CA - Empire Company: A Cheap Dividend Grower In A Defensive Industry

2023-05-18 08:05:52 ET

Summary

• Empire Company boasts an impressive 28-year dividend growth streak.
• Making up for lost ground, the company is expanding its discount retail footprint in response to evolving consumer trends.
• Empire is advancing significant investments in its e-commerce and distribution centers to Canada's major urban areas.
• These initiatives are intended to boost margins and deliver incremental EBITDA over a three-year period.
• Empire trades at a discount relative to its major Canadian food retail peers.

Author's note: All figures listed in CAD$ unless otherwise noted.

Investment Thesis

Empire Company Limited ( EMP.A:CA ) offers investors a high quality franchise in a defensive sector at an attractive valuation. Empire Company is advancing plans to round out its well established grocery brands with a growing discount label focused on value oriented consumers. Investments in e-commerce platforms and distribution centres are enabling solid growth in the grocery delivery business. Empire's defensive food retail operations have supported 28-years of consecutive dividend increases. While the current dividend yield is a modest 1.9%, the growth rate has been an impressive 9.5% over the past five years. Empire's current valuation makes it an attractive pick relative to its Canadian retail peers.

Company Profile

Empire owns and operates a portfolio of food retail brands that include: Sobeys, Safeway, IGA, Foodland, FreshCo, Thrifty Foods, Farm Boy, Longo’s, and Lawtons Drugs. The company also operates an e-commerce platform facilitating online grocery purchases through its labels: Voilà, Grocery Gateway, IGA.net, and ThriftyFoods.com.

Empire operates 1,598 retail locations and 350 retail fuel locations with a presence in all ten Canadian provinces. Serving over 900 communities across the country provides Empire with substantial regional diversification. Along with grocery retailers Loblaws ( L:CA ) and Metro Inc. ( MTRAF ), Empire accounts for approximately 60% of the food retail market share in Canada. Empire’s two leading brands, Safeway and Sobeys account for approximately 20% of national sales.

In addition to food retail segment, which accounts for 90% of operating income, Empire owns interest in Crombie Real Estate Investment Trust ( CRR.UN:CA ), a publicly traded REIT specializing in owning, operating and developing grocery and pharmacy-anchored shopping centers. Expanding its portfolio further, Empire owns a stake in California-based Genstar, a real estate developer.

Empire records approximately $31B in annual sales and holds $16.4B in assets. It is a significant employer, with 130,000 employees nationwide. Empire was incorporated in 1963, however its wholly owned subsidiary, Sobeys has retail roots dating back to 1907 where the company is headquartered in Nova Scotia, Canada. With a market capitalization of $9B, Empire trades on the Toronto Stock Exchange under the ticker "EMP.A" with average daily volume of 380,000 shares.

Project Horizon Strategy

Empire is currently executing on its Project Horizon, a three year, strategic program geared at adding $500M in incremental EBITDA. This strategy includes: consolidating various eCommerce platforms and driving order and delivery growth; optimizing its store mix to grow the portion of stores operating under Empire’s discount banner; and narrowing the EBITDA margin gap to peers Loblaws and Metro. In addition to EBITDA margin expansion of 50bp, the company expects to achieve compound average growth rate in EPS of approximately 13% over Project Horizon's 36-month timeframe.

Discount Retail Segment

The discount grocery segment is a growing part of the food retail industry. This has been especially true as food price escalation over the past 18 months has pushed many consumers to consider value options. Competitors including Loblaws, have a well established discount retail line. Empire is playing catch up in this segment through its FreshCo brand.

Empire expects to convert up to 25% of the 255 Safeway and Sobeys full-service format stores in Western Canada to the FreshCo banner. With 44 FreshCo stores currently operating in Western Canada, Empire plans to open an additional 31 before the end of fiscal 2023. While this expansion is essential from a market share perspective, there will be substantial capital expenditures associated with the conversions. These existing stores have performed well in recent quarters with same store sales growth reaching double digits.

In the recent Q3 2023 earnings call , Michael Medline, President and Chief Executive Officer addressed the inflationary impact on Empire’s food retail operations:

This quarter, we saw food inflation remains stubbornly high, and we saw customers continue to adapt their shopping behaviors due to this inflationary environment with many people shopping multiple stores, trading down on products, buying more on promotion and filling smaller baskets.

While higher prices drive higher revenues, margins have not improved materially for Empire as wage growth mitigates the impact of higher food prices. Changing consumer trends, accelerated by high inflation may push shoppers to consider generic in-house food labels at lower price points. Michael Medline again on the company's private label penetration:

Our own brands portfolio continues to provide significant value to customers and grew faster than the market for both the quarter and the fiscal year. We are focused on leveraging our own brand portfolio across all of our banners to provide value to customers. And this month, we began the rollout of 230 non-food owned brand products at Longo stores.

E-Commerce

While late to the game compared to some of its competitors, Empire has been making investments in Customer Fulfilment Centres or “CFCs” to support its growing e-commerce platform. Operating CFCs in Toronto and Montreal experienced double digit growth from Q2 2023 to Q3 2023. Capital costs associated with the full build out of the Montreal facility resulted in higher costs in the first half of fiscal 2023. A third CFC is scheduled to be opened in Calgary in the first quarter of fiscal 2024 with a fourth in Vancouver to follow in 2025.

In addition to these capital investments, Empire has been advancing its e-commerce capabilities through the integration of its software platforms Voilà and Grocery Gateway . The company anticipates this integration to be complete by July 2023. With these platforms amalgamated and additional CFCs coming online, the company expects sales volumes to increase and efficiencies to improve. Empire is offering monthly subscriptions to Voilà for ordering and delivery to lock customers into Empire’s sales ecosystem. Across the platform, momentum is growing as Voilà sales grew by 9.4% from Q2 2023 to Q3 2023.

Dividend Growth

Empire has a long track record of consistent dividend growth with a streak that began 28 years ago. While the current yield of 1.9% is modest, the firm’s 23% dividend payout ratio gives Empire lots of room for future increases. Even during the pandemic in 2020, the company’s payout ratio never exceeded 40%.

While the current yield is low, long term investors know that strong levels of dividend growth can result in high yield-on-cost and a strong total return. This dividend growth is impressive with 10-year CAGR of 7.2%, increasing to 9.5% over 5 years. The most recent 10% boost to the dividend as of Q1 2023 extends this pattern. With 33 years of consecutive quarterly dividends, Empire’s high dividend growth rate and low yield underscore that the share price has grown with the support of long term EBITDA growth rates of 14.8% over the past five years.

In addition to dividend growth, Empire is returning capital to shareholders through its normal course issuer bid program. In June 2022, Empire renewed its NCIB by with the intention to purchase up to 10,500,000 non-voting Class A shares for cancellation. This represents 7% of public float. For fiscal 2023, Empire announced its intention to repurchase $350M in shares. As of March 2023, the company had purchased approximately 7.4 million shares for a total cost of $276M.

Valuation

Relative to peers Loblaws and Metro Inc, Empire is attractively valued. On a forward P/E basis, Empire trades at 12.7X, compared to 15.9X and 21X for Loblaws and Metro respectively. On 2023 EV/EBITDA, Empire trades under 7X, well below 9.1X and 11.1X for Loblaws and Metro. This lower valuation reflects a number of factors including Empire's weaker e-commerce and discount brand profile compared to the others. This valuation discount may also reflect Empire's dual class share structure, which does not include voting rights on its publicly traded class-A shares.

One of the factors not captured in this discounted valuation is Empire's attractive gross margin. Empire has consistently achieved a gross margin of 25-26%, well above Metro's, which hovers around 20%. Loblaws, best-in-class gross margin averages around 30% due to its highly integrated business, strong pharmacy line and deep penetration of its private label products.

Tailwinds

While there is a perception that grocers are benefiting from higher food inflation, gross margins at Empire have been relatively flat since 2021. Margin improvement will likely stem from better store alignment within the discount retail segment and better penetration on private label products in store.

Investments in consumer data management will unlock greater targeting abilities. Personalized and regionalized promotions can be more effectively pushed. This is especially true for users of Empire’s e-commerce platform Voilà who can respond to push notifications and directed promotions in real time from their mobile devices. In an effort to defend market share, Empire has also expanded its loyalty program to include Cineplex Scene+ Rewards for free movies.

Risk Analysis

One of the key risks facing Empire is inflationary pressure on food prices and wages. With approximately 130,000 employees, Empire is sensitive to any increases in labour costs. On the food inflation side, Empire has reported receiving hundreds over supplier cost increase requests in the last quarter that continue to add to food inflation. Empire will attempt to raise prices to pass these costs on to consumers where it can. A failure to pass on these costs could result in margin erosion. Large food retailers could also come under increased public and government pressure to do more to address food prices for consumers.

In November 2022, Sobeys was the victim of a cyber security event that caused disruption to several key systems when company servers were accessed by an unauthorized party. In addition to some fresh inventory management tools, the company saw an interruption in sales as it was unable to process points redemptions or gift card transactions for a period. Empire estimates that the impact of the cyber security event on net earnings over fiscal 2023 and fiscal 2024 will be approximately $32M, after some mitigation from insurance recovery.

Empire’s subsidiary, Sobeys Inc., is rated by both DBRS Ltd. and Standard & Poor’s (S&P) with BBB Low (Positive Trend) and BBB- (Stable Outlook) respectively. The company has a solid balance sheet with $210M in current cash liquidity to fund growth.

Investor Takeaways

Empire Company is a high quality franchise in a defensive industry. The company's ambition to expand margins through a nationwide roll-out of a robust e-commerce platform and the growth of its discount grocery label should help to support multiple improvement over time. At current levels, Empire is attractively priced relative to its peers. The company's 28-year record of dividend growth underscores the resilience of its business model and the stability of its earnings.

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