TEXT-S&P affirms Loblaw, George Weston 'BBB' ratings
Overview -- We are affirming all our ratings on Toronto-based Loblaw Cos. Ltd. and George Weston Ltd., including our 'BBB' long-term corporate credit rating on each company, following Loblaw's announcement that it intends to contribute about C$7 billion of real estate assets into a publicly traded real estate investment trust (REIT). -- We expect that management will make financing and ownership decisions to capitalize the Loblaw retailer and REIT in a manner that keeps consolidated credit measures in line with the 'BBB' rating. -- We estimate that the proposed changes will have a limited effect on consolidated profitability and cash flow measures, with negative cash flow consequences restricted to the net of Loblaw rents and REIT investment returns to Loblaw. -- The stable outlook reflects Standard & Poor's expectation that steady operating performance would enable Loblaw to maintain its investment-grade financial risk profile despite ongoing pressures, such as intensifying competition and continuing large store-level and supply-chain investments. Rating Action On Dec. 6, 2012, Standard & Poor's Ratings Services affirmed all of its ratings on Toronto-based Loblaw Companies Ltd. and parent George Weston Ltd., including its 'BBB' long-term corporate credit rating on both companies. The outlook is stable. The affirmation follows Loblaw's announcement that it plans to contribute about C$7 billion of real estate assets into a publicly traded real estate investment trust (REIT). Loblaw intends to retain a significant majority interest in the REIT, which we view as a key determinant for the ratings. The affirmation reflects our expectation that Loblaw's financial risk profile--and by extension George Weston's--would remain consistent with the 'BBB' rating on both companies. We expect that management will make financing and ownership decisions to capitalize the Loblaw retailer and REIT in a manner that keeps consolidated credit measures in line with the rating. We believe the proposed REIT and the real estate that it owns will remain core to Loblaw and George Weston, even if a minority position is sold to public investors. The real estate being contributed is deemed integral to the strategy of supporting retail activities, considering that initially the REIT will own about 75% of Loblaw's real estate and that Loblaw will account for the overwhelming majority of REIT net operating income (NOI). Although we believe that Loblaw's ownership percentage and NOI concentration could decline as the REIT accesses public markets to fund growth in its non-Loblaw portfolio, we expect that it is highly unlikely that the REIT will be sold outright, and that Loblaw's ownership will remain elevated enough to ensure control. Moreover, we expect that Loblaw's long-term commitment to real estate is enhanced by the quality of the real estate portfolio and the group's capacity to support it financially. Rationale The ratings on Loblaw reflect Standard & Poor's view of the company's satisfactory business risk profile, characterized by its position as the largest grocer in Canada with leading market shares in all regions it serves and a well-established private-label program. We believe these strengths are partially offset by weaknesses in the company's operating infrastructure that have contributed to significant incremental capital and operating expenditures amid challenging market conditions. We view the real estate transaction as consistent with Loblaw's and George Weston's currently moderate financial policies, primarily because of the long-term stability expected in the group's consolidated financial risk profile. We believe that the imputed decline in Loblaw's stand-alone profitability from lease payments will be offset by a long-term shift in borrowings from Loblaw to the REIT. That said, our analytical consolidation of the REIT supports our rating on Loblaw, because we expect Loblaw's higher lease-adjusted leverage on a stand-alone basis to be offset largely by stable cash distributions from the REIT, given Loblaw's retention of a significant portion of the REIT's capital structure. We rate Loblaw and its 63% owner, George Weston, the same, but the ratings are linked, not equalized, whereby each rating is jointly influenced by the respective company's credit profile. The current linkage between the two companies is direct, because Loblaw accounts for the vast majority of George Weston's consolidated earnings, and Loblaw's financial performance is the primary determinant of George Weston's. Furthermore, we believe that Loblaw's equity value would affect George Weston's financial flexibility. That said, the ratings on the two companies could differ by up to one notch given the current capital structures. Loblaw is well-positioned among grocery retailers, with the industry's broadest offering that covers all market segments in all regions. Nevertheless, we believe the company's breadth exposes it--and particularly its large hard-discount format--to increasing competitive pressure as Wal-Mart Stores Inc. (AA/Stable/A-1+) ramps up its grocery offering in Canada and Target Corp. (A+/Stable/A-1) launches in Canada in 2013. Loblaw's last 12 months' (LTM) revenue growth increased 1.7% year-over-year, which is the lowest among its direct peers, although we do not believe this necessarily indicates any notable decline in Loblaw's market share, in part because of the company's shift away from higher-ticket, lower-margin general merchandise. Loblaw's LTM reported EBITDA margin has declined about 25-30 basis points since late 2011, reflecting lower food price inflation in 2012 and higher selling, general, and administrative expenses. We believe that lower food price inflation and continuing intense competition into 2013 could stagnate the revenue growth for supermarkets in Canada, potentially translating into margin pressure. Moreover, we expect that a modest escalation of price competition is inevitable, as Wal-Mart and Target aim to capture a sizable portion of the market's growth in Canada. That said, we believe that the Canadian incumbents are well-positioned to withstand their competitors' aggressive square footage growth and pricing, not least of which because of their long-standing, attractive locations. Consumers continue to shift toward discount stores, private label products, and home meal replacements as lower-cost alternatives to full-service formats, national brands, and restaurant outings. Loblaw aims to capture this market by emphasizing its extensive private label program, as well as its national network of hard discount stores. Such a shift typically weakens revenue growth, but it would likely not have a meaningful impact on profitability because the company's private label products should generate better margins than its national brands. In addition, we believe the cost structure of Loblaw's discount stores is aligned to its lower-price strategy, leading to profitability similar to that of its conventional and superstore formats. The company's credit metrics are consistent with the rating, and have improved meaningfully in the past two years along with benign market conditions for grocers in Canada, as well as Loblaw's operational improvements. As of Oct. 6, 2012, LTM adjusted debt to EBITDA was steady year-over-year at 2.8x, while adjusted EBITDA interest coverage has improved modestly to 6.2x. Assuming 1%-2% revenue growth for 2012 and 2013, consistent with our views on Canada's GDP growth and Loblaw's modest growth plans, and assuming 6.5% reported EBITDA margins, we estimate that Loblaw could maintain leverage of about 2.9x through 2013. That said, we believe that our margin assumption could face some pressure through 2013 amid continued heavy expenditures on restructuring activities, potential operational risks, and intense competition. The creation of the REIT does not alter our view of Loblaw's intermediate financial risk profile, despite some meaningful changes expected in its capital structure and financing strategies. We estimate that the proposed changes will have a limited effect on consolidated profitability and cash flow measures, with negative cash flow consequences restricted to the net of Loblaw rents and REIT investment returns to Loblaw, which we estimate should preserve funds from operations to debt within a range of 25%-27% in the next several years on a consolidated basis. We believe that the overarching risk to Loblaw's profitability and cash flow protection remains the high transitional costs to support IT and supply chain technology investments. We expect costs to drop at the outer end of our rating horizon in two years, which we believe could be a catalyst for a meaningful boost to Loblaw's free cash flow. Liquidity Loblaw's liquidity is strong. At Oct. 6, 2012, the company had C$1.6 billion in cash and short-term investments, C$243 million held as security deposits, and full availability on its C$800 million committed credit facility maturing in 2017. We do not incorporate into our liquidity assessment the prospective nature of sources and uses from any potential REIT transaction, but we expect that such a transaction will likely bolster Loblaw's currently strong liquidity position. Our view incorporates the expectation that the company will meaningfully exceed the following liquidity thresholds as defined by our methodology: -- Liquidity sources (including cash, discretionary cash flow, and availability under its revolving credit facility) will exceed uses by at least 1.5x through 2013; -- Liquidity sources will continue to exceed uses, even if EBITDA were to decline by 30% in 2012 and 2013; -- Heavy capital expenditures and elevated operating costs could constrain free cash flow; -- Loblaw's maturities are modest, with US$150 million due in May 2013 and C$200 million due in November 2013; -- The company has good relationships with its banks and a solid standing in capital markets; and -- We believe that Loblaw comfortably met the financial covenants under its committed credit facility at Oct. 6. Outlook The stable outlook reflects Standard & Poor's expectation that steady operating performance would enable Loblaw to maintain its investment-grade financial risk profile despite ongoing pressures, such as intensifying competition and continuing large store-level and supply-chain investments. Moreover, we expect the creation of a publicly traded REIT will be neutral to credit quality on a consolidated basis, with the REIT's moderate capitalization offsetting higher lease-adjusted debt at the Loblaw level. We believe that ratings stability is supported by the industry-leading breadth of Loblaw's retail platform and credit measures consistent with the ratings. The ratings could come under pressure if any combination of intense competition or operating disruptions weakened profitability, or if sharp unexpected increases in restructuring costs or capital expenditures contributed to a sustained rise in leverage approaching 3.5x. Notwithstanding the meaningful buffer in a downside scenario, an upward revision is unlikely in the 12-to-18-month horizon for our outlook for the rating, as internal challenges and REIT execution risks, as well as increasingly competitive conditions in the Canadian supermarket industry, will likely preclude significant improvements in credit measures. Related Criteria And Research -- Key Credit Factors: Business And Financial Risks In The Retail Industry, Sept. 18, 2008 -- 2008 Corporate Criteria: Analytical Methodology, April 15, 2008 -- 2008 Corporate Criteria: Ratios And Adjustments, April 15, 2008 -- Corporate Criteria--Parent/Subsidiary Links; General Principles; Subsidiaries/Joint Ventures/Nonrecourse Projects; Finance Subsidiaries; Rating Link to Parent, Oct. 28, 2004 Ratings List Ratings Affirmed Loblaw Cos. Ltd. George Weston Ltd. Corporate credit rating BBB/Stable/-- Loblaw Cos. Ltd. Senior unsecured debt BBB Preferred stock P-3(High) George Weston Ltd. Senior unsecured debt BBB Preferred stock P-3(High) Complete ratings information is available to subscribers of RatingsDirect on the Global Credit Portal at www.globalcreditportal.com. All ratings affected by this rating action can be found on Standard & Poor's public Web site at www.standardandpoors.com. Use the Ratings search box located in the left column.