Although the grocery business is well known as one of the more boring sectors out there, it’s still been a pretty exciting ride for shareholders of Loblaw Companies Limited (TSX: L) over the last few years.
In 2012 shares of Canada’s largest grocer sank to $30 each as earnings were impacted by supply chain issues. As the company found out the hard way, it’s hard to sell groceries if they’re not on the shelf. Investors beat up the stock because these kind of issues simply can’t happen if a retailer wants to maintain market share. That’s retailing 101 stuff.
But Loblaw did a nice job pulling out of its funk, and management really sent shares soaring when it agreed to acquire Shoppers Drug Mart in 2014. Loblaw was already Canada’s largest retailer; with the acquisition it suddenly became Canada’s largest pharmacy chain as well, with more than 2,000 different locations with drug dispensaries.
Now that shares are just under $70 each, investors might be concerned that there’s no upside left. Has Loblaw’s valuation gotten out of hand? Or has it earned a premium valuation? Let’s take a closer look.
Valuation
Upon first glance, there’s no doubt that Loblaw shares look expensive. They trade at nearly 40 times trailing earnings, which isn’t usually a multiple you’d associate with a grocery chain.
Looking forward, the company’s earnings are expected to skyrocket from the $1.71 in earnings it has posted over the last 12 months. Analysts project the company will earn $3.54 per share in 2015, growing that nicely again in 2016 to $4.09 per share. That puts shares at just 19.1 times 2015’s expected earnings, and at 16.6 times 2016’s expectations.
Let’s compare that with Empire Company Limited (TSX: EMP.A) to see whether or not Loblaw is a good deal compared with its biggest rival. Empire currently trades at 18.4 times earnings, falling more than 12% in the last week when its quarterly earnings disappointed the market.
Empire is projected to make $5.72 per share in its fiscal year 2016, which ends in April. In 2017 earnings are expected to increase to $6.37 per share. That puts the company at just 14.1 and 12.6 times earnings, respectively.
It’s obvious the market isn’t as confident in Empire’s earnings as it is in Loblaw’s expectations. Still, the company’s biggest competitor trades at a much cheaper valuation.
Growth potential
There’s a pretty compelling argument to be made for why Loblaw shares should trade at a premium compared with its biggest competitor. The growth potential in the pharmacy business over the next few decades looks to be pretty attractive.
It starts with demographics. There are more than nine million Canadian baby boomers, most of which can look forward to a retirement spanning at least a decade, or likely even two or three decades. That’s a lot of time to be popping pills.
There’s also the stickiness of the revenue from these consumers. The relationship between a pharmacist and a customer is sort of like the one between a doctor and a patient. Most customers are going to stick with their pharmacist through thick and thin, since the pharmacist knows so much about their medical history.
Shoppers potential
There’s another reason to like the acquisition of Shoppers. I’m convinced smaller stores will become the shopping destination of choice for older customers.
My grandmother is a perfect example. When she got to the point where walking was difficult, a big-box store was out of the question. So she’d pick up her staples at convenience stores. Paying the extra dollar for a gallon of milk was well worth it, so she wouldn’t have to walk all the way across the huge Loblaw store.
As the baby boom generation continues to age, this will become more and more important. Not only is Shoppers Drug Mart well positioned to capture this traffic, but Shoppers also boasts hundreds of locations in the heart of Canada’s biggest cities, places that are just too crowded for a traditional grocery store. These stores should continue to do well.
Loblaw is an expensive stock, at least compared with its biggest rival. But it has compelling growth potential and owns interesting assets like Canada’s two largest private food labels, PC Financial, and a mountain of good real estate. It just might be the best retailer in Canada.
