacing depreciated assets and how
much relates to new capacity investments. Earnings persistence has been
excellent prior to 2005, but with the current decline in earnings attributed
to the implementation of the supply chain management system the recovery and
continued growth is somewhat in doubt.
Persistence of earning could also be affected in future by more fierce
competition. |
| P/E ratio based on latest four quarters earnings, adjusted |
17.1 |
| Latest fiscal year annual earnings: |
$746.0 |
| P/E ratio based on latest fiscal year earnings: |
18.1 |
| Fiscal earnings adjusted: |
$843.0 |
| P/E ratio for fiscal earnings adjusted: |
16.0 |
| Latest four quarters profit as percent of sales |
2.8% |
| Dividend Yield: |
1.7% |
| Price / Sales Ratio |
0.48 |
| BALANCE SHEET
ITEMS |
| Price to (diluted) book value ratio: |
2.20 |
| Quality of Net Assets and Book Value Measurement: Assets are
solid. There is a significant (but not overwhelming) amount of goodwill but
the fact that earnings are relatively strong proves that the goodwill has
real value (unlike the case for many high-tech companies). The stock is also trading at 2.2 times book
value, which is reasonably attractive considering the likely market value of
its store locations. |
| Number of Diluted common shares in millions: |
274.5 |
| Controlling Shareholder: Gaylen Weston controls 62% of George
Weston Limited which controls 63% of Loblaw. |
| Market Capitalization $ millions: |
$13,453.2 |
| Percentage of assets supported by common equity: (remainder is
debt or other liabilities) |
44% |
| Interest-bearing debt as a percentage of common equity |
84% |
| Current assets / current liabilities: |
1.2 |
| Liquidity and capital structure: Strong balance sheet. Debt was
recently about 84% of equity. |
| RETURN ON
EQUITY AND ON MARKET VALUE |
| Latest four quarters adjusted (if applicable) net income return on ending equity: |
12.9% |
| Latest fiscal year adjusted (if applicable) net income return on average equity: |
14.1% |
| Adjusted (if applicable) latest four
quarters return on market capitalization: |
5.9% |
| GROWTH RATIOS,
OUTLOOK and CALCULATED INTRINSIC VALUE PER SHARE |
| 5 years compounded growth in sales/share |
6.8% |
| Volatility of sales growth per share: |
Steady growth |
| 5 Years compounded growth in earnings/share |
9.6% |
| 5 years compounded growth in adjusted earnings per share |
10.4% |
| Volatility of earnings growth: |
Quite strong and steady for at least the
nine years prior to 2005 |
| Projected current year earnings $millions: |
not available |
| Projected price to earnings ratio: |
not available |
| Over the last five years, has this been a truly
excellent company exhibiting strong and steady growth in revenues per share
and in earnings per share? |
(see
graph) Prior to 2005 it did exhibit great growth but earnings have declined
for the past 18 months. |
| Expected growth in EPS based on adjusted fiscal Return on equity
times percent of earnings retained: |
9.9% |
| More conservative estimate of compounded growth in earnings per
share over the forecast period: |
7.0% |
| More optimistic estimate of compounded growth in earnings per
share over the forecast period: |
12.0% |
| OUTLOOK FOR GROWTH: Earnings growth has been in decline
commencing in the 2005 fiscal year, and to the end of the second quarter of
2006. For valuation, we are continuing to assume and pay for a growth
rate of 7% to 12%, but focusing on the lower end. For the first and second
quarters of 2006 earnings growth has faltered because of the major
restructuring still under way. The company believes that customers are
strongly looking for value and is positioning itself to offer lower prices
accordingly it has lowered its projection of 4-7% increase in sales to
3-6% and earnings to be flat or slight
decline for fiscal 2006 compared to 2005. This would suggest an approximate
10% increase in earnings per share for the remainder of the year. With
increased competition the high historic growth rate will likely not be
achieved but it does not seem unreasonable to assume perhaps 7% to as high as
12% in the future given the strong past record. |
| Estimated
present value per share: More conservative case, $47.88 of earnings per share
grow for 5 years at 7% per year and the shares are sold at a P/E of 16 after
5 years. More optimistic case $66.59 if earnings per share grow at 12% per
year for 5 years and the shares are then sold at a P/E of 18. Both estimates
use an 8% required rate of return. This is not a share price prediction. |
| ADDITIONAL
COMMENTS |
| INDUSTRY ATTRACTIVENESS: (These comments reflect the industry
rather than any particular company.) Michael Porter of Harvard argues that an
attractive industry is one where firms are somewhat protected from
competition. For grocery chains there are some barriers to entry in terms of
favourable store locations. Also there is some ability to develop a brand
value with in-house brands and a reputation for quality. The industry is not
subject to powerful suppliers or customers who could usurp the industry profit.
The industry has no substitute product. Unfortunately, the industry does
compete heavily (but not ruinously) on price. Overall, there is only a
moderate ability to be protected from competition. Grocery retailing tends to
grow faster than the general economy as consumers pay more for quality and
convenience. Overall, the industry is
moderately attractive. |
| COMPETITIVE ADVANTAGE: Low cost leadership. An extremely
successful house-brand with President's Choice. Low borrowing costs (Recently
borrowed money for 30 years at just 5.9%). |
| RECENT EVENTS: The supply chain management system implementation
has not gone well and is a major reason for the earnings decline. The company now expects to have the system
fully implemented by the end of 2008 with $21 million of remaining costs to
be expended. The total expected cost
is $90 million so the majority of conversion has now been completed but it
will not be fully implemented until the end of 2008. It's not clear when the
bulk of the benefits of this spending will be realised - hopefully well
before 2008. Wal-Mart has plans to open over 100 supercentre stores across
Canada in the next five years which may directly affect Loblaws
competitiveness. |
| ACCOUNTING AND DISCLOSURE ISSUES: Provides good concise and
focused disclosure in its reports. One small complaint, we would like to see
capital spending segregated into the amount to replace "retired"
square footage and the amount that represents new capacity. The company also reported the change in
reporting vendor incentives which is a reclassification of accounts from cost
of goods sold to expenditure but has no impact on net income. |
| COMMON SHARE STRUCTURE USED: Normal, 1 vote per common share |
| MANAGEMENT QUALITY: High quality, historically the acknowledged
leaders in the grocery business in Canada.
Management has not implemented its new supply chain management system
as well as it had planned and is now dealing with implementation
problems. Management has also now
revised projections downward from earlier statements. They seem conservative and admitted to
their current problems. They have resisted the urge to extract short-term
value through extensive use of sale and lease-back of real estate. |
| EXECUTIVE COMPENSATION: Generous but probably not excessive.
Given the size and profitability of this company, management compensation is
not a material item. |
| BOARD OF DIRECTORS: An 11 member Board chaired and controlled by
Gaylen Weston, most Board members own a significant amount of shares. |
| Basis
and Limitations of Analysis: The following applies to all the companies
rated. Conclusions are based largely on achieved earnings, balance sheet
strength, earnings growth trend and industry attractiveness. We undertake a
relatively detailed analysis of the
published financial statements including growth per share trends and my
general view of the industry attractiveness and the companies growth
prospects. Despite this diligence our analysis is subject to limitations
including the following examples. We have not met with management or
discussed the long term earnings growth prospects with management. We have
not reviewed all press releases. We typically have no special expertise or
knowledge of the industry. |
| DISCLAIMER:
All stock ratings presented are "generic" in nature and do not take
into account the unique circumstances and risk tolerance of any individual.
The information presented is not a recommendation for any individual to buy
or sell any security. The authors are not registered investment advisors and
the information presented is not to be considered investment advice to any
individual. The reader should consult a registered investment advisor or
registered dealer prior to making any investment decision. For ease of
writing style the newsletter and articles are written in the first person.
But, legally speaking, all information and opinions are provided by
InvestorsFriend Inc. and not by the authors as individuals. InvestorsFriend
Inc. itself does not have a position in any of the indicated securities while
the authors may have a position. |
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