Are Loblaw Shares Ripe for Picking?

05/15/2013 10:15 am EST


John Heinzl

Reporter and Columnist,

The well-known Canadian grocer has raised its dividend twice in six months...but competition in the sector is fierce and growing fiercer, writes John Heinzl, reporter and columnist for Globe Investor.

On the surface, Loblaw (Toronto: L) seems like a classic turnaround story.

Hampered by competition from Walmart (WMT), protracted struggles with a new information technology system, and a consumer hooked on discounts and promotions, Canada's biggest food retailer didn't raise its quarterly dividend for seven years from 2005 to 2012.

As its stock price gyrated, many dividend investors grew impatient and moved on. But those who stuck with the Toronto-based retailer were rewarded with not one, but two dividend increases in the past six months. The most recent hike was a 9% increase announced May 1, when the company posted better-than-expected first-quarter results, including a 2.8% increase in sales at established stores.

The share price has also shot higher, lifted by the retailer's plans to unlock shareholder value by contributing about $7 billion of property to a real estate investment trust that's expected to complete an initial public offering in July. Loblaw shares, which closed Tuesday at $46.47 and yield 2.1%, have gained 38% since the REIT was announced in December.

So is it safe for investors to go shopping in Loblaw again? Certainly, there are some encouraging signs, but investors need to be mindful of the risks still facing the operator of Loblaw, No Frills, Zehr's, Fortinos, and other stores.

Let's deal with the positives first.

Loblaw has made progress on the retail floor. Out-of-stock issues have improved, and the company has moved away from heavy promotional activity in favor of lower regular prices on a wider variety of items. Particularly impressive is that Loblaw was able to drive same-store sales growth despite heavy competition and an absence of food price inflation.

"Loblaw's strategy of more value, on more shelves, on more days, driving more engagement, is resonating more with consumers than having to try and play pin the tail on the promotion," Kenric Tyghe, an analyst with Raymond James, said in a recent note in which he reiterated his "outperform" rating.

What's more, the real estate IPO will put more cash in Loblaw's coffers, potentially supporting an accelerated share buyback or an acquisition in the grocery space. Based on the recent dividend increases, some analysts expect the company to resume annual hikes in the low double-digit range.

Even after the recent surge in the share price, Desjardins Securities Inc. analyst Keith Howlett says Loblaw is undervalued. He has a target price of $50, based on the sum of the retail business ($22.15 a share), a controlling interest in the REIT ($24.15), the value of putting additional properties into the REIT in the future ($6) and an expected reduction in IT and supply chain spending ($3.25).

To arrive at his $50 target, he applied a 10% holding company discount, but will revisit that number when the REIT begins trading.

"A number of positive factors are emerging together-increasing consumer engagement, increasing management confidence in the results of the IT and supply chain project, improving free cash flow, and the surfacing of very significant underlying real estate value," he said in a recent note.

Now, for the risks.

All of this is happening at a time when competition-already fierce-is intensifying, which will put increasing pressure on Loblaw and its various banners to engage in the very promotional activity it is trying to avoid. That, in turn, poses a threat to the company's margins.

In Ontario, for example, retailers such as Wal-Mart, Target (TGT), and various ethnic grocers "are adding square footage at a furious pace," CIBC World Markets analyst Perry Caicco said in a recent note.

With 90% of Target locations near a Loblaw store, "all nearby competitors have sharpened assortments, sharpened pricing, and expanded flyer breadth and depth in an attempt to defend their businesses."

Particularly worrisome is that grocers are now promoting commodities such as milk, eggs, bread, flour, and bananas on their front pages-a rarity because these high-volume items are usually sold at or below cost anyway. "When we see these items with reduced prices on the front pages, look out," Caicco says.

And the price wars will only heat up with the coming long weekends. Loblaw-which recently promoted eggs for $2 in Ontario, for example-has little choice but to play this game, or risk a weakening of same-store sales, he says.

To protect its profit, Loblaw will have to find ways to wring more costs out of its business, Caicco says.

Loblaw has made a lot of progress, but the grocery business is a battleground. Keep that in mind if you're thinking about filling your shopping cart with Loblaw shares.

Read more from Globe Investor here...

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