CA - Loblaw Companies: Sales Growth Remains Price-Driven Rather Than Volume-Driven

2023-07-31 05:51:08 ET

Summary

• Loblaw Companies has continued to see sales growth.
• This has been price-driven rather than volume-driven.
• Long-term debt to total assets has not decreased from last year.
• I take the view that investors would like to see a rebound in volume-driven sales growth as well as a reduction in long-term debt to justify further upside.

Investment Thesis

Loblaw Companies needs to see an improvement in volume-driven sales growth, as well as short and long-term balance sheet metrics to justify further upside from here.

In a previous article back in May, I made the argument that Loblaw Companies ( L:CA ) could see further upside from here, but investors would ideally like to see more evidence that Drug Retail sales can ultimately lift overall earnings.

My reason for making this argument was that while food retail has been seeing strong growth - this could be down to price growth rather than organic demand and the company could see sales plateau once inflation starts to level off.

Since my previous article, the stock has descended to a price of CAD 116.75 at the time of writing:

The purpose of this article is to assess whether Loblaw Companies has the ability to see continued growth from here taking recent performance into consideration.

Performance

When looking at the most recent earnings results for Loblaw Companies, we can see that food retail growth saw an increase to 6.1% from that of 3.1% in the last quarter.

However, food inflation continues to remain high - with The Consumer Price Index for Food Purchased From Stores up by 9.1% from that of last year. In this regard, the growth we have been seeing in food retail sales largely continues to reflect price growth as opposed to increased demand. Moreover, with such price growth being driven by higher supplier costs - gross margins have gone down in spite of higher profitability.

As regards the Drug Retail segment, we can see that as compared to the last quarter, growth in the Drug retail segment slowed from 7.4% in Q1 to 5.7% in Q2.

In addition, we can also see that while pharmacy and healthcare services (denoted as P & H below) saw growth from 4.7% to 6.3% - that of the front store segment saw a significant decline in growth from 10.3% to 5%. Note that of total sales of CAD 3.911 billion for Drug retail - both the front store and P&H contributed CAD 1.984 billion and CAD 1.927 billion respectively.

Balance Sheet

With regards to short-term liquidity, we can see that the quick ratio of Loblaw Companies (calculated as total current assets less inventories all over total current liabilities) has seen a slight increase from that of last year but still remains below 1 - indicating that the company still does not have sufficient liquid assets to fund its current liabilities.

Source: Figures (in millions of Canadian dollars) sourced from 2023 Second Quarter Report to Shareholders. Quick ratio calculated by author.

In addition, we can see that the long-term debt to total assets ratio for Loblaw's is up slightly from that of last year.

Source: Figures (in millions of Canadian dollars) sourced from 2023 Second Quarter Report to Shareholders. Long-term debt to total assets ratio calculated by author.

My Perspective

As regards my take on the above results and the implications for the growth trajectory of the stock going forward, we are seeing evidence that while growth across the Drug retail segment is continuing - the same is starting to level off on a quarterly basis.

In addition, sales growth across the food retail segment continues to be price-driven as opposed to demand-driven.

From a balance sheet standpoint, the company's quick ratio continues to remain below 1 - while long-term debt relative to total assets has not decreased in the past year.

In addition, Loblaw took the decision back in May to close its e-commerce marketplace for third-party sellers - after being unable to compete with larger competitors such as Amazon ( AMZN ) and Walmart ( WMT ) - instead choosing to focus solely on core grocery and pharmacy online sales. While choosing to refocus its business could allow the company to reap cost savings over the longer-term - it does also mean that a decline across the core segments of food and drug retail would be expected to have a significant impact on the business.

Taking these points into consideration, I do not see a case to be made for upside in the stock at this moment in time.

Risks and Looking Forward

Going forward, the main risk to Loblaw at this time is demand remaining low in the face of inflation, which will ultimately lead to a decline in sales growth once price inflation starts to level off.

With that being said, this is in many ways dependent on the broader macroeconomic picture - and we could see a situation whereby demand rebounds once price inflation starts to moderate.

I would expect that if this were to be the case, investors will also want to concurrently see an improvement in Loblaw's balance sheet metrics, i.e. a reduction in long-term debt and a higher quick ratio. Even if sales volume were to rebound - I take the view that this would need to translate into a reduction in long-term debt and an enhanced short-term liquidity position for investors to see prospects of upside going forward.

Conclusion

To conclude, Loblaw Companies has continued to see growth across food retail, but this has been price-driven rather than demand-driven. Additionally, drug retail sales have started to moderate due to a drop in growth across the front store segment.

My overall view is that Loblaw would need to see both a rebound in volume-driven sales growth, along with a reduction in long-term debt relative to total assets and an improvement in short-term liquidity to justify further upside from here.

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