There is an interesting deal taking place in the Canadian retail space - Loblaw Companies Limited (will be referred to as Loblaw) has announced that it will be acquiring Shoppers Drug Mart Corporation (will be referred to as Shoppers) for C$ 12.4 billion. The deal was announced on the 15th of July 2013 and is likely to be executed by end of this year. According to analysts, this deal is likely to be the largest deal this year. It is an interesting deal for at least three reasons - the strategy behind the deal, structuring of the deal, and the proposed synergies out of the deal.
Canadian Food retail industry
With a GDP of US $1.8 trillion (almost equivalent to India), Canada has a population of 34.9 billion. Between 2000 and 2012, the population of the country has grown by 13.4% at an average of 1.1% per year. As of 2012, more than 35% of the population is aged more than 50 years and about 5.5% of the population is aged less than 4 years. It is estimated that by 2036, the country would have about 25% of the population represented by people above 65 years of age and currently people above 65 years of age account for 45% of the government healthcare spending thus indicating that as the country grows old, the healthcare spending is going to rise. As per the report published by the government, in 2012, the total retail sales in Canada was about C$ 470 billion, a 3% increase over 2011. Food retail sales represented 19% of this total retail space thus contributing about C$ 87 billion. The industry is expected to grow at a CAGR of 2% between now and 2016 and it was also expected that much of this growth will happen through expansion in the selling space (measured in Square feet) but not much increase in the number of stores. Grocery retail in Canada is a matured and highly developed industry and as a result of slower population growth, the overall growth rate in the industry is slowly declining (3.9% in 2009, 2.6% in 2010, and 1.2% in 2011). By the end of 2012, the industry was dominated by domestic retail players such as Loblaw Companies Limited, which had a market share of 20% by value, Sobeys Inc, which had a market share of 12% by value, and Metro Inc, which had a market share of 9% by value. However with the arrival of US retail giants such as Walmart and Target, the scenario is fast changing. Walmart arrived in to Canada in 1994 and as on 2012, the retail giant reported a revenue of US$ 22.3 billion and occupied the third position in the retail space. Despite slow growth in the retail sector (owing to various reasons such as the consumer debt to GDP is at all time high in the economy and consumers have been conscious of their spending patterns), Target entered the market in 2013 after acquiring a series of retail chains. So the industry as a whole is moving towards consolidation. The arrival of deep pocket US retail giants is not just changing the dynamics of the industry but also creating a sense of nervousness among the existing players. As a result of this, Sobeys, earlier this year, announced a C$ 5.8 billion acquisition of 200 Safe way stores (Drug stores). This is now being followed by Loblaw that has announced acquisition of Shoppers for C$ 12.4 billion. It is also anticipated that Metro and Jean Coutu, a drug store chain, may join to form one company. So over next few years, it is highly likely for us to see a few big retail chains dominating the industry.
Loblaw Companies Limited
Loblaw is the largest food and grocery retailer in Canada and is listed on the Toronto Stock Exchange. The company is the leading provider of drug store, general merchandise, and financial products & services. The company is a subsidiary of George Weston Limited, which owns 63% of Loblaw. As of 2013, Loblaw operated more than 1000 corporate and franchisee stores. For the year ending 2012, Loblaw reported an operating revenue of C$ 31.6 billion with an operating income of C$ 1.19 billion. Between 2008 and 2012, the revenues of the company grew by 2.6% at an average of 0.6% per year. Loblaw has two major operations - Retail and Financial services (credit cards and other financial products). This end to end everything under the sun business model helped the company maintain huge customer loyalty. Between 2010 and 2012, the operating revenue from Financial products and services increased by 23.6% to reach C$ 644 million in 2012 and the operating revenue from retail increased by 2.1% to reach C$ 30.96 billion. The gross profit margin, between this period, was relatively stable at about 23.5% thus indicating that the company although was able to increase sales but was not really able to increase its marginal revenue. This could partly be because Loblaw operated in a very highly competitive and a matured market that hardly showed signs of inflation. However during this period, Operating income grew by 13.68% at an annual growth rate of 3.9%. This indicates that the company was better able to streamline its operations between 2008 and 2012. The operating profit margin for the company was 3.8% in 2012 as against 3.4% in 2008 although it is worthwhile to note that the operating profit margin did reach 4.4% in 2010 and 2011 before slipping to 3.8%. Another indication of the market being matured was - the same store sales (in retail, same store sales is used to compare sales of stores that have been in operation at least one year) for Loblaw declined 1.1% in 2009, 0.6% in 2010, and 0.2% in 2012. From an investor point of view, this is important because - although it is evident that the company has been growing year on year however much of the growth has come from the stores that have less than a year of operational experience (new stores) and the growth from existing stores have been saturating. In addition, retail chains are always measured by growth in sales. So combining both the growth in sales over the last five years and the growth in same store sales, it looks like Loblaw has reached the maturity stage in the business life cycle despite the company attempting to grow organically (Loblaw opened 26 new stores between 2010 and 2012). As a result of this, the company sought to grow inorganically as the strategy would not just bring growth to its otherwise declining top line growth but also safeguard the company from mammoths such as Walmart and Target. In addition, realizing the significance of its retail space, the company launched a REIT fund in 2013. With interest rates looming uncertainty, the REITs are actually operating at relatively low P/E ratios (compared to their historical average) particularly in the US (however there is a scare of real estate bubble in the Canadian economy). Once there is some news on the US likely tapering off the monetary easing, the markets will settle down and as a result REIT fund strategy of Loblaw might benefit the company.
Shoppers Drug Mart Corporation
Shoppers is a licencor of full service retail drug stores and is listed on the Toronto Stock Exchange. The company operates 1242 Shoppers drug mart and Pharmaprix (called in Quebec). In addition, the company also operates 57 medical clinic Pharmacies, 6 luxury beauty destinations, and 62 Shopper home health care stores. Shoppers is the leader and number one provider of pharmacy products and services in Canada. For the year ending 2012, the company reported a total revenue of C$ 10.78 billion with an operating profit of C$ 881 million. Shoppers Pharmacy segment contributed 47.3% to this revenue pie and the Front store (that sells OTC medication, health & beauty aids, Cosmetics & fragrances, Seasonal products, and Everyday household essentials) contributed the remaining. Between 2008 and 2012, the revenue from Pharmacy operations has increased by 13.7% at an annual rate of 3.3% to reach C$ 5.1 billion in 2012. During the same period, the revenue from front store operations has increased by 15% at an annual rate of 3.6% to reach C$ 5.68 billion in 2012. Although the number of prescriptions dispensed in 2012 was more than 100 million, 5.4% increase over 2011, Pharmacy sales increased only 2% in 2012. Part of the reason was generic penetration and government's control over increasing healthcare costs. As we look in to the future, generic penetration is likely to increase more as the government would want to control increasing healthcare cost so although we are likely to see increase in the volume of prescriptions and as a result increase in the volume of sales but the value of sales is less likely to grow at the same pace. Between 2008 and 2012, the operating revenue of the company increased by 14.4% at an annual rate of 3.4%. The gross margin of the company averaged 38.1% and in fact bettered from 37.4% in 2008 to 38.7% in 2012, thus indicating that the marginal revenue of the products sold by the company improved over this period. The operating profit of the company however remained pretty much stable during this period and grew by just 1.6% to reach C$ 881 million in 2012. EBITDA (Earnings before interest, tax, depreciation, and amortization) though increased by 11.4% to reach C$ 1.12 billion in 2012 thus indicating that the expansion plans of the company that were put in to effect during this period drove away some of the potential operating profits in the form of depreciation and amortization. As a result of this, ROA of the company declined from 8.7% in 2008 to 8.1% in 2012. In addition, between 2008 and 2012, the selling expenses of the company increased from 26% of revenue to 27.5% of revenue. However in 2010, the company delivered a ROE of 14.4% and with a retention ratio of 70%, theoretically Shoppers should have grown at 10% in 2011 but the actual growth rate was 2.6%. Similarly, the sustainable growth rate was 9.7% for the year 2012 but the actual growth rate was 3.1%. This is the case even when the total debt of the company remained largely same between 2010 and 2012 (C$ 1.294 billion in 2010 and C$ 1.138 billion in 2012). So it is hard to predict if the company will grow at a theoretical growth rate of 9.2% in 2013 as arrived after using the ROE and retention ratio of 2012. Growing concerns on healthcare costs is putting increasing pressure on hospitals and pharmaceutical companies to reduce the total cost of care and this might affect Shoppers going forward. On the positive side, as the primary care is experiencing shortage of physicians, pharmacists have become the second line of care and the state of Ontario and other provinces are looking at possibilities of licencing pharmacists to provide basic primary care to the patients. So the Medication Therapy Management (MTM) that includes clinical services by pharmacists provided to the patients could generate some revenue for the company. Looking at the past growth, future challenges, and the growth prospects for the industry, Shoppers should grow at a minimum rate of 2.5 to 3% per year for the next five years and there after, it will be safe to assume that the company will grow at a rate of 2% year on year perennially for the Canadian economy should be growing at a real rate of 2%.
Valuation of Shoppers
With a systematic risk (Beta) of 0.39 (as reported by FT and Reuters), the weighted average cost of capital for Shoppers is 5%. For the year 2013, Shoppers management is investing C$ 275 million in capital expenditure. It is assumed that for the next five years, the management will further continue to make investments equivalent to C$ 250 million year on year. After the fifth year, the investments have been reduced to C$ 200 million per year perennially. In addition, it is also assumed that the changes in working capital are likely to grow at the same rate as the overall growth rate. This is theoretically a correct assumption for the changes in working capital (if not improved upon) should grow at the same pace as the changes in sales. Finally it is assumed that the company will not go for any additional debt for there is evidence for the same - between 2010 and 2012, long term debt of Shoppers decreased from C$ 943.4 million to C$ 247 million although the total debt remained pretty much the same. So based on this assumption, the interest expense has been assumed to remain constant year on year.
Based on the above assumptions and future growth rate of the company (2.5% for the next five years till 2017 and 2% there after), the present value of Shoppers operating assets is C$ 15.135 billion. Adjusting for the total debt and cash components, the value of Shoppers equity is C$ 13.89 billion.
Loblaw offer to Shoppers
Loblaw has announced on the 15th of July 2013, that it would be acquiring Shoppers for C$ 12.4 billion. The deal is structured in such a way that Loblaw would pay C$ 61.54 per Shoppers share using cash and its own stock. Each Shoppers shareholder will receive a cash of C$ 33.18 per share and 0.5965 of Loblaw share for each Shoppers share. The transactions in cash amount to C$ 6.7 billion and the stock transfers amount to C$ 5.7 billion. In addition, Shoppers shareholders can avail capital gains tax deferral out of this transaction which means they will not need to pay any tax in receipt of the cash and Loblaw shares as against the Shoppers shares they are holding currently.
What this means to the Shoppers shareholder -
- Between 17th July 2003, when the company actually got listed on the stock exchange, and 12th July 2013, the day before the announcement of the deal, the Shoppers stock gained 9.64%. During the same period, the S&P/ TSX Composite index delivered a return of 7.48%. So the Shoppers stock did reasonably better than the market.
- On 12th of July 2013, the Shoppers stock was trading at C$ 48.4 and on 15th July 2013, the announcement meant that Shoppers stock holders will be richer by 27%. In addition, they will become shareholders of Loblaw once the deal materializes
- It was interesting to note that the price paid by Loblaw is at least C$ 1.5 billion lower than the proposed valuation of Shoppers Drug Mart Corporation. This indicates that Shoppers shareholders should have received C$ 69.4 for each share as against the proposed C$ 61.54. However if we analyze the returns delivered by the Shoppers stock in the last five years (period before the announcement of the deal), the stock just delivered 1.77%. So it could be that the shareholders are happy that finally they are seeing some value in holding the stock.
What this means to the Loblaw shareholder -
- After the announcement of the deal, George Weston Limited, which once held 63% of Loblaw Companies Limited, will now hold only 46%. This means the parent company losses its majority shareholder status. Shoppers shareholders through the stock transfer will hold 29% of Loblaw shares. The institutional and retail investors of Loblaw, who once held 37% of the total outstanding shares will now hold only 25% of the total outstanding shares. So because of this deal, the Loblaw institutional and retail shareholders have got their stake in the company diluted by 48%.
From the financial point of view, Loblaw benefited from the deal where in it got Shoppers relatively cheaper than the proposed valuation and from the shareholder point of view, Shoppers shareholders benefited for they got results for holding on to a stock that was under performing for quite sometime now. However an interesting point to be noted is that - the parent company, George Weston Limited, was happy to give away its majority shareholder status thus indicating something around the interest of the parent company in this business.
Proposed Synergies and applicable logic
It is often said that "You buy growth in M&A". In this case, however we are seeing two mature companies coming together to form a big company. Both Loblaw and Shoppers span coast to coast and have significant presence in each of the provinces in Canada. On one hand, this new company will deter competition for sometime till Walmart and Target gear up. However it also showcases the nervousness of Loblaw to do something particularly after we know that Sobeys Inc acquired 200 Safeway stores earlier this year. On a broader scenario, we have to understand that Loblaw is fighting against the financial muscles of retail world - Walmart and Target. If they see an opportunity in the market, they have all the financial and operational resources to tap in to the opportunity and it will all be game over for Loblaw.
Through this deal, Loblaw proposes that it will gain synergies equivalent to C$ 300 million over the next three years. 40% of this synergy is likely to yield from operational expenses - SG&A, Supply Chain, IT, and Shared infrastructure. 45% of the synergy is likely to yield from COGS (procurement) and the remaining 15% from loyalty and Financial services. On the Hindsight, it must be noted that Loblaw is a food retailer and Shoppers is a drug store. So I am puzzled as to what synergistic benefits the combined company could earn through procurement, which is likely to deliver 45% of this proposed synergy. Also when you have two different companies, which have varied business operations, I am not sure how marketing activities can be combined. Finally distribution channels and warehousing can barely be shared when Loblaw sells food and grocery and Shoppers sells high end merchandise and Pharmaceutical products. However since both the companies are relatively strong in their private label brands, this M&A could mean that there could be some synergies out of cross selling and reaching out to a wider population. Besides Shoppers is very strong in convenience store format in urban areas and with this acquisition, Loblaw can tap in to these stores though the scope of synergy is limited. In addition, Shoppers loyalty program is regarded one of the best in the country. So Loblaw could benefit by expanding the program to its stores as well. So overall, I am a bit skeptical about this C$ 300 million synergy that has been proposed by Loblaw management although there are a few foreseeable benefits though this deal clearly showcases some eagerness from the company to make some news. However it is not a bad news considering that Shoppers has some reasonably better growth prospects than that of Loblaw.
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