EUR 850.00 For Business Accounts Only

Morningstar | No-Moat Weston Continues to Face Numerous Headwinds; Shares Undervalued

We don't expect a material change to our CAD 122 valuation after no-moat George Weston reported third-quarter revenue up 1.5% (down 0.1% year to date) versus our 2018 0.7% growth estimate, aided by 1.8% sales growth at its Loblaw division (95% of total sales), while its Weston Foods (5%) business experienced a 6% drop. Shares are undervalued, trading at around 12.5 times our 2019 adjusted earnings per share.

Weston Foods sales were down 5.7% in the quarter (down 5.9% year to date), as a 1.6% favorable currency benefit wasn't enough to offset the loss of sales to key customers and efforts to reduce the SKUs that tend to be promotional (a headwind we believe will subside in 2020). As a result, we plan to slightly reduce our 2018 and 2019 sales forecast for a 3% drop and 1.5% lift, respectively, resulting in a nominal impact to our fair value estimate.

Loblaw reported 1.8% sales growth (up 0.2% year to date) versus our 1% lift 2018 forecast. Loblaw continues to face several headwinds (wage inflation, transportation costs, drug price deflation, competition, and tariffs), offset by digital and data initiatives.

Loblaw's top-line results in its food retail (73% of the segment's sales) segment highlight our concerns that ongoing competition from the likes of wide-moat Walmart will remain intense. This is illustrated by the 0.9% food retail same-store-sales increase in the quarter (1.1% year to date), tracking near our 1% 2018 estimate. Also, Loblaw's food inflation saw a marginal decline versus the national 0.3% increase, although when adjusting for mix the company experienced basket growth just slightly below the market. This is a signal that the company is challenged to pass pricing along to its customers.

Meanwhile, Loblaw's drug store segment (27% of the division's sales) performed a bit better, showing same-store-sales growth of 2.5% (2.6% year to date), above our 1.5% 2018 estimate. Still, headwinds from several Canadian provinces cutting generic drug prices and increasing wage growth present ongoing challenges and frame our forecast for low-single-digit annual consolidated sales growth the next five years with gross margins dropping to 27.5% in 2022 from 28% in 2019 (the first full-year post the Choice Property spin-off this November).

Loblaw's digital and data efforts are aiding profit, helping to mitigate the competitive headwinds. To illustrate, data is allowing Loblaw to customize offerings to its 15 million loyalty members versus prior mass mail, allowing for a 200-basis-point lift in promotional margins. Further, locations with click and collect (in over 500 units) are seeing meaningful same-store-sale improvement (unquantified).