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Morningstar | Loblaw's Digital Investments Continue but Aren't Enough to Offset Competition; Shares Overvalued

We see little reason to materially change our five-year outlook of low-single-digit annual sales growth and gross margins that average near 29% (versus 30.3% in 2018) for no-moat Loblaw, after the company reported first-quarter revenue growth of 3% with total retail gross margins of 29.6% (down 30 basis points). Trading just over 14 times 2019 adjusted earnings, we see shares as overvalued to our existing CAD 57 per share valuation.

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.

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.