The grocery business in Canada is particularly comfortable right now. These companies have successfully passed on higher costs of food and essentials to consumers. Now that inflation is easing, they could be in for a period of higher margins.
Over the past year, Loblaw Companies (TSX:L), Canada’s largest retailer, has evolved alongside these trends. Now, investors should take a closer look at the stock to see if it fits their portfolio.
Inflation hedge
Food prices have skyrocketed in recent years. The average Canadian grocery bill is 21% higher than three years ago, according to the latest data from Stats Canada. Prices are up 8.9% over the past year alone.
Food isn’t the only thing that’s more expensive. Fuel, household products, pharmaceuticals and alcohol have all seen a surge over this period. Simply put, everything on Loblaw’s shelves has a bigger price sticker in 2023 than it did in 2020.
However, the company has managed to pass these costs along to the consumer and absorbed none of the impacts. The company registered a gross profit margin of 31.3% in the first three months of 2023. The margin was 31.1% in the same period last year. In other words, the company has pricing power.
That pricing power stems from its market dominance. Loblaw (and all the various companies within this conglomerate) controls roughly 28% of the Canadian grocery market. This gives it leverage over consumers, who have few other options for their necessary household spending.
This leverage also helps to sustain prices when costs are falling.
Higher margins
Wholesale prices — the prices a grocery chain like Loblaw would pay to acquire products — have been dropping for several months. The price for chicken on the wholesale market has dropped from $4.77 to $4.59 per kilogram between March 2022 and May 2023. Similarly, egg prices were lowered by 14 cents per dozen by the Egg Farmers of Ontario in January. Meanwhile, crude oil prices are down from last year, which makes transporting these items cheaper.
These cost savings are only passed along to consumers if grocery chains indulge in aggressive discounts and price wars. However, when one entity holds 28% of the market, there is less incentive to pass these cost savings along to consumers quickly.
That’s why I expect higher margins at Loblaw in the months ahead. Investors should keep an eye on better profits and, perhaps, dividend boosts in the months ahead.
Valuation
Despite these tailwinds, Loblaw stock is down 2.9% year to date. The stock now trades at a price-to-earnings ratio of 20 and offers a 1.5% dividend yield.
It’s undervalued, given its position in the market and robust earnings growth. Investors should add it to their safe-investment watch list.
Bottom line
Loblaw dominates Canada’s grocery market. It has passed on higher costs to consumers quickly but may not be so quick to pass savings in wholesale prices. That’s why I expect better margins and higher dividends in the year ahead. Keep an eye on this stock.
