BAY STREET-Best deals at Canadian grocers may be their shares

Sun Jul 8, 2012 10:29am EDT

* Analysts see upside in discounted grocery-chain shares

* Threat from U.S. retailers weighs on valuations

* Food retail earnings seen slowing, still growing

* Grocers seen fighting Wal-Mart, Target with discount units

By Claire Sibonney

TORONTO, July 8 (Reuters) - Canadian investors looking for bargains should check out their local grocery stores, whose stocks are trading at an attractive discount due to a looming expansion in Canada by Wal-Mart Stores Inc and Target Corp.

Industry watchers and fund managers say Loblaw Cos Ltd , Metro Inc and Empire Co Ltd - the three biggest publicly traded grocery chains - are undervalued, despite an expected loss of market share to the two big U.S.-based discounters.

Analysts have cut their price targets on the stocks, but still expect them to deliver solid gains on earnings. They note the Canadian retailers still boast popular brands, enviable locations and other advantages.

"The risks of growing square footage by Wal-Mart and ... Target offering more food items is a concern," said Barry Schwartz, portfolio manager at Baskin Financial Services. "However, I think it's been priced in the valuations of some of these companies, and I think some of those fears are overblown."

Indeed, investors appear to have already "baked in" much of the threat from far larger U.S. competitors such as Wal-Mart, which has stepped up the rollout of Canadian supercenters offering a full selection of grocery items, in advance of Target's entry into the Canadian market next spring.

Costco Wholesale Corp also plans to expand Canadian operations.

GROCERY STOCKS CHEAPEST IN SECTOR

Canada's grocery landscape is still dominated by the three domestic chains. Loblaw has around 36 percent of the market, followed by Empire's Sobeys at 18 percent and Metro at 13 percent, according to a BMO Capital Markets report in March.

Wal-Mart is estimated to have just 6 percent of the market, and Costco about 7 percent.

Analysts say the three Canadian grocers have competitive advantages that tend to be overlooked.

They've kept a strong foothold in desirable urban locations, acquired smaller ethnic grocers, cut prices, launched new products and improved efficiency. They also have plenty of cash to buy back shares and raise dividends.

BMO Capital Markets analyst Peter Sklar and associate analyst Emily Foo lowered their share-price targets on Empire and Metro in late June, warning that grocery square footage is set to grow by 2.5 percent to 3 percent over the next few years versus population growth of 1 percent.

They left Loblaw unchanged, but lowered their share price target for food producer and distributor George Weston, Loblaw's parent.

Although mostly lower, BMO's targets still represent increases of around 3 to 6 percent in the grocery chains' share prices in a year's time, compared with their levels on Friday.

"We still see them having some growth," Sklar said in an interview. "But we think the growth will be less than it would have been otherwise."

Analysts and fund managers also point to the modest valuations of the stocks. For example, Loblaw trades at about 12 times 12-month forward earnings per share and Empire trades at less than 10 times, according to Thomson Reuters data. Metro trades a bit higher, at close to 14 times.

By comparison, the Toronto Stock Exchange's consumer staples group, which includes grocers, trades at around 16 times forward earnings and the S&P/TSX benchmark index trades at about 13 times.

DEFENSIVE NATURE APPEALS

The traditionally defensive nature of grocery stocks also appeals to investors given global economic problems. Consumer staple shares historically outperform more cyclical sectors such as energy and mining companies during tough times.

"We like that space particularly in this environment right now where there is a tremendous amount of uncertainty," said Craig Fehr, Canadian market strategist at Edward Jones in St. Louis, Missouri.

With Europe's debt crisis raging, consumer staples have been one of the best performing sectors on the Toronto Stock Exchange, rising around 9 percent year to date. Energy stocks have fallen around 13 percent and the benchmark index is off around 3 percent.

Izabel Flis, a research analyst at Bissett Investment Management in Calgary, noted that while earnings growth could certainly slow, "people have got to eat".

Among the Canadian grocers, Flis likes Metro in particular, partly due to its strong exposure in Quebec, where Wal-Mart's supercenter rollouts have been slower than in Ontario and other provinces. Quebecers are also perceived to have a higher-end approach to food, which could pose a challenge to Wal-Mart.

Sobeys, with more suburban locations than the two others, is seen as the most vulnerable to the U.S. invasion. But its parent company, Empire, will benefit from a deal to supply Target with groceries.

Flis also sees Canadian grocery chains defending market share by adding more discount-format stores, such as Metro's Food Basics, Loblaw's No Frills, and Sobeys' Freshco.

She said Wal-Mart, which has already converted half of its stores to supercenters, hasn't priced itself that much lower than the discount banners of the incumbents, and hasn't yet tried to undercut the rest of the market as it did in the United States.

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