Morningstar | Loblaw Packs a Mixed Bag of Solid Profit and Weak Food Traffic in 2Q; Shares Overvalued
No-moat Loblaw reported mixed second-quarter results, with solid gross margins of 31% (up 20 basis points versus our 2019 estimate of a 60-basis-point decline) and drug retail same-store sales growth of 4% (the strongest in three years and ahead of our 2.5% estimate for 2019), mitigated by weak food retail same-store sales growth of 0.6%, down from a 2% increase last quarter (tracking near our 2019 forecast for 1% growth). We plan to increase our CAD 58 fair value estimate by CAD 2-CAD 3 to account for higher anticipated gross margins and drug retail sales over the next few years, as well as for the time value of money, while keeping our out-year forecasts intact. Despite the planned increase, we still see shares as overvalued, trading at 14.5 times 2019 earnings, in what remains a competitive environment.The source of both Loblaw’s stronger gross margins and weaker food retail sales was the company’s use of data analytics to drive profitable segment traffic. According to the company, the data algorithm has been built to focus on profit, and this quarter customers become more sensitive to promotional activity, a signal that supports our long-held view that the competitive environment remains intense. As a result, Loblaw sent out fewer promotions, buoying gross profit, but hindering traffic. Loblaw is not satisfied with such results and is refining the algorithm to more evenly focus on profit and volume, which could take a few quarters to work out.
On the more constructive side, Loblaw’s drug retail business is doing well, driven by the launch of in-store beauty experts, a stronger cold and allergy season, and lapping generic pricing headwinds from healthcare reform (prescription pricing returned to growth, increasing 0.6% in the quarter).
Overall, we support Loblaw’s continuing investment in data analytics and omnichannel buildout. Still, competition from Target, Walmart, and other scale-advantaged company’s present long-term pressure to Loblaw’s margins, and we continue to model the company’s gross margins falling to 27.5% at the end of our forecast from 30.3% in 2018.
Loblaw is a Canadian food distributor and provider of general merchandise, drugstore and financial products and services. Traditional food offerings remain at the core of Co.'s business. Co. operates conventional, superstore, and hard discount stores. Co. offers products through control label program with famous brands including President's Choice, no name and Joe Fresh Style. Co. also offers President's Choice Financial services and offers the PC points loyalty program.
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