Page 2 Fixed Income Quarterly—Retailing/Consumer Products
Viewpoint
We rate the sector Underperform, reflecting challenging mar- ket conditions in light of intensifying competition in grocery retail, elevated financial risk following strategic M&A activity in 2013, and increasingly value-conscious consumer spending against the backdrop of high household debt. After a flurry of new issuance over the summer and fall, we expect a moder- ate amount of bond issuance in 2014. The “high beta” sector also remains vulnerable to underperformance if an industry price war breaks out and/or investors’ global risk tolerance deteriorates.
Retail Outperforms in Q1/14: Retail sector bonds generated a total return of 1.58% in Q1/14 in the short end, which slightly outperformed the short bucket of the FTSE TMX Canada Universe Corporate Bond Index total return of 1.39%. In the mid-term, the sector’s total return of 4.84% slightly outpaced the universe total return of 3.85%. In the long end, the sector’s total return of 7.94% was better than the universe total return of 6.06%. For full-year 2013, the retail sector underperformed by 28 bps in the short term and 109 bps in the mid term. In the long end, the sector outperformed by ~400 bps, resulting in overall outperformance of 31 bps on a broad basis.
Loblaw bonds generally outperformed in Q1/14, illustrated by the 2023 bond tightening by 27 bps, or by 15%, compared to the Tim Hortons 2023 bond that tightened by 14% and Sobeys 2023 bond that tightened by 12% (measured by spread to curve).
The long Metro 2035 bond now trades ~13 bps wider than the Loblaw 2035 bond, which we believe signals market un- certainty about Metro’s plans to restore its debt leverage to more normal levels in the 2.5x area (currently 2.0x December 31, 2013) and pursue growth opportunities to combat in- creasingly competitive grocery retail environment driven by the consolidation (Loblaw/Shoppers, Sobeys/Safeway) and Walmart’s expansion in Quebec. We think there is a short-term trading opportunity, as we do not expect Metro’s leverage will rise above Loblaw’s leverage.
Key Themes
Canadian Economy to Pick-up Modestly in 2014 – BMO Eco- nomics expects Canadian economic growth to pick-up mod- estly to 2.3% in 2014 from 2.0% in 2013. Consumer spending growth is expected to remain modest in 2014, at 2.5% compared to 2.2% in 2013. Consumer insolvencies increased in 2013 for the first year since 2009 by 0.2% after the number of filings (bankruptcies + proposals) declined 3.7% in 2012. However, 2014 has started strong with a 5.6% y/y decline in consumer insolvency filings in January, which is an improvement from a 4.5% y/y increase in January 2013. The unemployment rate is expected to improved slightly in 2014 and decline below 7.0% to 6.9%, the lowest level since the credit crisis, but still higher than pre-credit crisis levels. While the trend in the unemploy-
ment rate is encouraging, we do not expect a strong recovery for Canadian consumer spending, and we expect consumers to maintain their preference to eat at home and continue to be focused on value.
Rising Indebtedness of Canada’s Household Sector – The Bank of Canada and others continue to express concern regarding the high level of indebtedness of Canada’s households. The Bank of Canada wrote in its December 2013 Financial System Review that the level of indebtedness is still elevated, and the Bank’s stress tests suggest that households are vulnerable to adverse economic shocks. The central bank also notes hous- ing valuations remain stretched, in certain markets, and there continue to be signs of overbuilding. These imbalances will take some time to correct since they were built over a long period of time. The Bank cautioned that while a gradual un- winding of imbalances is expected, there is a risk of a sharper correction.
Retail Food Inflation – Wholesale food inflation has accelerated at faster pace than the rate of growth in retail food inflation, which puts pressure on gross margins, all else equal. BMO Economics expects food price inflation to pick-up in 2014 to 1.5% compared to 1.2% for 2013, which is still lower than 2.4% in 2012. We remain cautious about grocers’ ability to pass along price increases to consumers in light of intensify- ing competition in grocery retail, driven in part by the excess supply of selling space.
Increasing Competition – Food retailing is becoming more competitive with Walmart’s continued expansion activity in Canada and its stated goal of being the fastest growing retailer in the region, as well as Target Canada’s 2013 entry. Walmart Canada currently has 247 supercentres and 142 conventional stores in Canada (February 4, 2014). The company plans to complete 35 supercentre projects in fiscal 2015, as well as expand its distribution network and its e-commerce business. Eventually, Walmart plans to convert all Canadian stores to Supercentres. Target Corp. plans to add nine more stores to its current network of 124 stores (as of January 29, 2014). On October 31, 2013, Amazon unveiled its new grocery, health and beauty, and automotive e-commerce offering. In the quick-service restaurant sector, McDonalds has elevated the treatment of its coffee offering to a level just as critically important as it treats its iconic french fries.
Grocery Retail Square Footage – Industry square footage growth is a threat, as the growth in supply has continued to outpace demographic-driven demand. Over the last six years, industry square footage has grown 1.8% CAGR, which has exceeded annual population growth of 1.0% (DBRS), further intensifying competitive pressure in the industry.
E-commerce – On October 31, Amazon unveiled its new food, health and beauty, and automotive product offering on its amazon.ca website. On the surface, Amazon could be disruptive to food retailing in Canada as it has in music and