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Morningstar | Loblaw Executing Well as It Continues to Face Multiple Headwinds; Shares Slightly Overvalued

No-moat Loblaw reported a mixed quarter, as it 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 operation, which should help profitability. We don't expect a meaningful change to our CAD 62 fair value estimate and plan to keep our respective 2%-3% and 4%-5% average annual sales and earnings per share growth over the next five years intact. We see shares as slightly overvalued trading at 14 times 2018 earnings.

Consolidated sales dropped 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 (unquantified) 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, but mitigated by the 2.6% drop in prescription value, as provinces such as Quebec mandate generic pricing across the industry. As a result, we plan to slightly lower our 3% drug comp 2018 forecast toward 2%.

The bottom line is also facing wage and transportation cost headwinds, which drove 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 the company'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 the company's gross margin and continue to expect the figure to drop to 27.5% in 2021 from 29.5% in 2017 before stabilizing.