Fixed Income Viewpoint
Retailing/Consumer Products – April 2014
Sector Rating: Underperform Relative Value
5-Year: Underperform 30-Year: Underperform
Spread View – We rate the sector Underperform, reflecting challenging conditions in grocery retail (intensifying compe- tition, value-conscious consumer). The sector’s underlying credit fundamentals deteriorated in the summer of 2013 as both Loblaw and Sobeys leveraged up their balance sheets to make significant acquisitions. New issuance has significantly surprised on the high side in 2013 due to M&A; however, we expect more modest issuance in 2014. The sector also remains vulnerable to underperformance if investors’ global risk toler- ance deteriorates.
Credit Curve – The 10s-30s indicative curve for the retail sec- tor narrowed in Q1/14 to 47 bps from 61 bps at December 31, 2013, and is substantially narrower than 96 bps at December 31, 2012. We expect the sector to maintain a relatively steeper curve given the uncertainties the sector faces and lower credit quality.
Sector Value – The sector average spread in the long end of 214 bps is the widest amongst sectors. The 30-year basis to utilities narrowed significantly to 59 bps from 85 bps in Q4/13 and down substantially from 125 bps in December 31, 2012. The Retail sector’s short total return in Q1/14 of 1.58% slightly outperformed the short bucket of the FTSE TMX Canada Universe Corporate Bond Index total return of 1.39%.
Recommendation
Top Pick – Our preferred credit is Loblaw. Same-store sales and margin continue to be supported by investment in customer proposition. While additional debt incurred to acquire Shop- pers will raise leverage sharply, the acquisition is a strategic positive, in our view. There is a short-term trading opportunity in Metro’s two outstanding bonds as uncertainty over the gro- cer’s strategy to maintain its market position and profitability weigh too heavily on spreads.
Risks
External – Consumer spending growth is expected to pick up in 2014 but remain at modest levels. Unemployment trends are encouraging, though we do not anticipate a significant change in consumer spending. Consumer insolvencies declined in January 2014 after increasing slightly in 2013. The consumer
remains vulnerable owing to the high debt burden.
Competition – Food price competition remains fierce and is expected to intensify. U.S. retailers are expected to continue expanding. Am- azon has launched its Cana- dian e-commerce store.
Trading Liquidity – Sec- ondary trading is relatively limited for certain names, with Loblaw and Canadian Tire the most liquid. REIT debt issues in the future are expected to replace tradi- tional retail unsecured bond issuance.
Trevor Bateman, CPA, CA, CFA
BMO Nesbitt Burns Inc. trevor.bateman@bmo.com (416) 359-8238
.
New Issuance – After a busy year of M&A-driven bond issu- ance, we expect a more manageable pace of new issuance in 2014. Eagle Credit Card Trust (Loblaw) and Glacier Credit Card Trust (Canadian Tire) have demonstrated access to the ABS market.
Other – Shareholder activism was seen at Tim Hortons when a couple of hedge funds publicly argued for increased share- holder returns.
Credit Profile
Sector Financials – We generally expect low-single-digit growth in revenues, a range of EBITDA growth performance and posi- tive free cash flows. Positive free cash flow is expected to be used to repay elevated debt levels at Loblaw and Sobeys.
Sector Fundamentals – We believe food retailers are a defensive play, as the consumer is still under pressure with unemployment at elevated levels and moderate economic growth expected in 2014. However, our view is tempered by an intensifying competitive landscape in grocery retail as Walmart and Tar- get increase their competitive position. Industry retail square footage is expected to grow at a faster pace than domestic grocer store networks. Retail food price competition remains as intense as ever.
Credit Ratings – Ratings are generally stable after DBRS’ downgrade of Sobeys and the Negative outlook by S&P. DBRS recently wrote that Metro and Sobeys are most at risk of nega- tive credit rating pressure.