Although the grocery sector is traditionally a low-margin high-volume business, there are still plenty of reasons why you should have exposure to the sector in your portfolio.
The biggest is that grocery stocks tend to do well during falling markets. During the Great Recession, all of Canada’s grocers performed much better than the overall market. Some actually saw their shares go up during the crisis, putting them in a pretty elite group.
But which grocer should you own? I’ll pit the two largest up against each other to see which is more worthy of your portfolio dollars.
The businesses
Thanks to its acquisition of Safeway’s Canadian stores in 2014 to go along with its Sobeys, IGA, and Price Chopper brands, Empire Company Limited (TSX: EMP.A) cemented its status as the second largest grocer in Canada. The company’s stores focus on fresh products, innovative high-margin store brands, and giving the customer a better shopping experience. Safeway is especially good at these and therefore attracts customers who aren’t so price sensitive.
Loblaw Companies Limited (TSX: L) is Canada’s largest retailer. The company owns more than 2,300 stores, including its most recent acquisition, Shoppers Drug Mart. It also operates stores under the No Frills, Superstore, Zehr’s, Maxi, and Fortino’s banners. For the most part, its stores cater to a more price conscious crowd, a business model the company can pull off because of its size and its efficiency. The acquisition of Shoppers really boosted its pharmacy business, making it the clear leader in that space in Canada.
I’m more of a fan of Empire’s business model. Having customers who are willing to pay a little more for a premium product makes it easier for them to compete with the 600-pound gorilla in Canada’s retail space: Wal-Mart.
Valuation
On first glance, Empire looks to be pretty expensive from a price-to-earnings perspective. Shares currently trade hands for more than 34x trailing earnings.
But that was mostly due to the costs related to the Safeway acquisition, which now look to be largely behind it. The last two quarters saw earnings of $1.39 and $1.43 per share, both of which handily beat analyst expectations. Full-year earnings are expected to be $5.60 per share in 2015 and $6.65 in 2016, which puts the company at 16.3 times 2015 earnings and just 13.7 times 2016’s expected results. That’s a cheap valuation for a company expected to grow earnings by nearly 20%.
Loblaw is even more expensive. Thanks to costs from its big acquisition, earnings over the last 12 months were actually negative, by two pennies per share. That’s also likely to change in 2015, with expected earnings to come in at $3.05 per share, increasing to $3.65 per share in 2016. That puts the company’s forward price-to-earnings ratio at 20.6 and 17.2, respectively.
On a valuation perspective, it isn’t even close. Empire looks to be much cheaper on a forward earnings basis.
Dividends
Both companies pay small but growing dividends.
Loblaw’s dividend comes in at $0.25 per share on a quarterly basis, good enough for a 1.6% yield. Since 2010, the payout has increased from $0.21 to $0.25, which is a pretty poor growth rate. The dividend stayed at $0.21 until 2012, and the company has raised it by a penny each year since. Based on 2015 projected earnings, the payout ratio looks to be quite low, at about 30%.
Empire’s dividend isn’t as attractive right now, but it has tons of potential for further growth. Shares currently yield just 1.2%, but the quarterly payout has increased from $0.19 per share in 2010 to $0.27 per share now. That’s an increase of 7.2% annually. The payout ratio is tiny too, coming in at less than 18% of 2015’s projected earnings.
Which should you own?
Both companies are great retailers, but for an investment, I’d be much more interested in Empire. The company trades at a lower projected price/earnings ratio, it caters to shoppers who are happier to pay a higher price, and it looks to be more serious about growing its dividend. Loblaw might be the king of Canada’s retail market, but it’s too expensive for this value investor.
