Keith Howlett, a Toronto-based Desjardins Capital Markets analyst, took a look at what disrupters have done to Macy’s, Williams-Sonoma and Bed, Bath & Beyond. He found two Canadian consumer goods stocks facing less immediate anxiety around digital disruption. Both enjoy lengthy track records of excellent operating execution and of generating financial performance ahead of their peer groups.
Entering 2018, our anxieties related to the future of NAFTA and the impact of US tax reforms on investment in Canada. Significant changes to minimum wage rates and drug reform posed a financial challenge to many retailers. Canada managed to muddle through to the new USMCA (still to be ratified) and, in addition, made changes to capital cost allowance to better compete with new US rules.
The election of a new government in Ontario resulted in the rescission of additional minimum wage increases and pay rules which had been scheduled to take effect in 2019. The wild cards during the year were the increase in differentials affecting the price of Alberta oil, the failure to materially progress on major pipelines to take energy to markets, and the escalation of the trade war between the US and China.
While employment continues to be strong, the market appears to be anticipating a more significant economic slowdown than the moderation experienced to date. Consumer balance sheets remain in reasonable shape, although net worth is tied to housing prices. Interest-sensitive purchases are already slowing with the rate increases in 2018.
2 stocks facing less anxiety from digital disruption
Given that digital disruption is more advanced in the US retail segment, we take a brief look at the impact on some top US retail stocks such as Macy’s, Williams-Sonoma and Bed Bath & Beyond, and at the disrupters such as online retailer Wayfair and brand owner Nike.
The drastic reaction of share prices to quarterly results may have made us excessively conservative in facing 2019. We have weighted management quality and consistency heavily, and prefer companies facing less immediate anxiety around digital disruption. Our top picks both have lengthy track records of excellent operating execution and of generating financial performance ahead of their peer groups.
Whether 2019 is better sailing than we expect or not, we are comfortable owning both consumer goods stocks Alimentation Couche-Tard Inc. (TSX—ATD.B) and Metro Inc. (TSX—MRU). Both Couche-Tard and Metro are ‘buys’ with target share prices of $77 and $50, respectively.
Consolidation under the Circle K brand
The management of Couche-Tard has a five-year plan to double the convenience stores company through a 50-50 balance of organic growth and acquisitions. The company has added key executive talent to accelerate the use of new technologies to improve decision-making (product mix, pricing, promotions) and to elevate its consumer research and marketing abilities.
Couche-Tard retains its unique combination of entrepreneurial enthusiasm and disciplined, fact-based decision-making, even as annual adjusted EBITDA (earnings before interest, taxes, depreciation and amortization) surpasses US$3.5 billion (up almost US$2 billion from five years ago).
The company is well-advanced in converting all stores outside of Québec (and excluding automated unmanned filling stations in Europe) to the updated Circle K brand trademark. Ireland is the last market in Europe to be converted, with the process ongoing.
The process in the US and Canada will continue for another 2.5 years, which includes refreshing existing Circle K stores which are still using the brand’s previous design and colour scheme. Conversion has gone very well in markets where Circle K is already known (e.g.- Arizona, Texas), and has generated positive same-store sales in others where the brand had minimal existing recognition (e.g. Norway, Denmark). The unified branding will facilitate private label programs, loyalty programs, purchasing efficiency and marketing efficiency.
The company has consistently proven its credentials as an acquirer, most recently with the Pantry, CST Brands and Holiday stores acquisitions in the US, and the Esso stores acquisition in Toronto and Montréal. Adjusted net debt-to-EBITDAR (EBITDA and rent) was reduced to 2.79 times at the end of its fiscal 2019 second quarter, and should fall further with the cash generated from extraordinarily high US fuel margins in the third quarter (through the first eight weeks of the 16-week quarter).
The shares are trading at a P/E ratio of 15.4 times forward EPS, well below the five-year average of 18.9 times. Free cash flow generation has been strong.
Metro’s 3-year integration of Jean Coutu underway
Changing gears, for the last 25 years Metro has been the most consistently well-run major supermarket chain in Canada and the US, as measured by financial outcomes and share price performance. We believe that result flows from a clear, consistent and focused strategy, sharp operating execution, financial discipline and great merchandising. While the ‘grocery trade’ appears to be crowded at the moment as investors seek a safe domestic haven from a possible economic slowdown or recession, our selection of Metro is as much about confidence in management as the sector.
Metro is at the front end of a three-year integration of Jean Coutu Group, acquired in May of 2018. Cost synergies over 36 months should be roughly $75 million. Revenue synergies have not been quantified; they would include distribution of Pro Doc generic drugs through Brunet pharmacies (at the pharmacists’ discretion).
Metro is currently trading at a forward P/E of 16.1 times, compared with its five-year average of 15 times (which excludes Jean Coutu for most of the period). The company has already paid down enough of the acquisition debt in relation to Jean Coutu Group that the share buyback has recommenced. The adjusted debt-to-EBITDAR ratio that management will maintain going forward is 2.5 time. The dividend is increased every year in line with paying out a quarter of the prior-year’s normalized earnings.
Still, the reputation of consumer staples as a safe haven has been shaken by the digital era’s advent. While consumer discretionary stocks have taken the brunt of the punishment of digital disruption, staples have been affected by Amazon’s acquisition of Whole Foods and foray into health.
This is an edited version of an article that was originally published for subscribers in the January 25, 2019, issue of Investor’s Digest of Canada. You can profit from the award-winning advice subscribers receive regularly in Investor’s Digest of Canada.
Investor’s Digest of Canada, MPL Communications Inc.
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