Buy Metro; hold or sell Jean Coutu Group

Blue-chip consumer goods stock Metro Inc. has agreed to acquire drugstore chain Jean Coutu Group. We think that Metro will profit from this transaction. It remains a buy. Coutu’s shares trade a little above their takeover price. Sell Coutu if you need cash now or tender later for Metro shares and cash.

Blue_Chip_Consumer_Goods_StockMontreal-based Key consumer stock Metro Inc. (TSX—MRU) has agreed to acquire fellow Key consumer stock Jean Coutu Group (TSX—PJC.A). This will unite Quebec’s largest supermarket chain with its largest drugstore chain. When Metro and Coutu confirmed that they were in ‘advanced’ talks about a transaction, Metro’s shares jumped by 8.8 per cent. Coutu’s shares jumped by 6.3 per cent.

(This is similar to Key stock Loblaw Companies’ (TSX—L) acquisition of former Key stock Shoppers Drug Mart. It united Canada’s largest supermarket chain with the country’s largest drugstore chain. Loblaw has prospered with Shoppers at its side. Metro hopes to similarly prosper from combining with Coutu—something we expect.)

Metro plans to buy Coutu for $24.50 a share. That’s 15.4 per cent above Coutu’s market share price in the 20 days to August 21—before the transaction was largely negotiated. Coutu’s climbing share price so far this year suggests that word of the transaction leaked out. The premium is attractive. The Coutu family intends to support the transaction.

We see no competing bid for Coutu

Since the announcement, Coutu’s shares have traded above the takeover price. This suggests that the market expects the drugstore chain to eventually fetch more than the $24.50 a share takeover price. We disagree for several reasons. First, it seems that Metro and Coutu are ideal partners. They write that they have “highly complementary operations”. We think that few other companies could benefit from a merger to the same extent as Metro. Its president and chief executive officer, Eric La Flèche, said: “This transaction is attractive and compelling from a financial and commercial perspective. The Jean Coutu Group’s extensive retail and state-of-the-art distribution center will provide us with increased scale and reach, operational efficiencies and enhanced growth potential.”

There are two other reasons why we don’t expect a competing offer. For one thing, Coutu would have to pay a termination fee of $135 million if it accepts another offer. This hefty fee is likely to deter other potential bidders. For another thing, the acquisition strengthens what’s known as ‘Quebec Inc.’. If a company from outside Quebec were to make a competing bid, it would likely start a political storm. With no competing bid likely, consider selling Coutu. But only if you see a compelling alternative use of the funds. Otherwise, tender for Metro shares and cash when the time comes and side-step brokerage fees.

Metro will pay cash for about three-quarters of the compensation and issue shares for the other quarter. Based on 183.7 million fully-diluted Coutu shares outstanding, the cash requirement totals $3.375 billion (183.7 million shares times $24.50 a share times 0.75). We think this is doable. Coutu is debt-free and has cash of $189.3 million. Metro’s net debt-to-cash-flow ratio is 1.9 times. That’s within our comfort zone of two times or less. Even better, Metro’s cash on hand of $61.9 million exceeds its debt of only $11.4 million due within the next 12 months.

Together, Metro and Coutu now have an attractively-low net debt-to-cash-flow of 1.25 times. Let’s say they borrow cash of $3.375 billion to fund the cash payment. The companies’ net debt-to-cash-flow ratio would jump to 4.8 times. On the positive side, they generate growing and stable cash flow. They could service and reduce the debt.

The net debt-to-equity looks reasonable

When major transactions occur, the debt jumps immediately. The corresponding cash flow shows up only over the following 12 months. In these cases, we calculate the net debt-to-equity ratio. Metro and Coutu’s net debt will total $4.581 billion ($3.375 billion plus Metro’s $1.206 billion). Their combined equity will total $5.117 billion. This includes the $1.125 billion in shares that Metro will issue. Divide net debt by the equity and you get a ratio of 0.895 to one.

Metro and Coutu will likely continue to build their equity as they make money. Metro is thought to have earned $2.56 a share in fiscal 2017 (which ended with September). This would represent earnings per share growth of 7.1 per cent. This year, the company’s earnings are expected to rise by 7.8 per cent, to $2.76 a share. But the acquisition of Coutu could improve that. As a stand-alone company, Coutu is now expected to earn $1.03 a share in fiscal 2019 (which ends with February). This would work out to an earnings decline of 4.6 per cent. Next year Coutu’s stand-alone earnings are expected to rebound by 11.7 per cent, to $1.15 a share. It’s clear that a transaction that combines Metro and Coutu will build their equity. This alone would improve their net debt-to-equity ratio even if they repaid no debt.

Metro could sell Couche-Tard to raise cash

Keep in mind, too, that Metro owns a valuable stake in Montreal-based Key stock Alimentation Couche-Tard (TSX—ATD.B). If need be, Metro could sell this stake and redeploy the money into its supermarket and drugstore operations.

Metro owns about 32.2 million shares of Couche-Tard. With Couche-Tard trading at $58 a share, Metro’s stake is worth $1.868 billion. But Metro is in no hurry to sell Couche-Tard. That’s a plus, because suddenly dumping all of its shares in the market would likely hurt Couche-Tard’s price and Metro’s proceeds.

Synergies from combining operations

What’s more, combining the Metro and Coutu operations could drive up earnings. This includes savings from eliminating redundancy from such areas as procurement, distribution, staff and public-company costs. Metro and Coutu expect to generate ‘synergies’ of $76 million within three years. Metro plans to keep its current investment-grade credit rating of BBB.

Together, Metro and Coutu operate 933 stores in Quebec and 374 in Ontario. This gives them 1,307 stores. Coutu is also a franchisor of independent stores, including some in New Brunswick.

We formerly rated Jean Coutu a ‘hold’. That’s because its earnings were largely stagnant. And the interventionist Quebec government’s rule changes raised risk. Now that Coutu’s share price has jumped, it remains a hold. Only sell if you need the money or if you see an attractive alternative opportunity. Otherwise, when the time comes, tender for the cash and Metro shares.

Metro remains a ‘buy’. Its earnings have increased since at least the early 1990s. The company is expected to earn record-high profits both this year and next. And it remains a dividend aristocrat that raises its dividend year after year. The consensus recommendation of 10 analysts is ‘Buy’. We agree.

Coutu expects to hold a special meeting of its shareholders in November to vote on the proposed acquisition. It’s certain to pass. That’s because the Coutu family has 93 per cent of the votes. They’ve made an “irrevocable” agreement to support the acquisition. National Bank Financial and TD Securities said “the consideration to be received by Jean Coutu Group shareholders in connection with the Transaction is fair, from a financial point of view”. Metro expects to complete its acquisition of Coutu in the first half of calendar 2018. That is, by June 30.

This is an edited version of an article that was originally published for subscribers in the October 13, 2017, issue of The Investment Reporter. You can profit from the award-winning advice subscribers receive regularly in The Investment Reporter.

The Investment Reporter, MPL Communications Inc.
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