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Morningstar | Weston's Bakery Segment Headwinds Should Start to Wane, but Landscape Remains Competitive

With its retail Loblaw operations (93% of 2018 revenue before intersegment eliminations) having already reported 3% sales growth for the first quarter (giving us little reason to change our five-year outlook of low-single-digit annual sales growth for the business) there was not much new material information in no-moat George Weston's earnings update. That said, we plan to lift our 2019 0.2% sales growth forecast toward a 2% rise to account for additional lease revenue recognized from the company's May 2018 acquisition of CREIT (a Canadian real estate portfolio). This increase should not have a meaningful impact on our CAD 122 per share valuation, rendering shares undervalued.

In our view, the competitive environment remains intense for Loblaw. This stance was supported by the company's food retail same-store sales growth of 2%, which was below the national food inflation growth of 3.3%. This is the third straight quarter of Loblaw's food retail sales lagging the national inflation average. Further, although food retail basket was up (unquantified), traffic was flat and pricing was below the national average (unquantified), signaling competition remains fierce. Weston maintained its view of positive Loblaw same-store sales in 2019, which harmonizes with our forecast of 1% and 2.5% food and pharmacy growth, respectively.

Weston Food (North American bakery business that was 4% of 2018 sales before intersegment eliminations) sales dropped 0.2% despite a 2.9% favorable currency impact, as product rationalization and lost customers in 2018 continued to weigh, supporting the 2% 2019 sales decrease we are forecasting. That said, we see these headwinds waning, leading to a return to low-single-digit sales growth in 2020. This stance is buoyed by commentary around new customer wins and sequential lift in volumes, driven by improved service, quality of produce, and leveraging of data insights.

While we are encouraged with Loblaw's digital investments (e-commerce is around 1% of total sales), we don't think they will be able to completely offset competition in brick and mortar. In fact, Loblaw commented on the call that digital investments were defensive. Still, this expense is necessary in today's landscape. Loblaw is doing well to use data analytics on its roughly 20 million loyalty members to improve consumer offers. One example given was offering customized promotions; for instance, someone who typically spends $20 per visit might get a promotional to gain loyalty points if they spend $30, while another who typical spends $50 would get points if they spend $60. The company's pharmaceutical business also faced headwinds. While pharmaceutical volumes were up 2.6%, pricing was down 2.1% driven by Canadian drug reform.