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Loblaw’s Hidden Gem

When investors think of Loblaw (TSX: L), they probably think of the company’s more than 1,000 stores across the country. They might think of Loblaw’s commitment to its President’s Choice private label brand, which might be the strongest private label brand in the world, never mind Canada. They might even think about the huge acquisition of Shopper’s Drug Mart, which added more than $11 billion worth of revenue and $600 million to Loblaw’s net profit.

These are all fine assets. But investors are missing an important piece of Loblaw’s success going forward.

Last week, Canadian Tire announced that Bank of Nova Scotia was acquiring 20% of its financial services division for $500 million, valuing the whole division at $2.5 billion. Bank of Nova Scotia has the option to acquire an additional 29% of Canadian Tire’s financial services at any point over the next 10 years.

Bank of Nova Scotia was attracted to the strong loyalty Canadian Tire customers showed the card, as well as the interchange fees charged when each user swipes the card. These fees — usually around 2% of a transaction — really add up, especially as customers use cards for a whole gambit of purchases.

This is just part of a big push from Canada’s banks to beef up their credit card businesses. Signup bonuses offered to customers are getting more attractive, and even a non-traditional retailer like Tim Hortons is pushing its own credit card. Signing up credit card business is an attractive business for banks, since high interest rates ensure good rates of returns, even after write-offs. Even customers who pay the balance each month generate interchange fees.

Loblaw has its own financial services division, which offers everything from bank accounts to insurance to its members, but is primarily driven by credit cards. President’s Choice revenues have increased by more than 15% annually over the last two years, and current cardholders owe the company more than $2.5 billion worth of debt. Even after losses, the company’s annualized yield on its credit card division is more than 13%.

While Loblaw’s credit card business isn’t quite as large as Canadian Tire’s — which has about $4.4 billion owing — it’s still a significant business. Most of its revenue increases have come because customers are using the cards more frequently and for smaller amounts, making the financial division an attractive acquisition for a Canadian bank looking for interchange fees.

The company has the potential to grow its credit division even more, as it rolls out more aggressive in-store efforts to entice customers to sign up for all of its financial products. It also rolled out a new loyalty program that lets customers earn additional points if they use a President’s Choice Mastercard to pay for their purchase.

Loblaw has recently shown its willingness to spin out non-core assets, reorganizing its properties into a REIT and listing it on the TSX as Choice Properties. The parent company retained an ownership stake of 82% of the new entity, but hasn’t shut the door on selling further stakes in the business to investors.

Once the company digests the Shopper’s acquisition, it suddenly has millions of new customers to sign up for financial services. It also has billions in new debt, which may start to make management nervous, especially if expected cost-cutting doesn’t happen as quickly as expected. Selling off a chunk of a non-core asset might start to look very attractive at that point.

Each of Canada’s other grocers are envious of Loblaw’s financial services division. It’s a terrific asset that has showed impressive growth. If the company decided to sell, now would be a terrific time to do so. Canadian banks have shown they’re hungry to acquire store-branded credit cards, and Loblaw has a lot of new debt to pay down. Don’t be surprised to see Loblaw join Canadian Tire in selling part of its credit card division.

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Fool contributor Nelson Smith has no position in any stock mentioned in this article.

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