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Morningstar | Structural Headwinds Remain for No-Moat Weston's Core Loblaw Operations; Shares Slightly Overvalued

No-moat George Weston’s first-half results are tracking generally in line with our estimates, leading to no expected material change to our CAD 121 fair value estimate. We continue to see 2%-3% annual sales growth over the next five years with operating margins dropping to 4.6% in 2022 from 5.3% in 2017, as Loblaw continues to face several headwinds (wage inflation, transportation costs, drug price deflation, competition, and tariffs), offset by traction with its digital initiatives and disposal of low-margin gas operations, which should help profitability. We see shares as slightly overvalued.

The Loblaw operations (96% of total sales) reported a mixed quarter with sales dropping 1.4% mostly because of the removal of the gas segment. Meanwhile, underlying revenue growth in the retail segment was mixed with Loblaw performing slightly better than the industry's 0.1% food inflation and comps remaining positive at 0.8%, although this was a deceleration from the 1.9% lift reported last quarter. Year-to-date retail comps are up 1.3% and we plan to maintain our 1% forecast for the year, as our concerns about structural price competition (from the likes of wide-moat Walmart and Costco) remain. The drug segment also saw decelerating comps of 1.7% growth in the quarter (versus a 2.4% year-to-date rise), driven by 3% volume growth. However, the 2.6% drop in prescription value, as provinces such as Quebec mandate generic pricing across the industry, mitigated this gain. As a result, we plan to slightly lower our 3% drug comp 2018 forecast toward 2%.

Loblaw's bottom line is also facing wage and transportation cost headwinds, which drove the segment's SG&A up 140 basis points as a percent of sales to 20.9%. Adjusted gross margin provided an offset to these challenges, increasing 140 basis points to 29.5%, benefiting from the disposal of the lower margin gas business, as well as the use of data analytics from its 13.5 million loyalty members.

While Loblaw's digital traction is encouraging (70% of transactions from loyalty members) and can drive analytic information to improve customer satisfaction, we still expect structural competition to eat away at Loblaw's gross margin and continue to expect the figure for this segment to drop to 27.5% in 2021 from 29.5% in 2017 before stabilizing.