Loblaw Companies Limited (L) Earnings Call Transcript & Summary

Good morning, ladies and gentlemen, and welcome to the Loblaw Companies Limited Second Quarter 2023 Results Conference Call. [Operator Instructions] This call is being recorded on Wednesday, July 26, 2023. I would now like to turn the conference over to Roy MacDonald. Please go ahead.

Thank you, Michelle. Good morning, everybody. Welcome to the Loblaw Companies Limited Second Quarter 2023 Results Call. As always, I'm joined this morning with -- in the room with Galen Weston, our Chairman and President; and with Richard Dufresne, our Chief Financial Officer. And before we begin the call, I want to remind you that today's discussion will include forward-looking statements, which may include but are not limited to statements with respect to Loblaw's anticipated future results. These statements are based on assumptions and reflect management's current expectations and as such are subject to a number of risks and uncertainties that could cause actual results or events to differ materially from our expectations. These risks and uncertainties are discussed in the company's materials filed with the Canadian securities regulators this morning. Any forward-looking statements speak only as of the date they are made. The company disclaims any intention or obligation to update or revise any forward-looking statements whether as a result of new information, future results or otherwise, other than what's required by law. Also, certain non-GAAP financial measures may be discussed or referred to today, so please refer to our annual report and other materials filed with the Canadian securities regulators for a reconciliation of each of these measures to the most directly comparable GAAP financial measure. And with that, I will turn the call over to Richard.

Thank you, Roy. And good morning, everyone. I'm pleased to report that we continued to deliver consistent operational and financial results with solid top line performance and strong earnings [ growth ]. We remain focused on delivering value to consumers and carefully managing our expenses, all part of retail excellence. On a consolidated basis, revenue grew by 6.9% and EBITDA increased by 9.4%. Adjusted earnings per share grew by 14.8% to $1.94 a share. On a GAAP basis, our earnings per share reflected a 36% increase. This was unusually high, as we lapped a $100 million onetime charge last year specifically related to PC Bank. In drug retail, absolute sales increased 7.4% and same-store sales grew 5.7%. Front store same-store sales grew by 5% on continued strength in cosmetics and health and beauty. OTC performance remained strong but off its peak levels. Similarly, growth in our drug business has moderated, as it laps last year's post-pandemic reopening. Pharmacy same-store sales grew 6.3%, driven by growth in acute and chronic scripts, partially offset by lower-comp COVID vaccines and testing. At the same time, we were pleased with the growth of services related to expanded scope of practice. In food retail, absolute sales increased 6.4% and same-store sales grew 6.1%. In Q2, our internal food inflation number was generally in line with the CPI. However, shoppers in our grocery stores actually beat inflation by taking advantage of our pricing, private brands and hard discount stores. That means that our Loblaw shoppers experienced a lower rate of inflation than CPI. As we battle inflation, we remain highly concerned about ongoing cost increases; and I wanted to offer some facts. This year, suppliers have raised the price we pay for products by more than $1 billion. This is double what we would expect normally. We have received double-digit increases from the same suppliers who gave us double-digit increases last year. That's why you see products that are noticeably more expensive than they were just a couple of years ago. While cost increases are coming in from all tiers of our supplier base, the largest global brands stand out. Let me give you an example. Since inflation began, one of our largest vendors has submitted price increases totaling 50% or $0.25 billion. That's just one supplier. Here's another good illustration: In Q2, the average price for meat, fruit and vegetable purchased in our stores were up in the mid-single digits, but the average purchase in the center of store, where you find the biggest brands, was up in the double digits. At the same time, our food project -- food profit margins have declined as our costs have grown faster than our prices. The math is very simple. Cost increases from big brands were well above Canada's food inflation and our food margin declined, suggesting that grocer profiteering just don't add up. Food inflation is a global problem. The causes range from climate change to war. We know that some cost increases are justified, but many are not. The price of transportation, wheat, flour, paper and plastic are all well off 2022 highs. Our teams are actively reaching out to our largest suppliers, pressing for cost decreases based on these facts. With lowered costs, we will lower on prices. Returning to our performance. Our ability to deliver value was reflected across our food business. Our hard discount banners continued to outperform the overall discount channel, delivering strong traffic and item count growth as customers continued to focus on value offerings. And in Quebec, our discount position continues to grow. We converted 10 Provigo stores to Maxi in the quarter, and we will convert another 10 stores in Q3. We continue to be very pleased with the sales growth being generated from these converted stores. Our market banners remain healthy despite the ongoing shift to discount stores. Having the right customer offer in all our stores remains a key focus. Right-hand side posted a solid quarter with all major categories delivering positive same-store sales and apparel outpacing food same-store sales. That said, net-net, it remains a drag on our same-store sales performance to the tune of 60 basis points in the quarter. We remain comfortable with our inventory levels. Online sales in the quarter increased 13.9%, reflecting the strength of our digital businesses as we lapped our first post-COVID quarter. Growth was led by PCX delivery and online pharmacy. We continued to enhance our customer experience and differentiate ourselves by offering more choice and flexibility. Retail gross margin was 31.1%, down 30 basis points compared to last year. The driving factor was higher shrink in drug, where we also saw pressure from lower services revenue. In food, we controlled costs well, investing our savings into lower prices. Across our Retail segment, another quarter of careful cost management resulted in an improvement of 60 basis points in our SG&A rate as a percentage of sales. Adjusted Retail EBITDA increased by $142 million or 9.8% in the quarter, yielding a margin of 11.8%, up 40 basis points compared to last year. PC Financial adjusted earnings before tax declined by $22 million, largely a function of increased net credit losses and loss provisions and higher interest rates this year. The top line business performance remains in line with our expectations, with revenue up $51 million, driven by higher interest income and an increase in consumer spending. On a consolidated basis, adjusted EBITDA margin was 11.9% in the quarter, up 20 basis points compared to last year. Our Retail free cash flow was $600 million in Q2, reflecting higher CapEx spend and lapping 1 year -- onetime tax recoveries from last year. In the quarter, we repurchased $500 million worth of common shares. Looking ahead, our second half same-store sales will reflect comparisons against our very strong sales performance last year in both food and drug. At the bank, we expect continued revenue growth from the growth in our portfolio, and we expect to see ongoing pressure on credit loss provisions given current economic forecasts. However, we remain confident in our ability to deliver our full year outlook. I will now turn the call over to Galen.

Thank you, Richard. And good morning. I was pleased with another quarter of consistent performance. The business charted strong core results, providing continued confidence that we are delivering retail excellence and serving our customers well. In our drug business, we returned to a more normal growth rate. And our front store elevated sales of cough and cold meds subsided, while beauty remained brisk. And although COVID services have declined nationwide, we are increasing our range of patient care. In fact, it feels like, every month, another province moves to expand and fund services that pharmacists can provide to plug growing gaps in primary care systems. Just this morning, New Brunswick announced its first 6 pharmacy primary care clinics, following an innovative recent rollout of 26 in Nova Scotia. Yesterday, in Ontario, we unveiled 2 pharmacy sites redesigned to provide more clinical services and a better patient experience. We'll invest in a total of 72 of these clinics this year, another step towards the pharmacy of the future and our journey to improving Canadians' access to primary care. In our food business, market stores continued to perform well, lifted in part by the customer response to our President's Choice summer product lineup, including new customer favorites like frozen Mochi and ube boba pie. The ongoing shift to discount continued to pick up steam, driving high growth in our stores. Our hard discount locations have never been busier, with our highest-ever customer count's double-digit growth. And No Frills was recently named the most trusted store for low prices. And we'll add 25 more to the network this year. As customers focus on value, sales in our private brands continue to outpace national brands, delivering an average savings as high as 25%. And more Canadians are turning to PC Optimum points to fill their carts, with redemption rates climbing. We were delighted to see a recent survey that said Canadians are paying more attention to loyalty programs; and that PC Optimum is by far their favorite, used an incredible 9 out of 10 times. As has been the case since this period of inflation began climbing, our food gross margins declined. The business was highly efficient in the quarter, and we invested those savings in promotions. And once again, our product costs increased more than our prices. Despite Canada having one of the lowest food inflation rates in the world, we continue to face historic cost increases. As our business moves forward, so do our efforts to manage our impact on the environment. It was a busy quarter in this regard. Shortly after our first electric truck hit the road, we announced that 5 hydrogen fuel cell electric trucks will join the fleet, allowing 0-emission deliveries. And we announced that electricity purchased for our Alberta supermarkets, drug stores, offices and distribution centers will soon come entirely from wind, sun and water. The impact will be the equivalent of taking all the homes in a city the size of Lethbridge off the grid, and we'll cut our national carbon footprint by 17%. We continue to execute well against our business plans and our purpose of helping Canadians live life well. I'll now open the call for questions.

Thank you, Galen. Michelle, if you'd please introduce the Q&A process.

[Operator Instructions] Your first question comes from George Doumet, Scotiabank.

Richard, I believe, last call, you mentioned a 6% Q1 exit in food same-store sales. I'm just wondering if you can talk to the trends that happened kind of intra quarter in Q2. Was it stable? How was the exit? And any general comments you can have on market share for the banner -- market banners?

Yes. So you're right. That's what we sort of guided towards. I think the key perspective to take into consideration is you look at our sales trajectory in dollars and [ that as ] continued, okay, as -- and that's what generated a 6% same-store performance in Q2, but you need to take into consideration then that, last year, Q3, yes, in food was 7% same-store sale. And Q4 was 8%, okay? So we're going to be cycling that versus -- like, this quarter, we cycled 1%. So while sales trajectory will continue, we're going to be cycling against those figures, so you're going to see same-store sale drop because of that, but that doesn't mean our sales are dropping. And you're going to be -- see the same for drug. Drug has been 6% this quarter. It was 6% last year, but if you look at Q3 and Q4 of last year, Q3 was 8% same-store sales and Q4 was 9%. So we're going to be phasing into that as we go forward, but like this is part of our plan. And so -- and we still remain very good regarding our outlook.

Okay. And just market share comments you have made for the market banners.

Yes. Market share, like, positive trajectory in the quarter, and that's what I'll say.

Okay. And can you talk a little bit the shrink? What areas of the business it's the most prevalent in? What impacts that had on gross margins; maybe what we're doing to fix it; and just kind of how confident you are in kind of maintaining the gross margins flat, I guess, for the year...

Yes, very good question. I think that's everybody's questions this morning, so yes. So our gross margin is down 30 basis points, okay? In food, it's a combination of shrink but also -- of also what we call trading margins, okay, being the fact that our costs have gone up a little bit more than our price. And Shoppers, it's essentially all shrink, okay? So we've been talking about shrink for a few quarters now. I think the key point on shrink is that we've been investing capital and labor in store for close to a year now. And our view right now, if early though, is we see it peaking. We've got indicators that are telling us that it is peaking and in certain instances getting a little bit better, but we will comment on that in the next quarter because we're going to be recounting a significant number of stores in this quarter. So we'll be able to affirm this with confidence when we release Q3 and it's important for us as we plan for 2024. So I don't know if that's helpful. Other than that, we feel good about our gross margin performance going forward.

Okay. And just one last one, if I may. One of your competitors observed that promotional penetration is exceeding pre-pandemic levels. I'm just wondering how you guys -- how do you guys see that and perhaps any commentary you can share to that.

Yes. The what -- we have commented on pre-pandemic promotional penetration. What we realize also in our own approach to our business is we took out a lot of inefficient promotions, as you'll remember, in 2020, so we're pretty much at what we'd call a normalized level of promotional penetration at the moment. And so we're not going to comment too much on that in the future. Just think about us being back there now.

The next question comes from Irene Nattel of RBC Capital Markets.

I guess what we're all struggling with is the interplay between the tougher comps a year ago, so slowing same-store sales, but also your ability to get some margin catch-up, which was so challenging when we were facing that almost double-digit inflation, so can you talk to a little bit some of the puts and takes there and how we should be thinking about that?

Okay, Irene. Good question. I think, for us, like, we've been focused on stability of gross margin, and we still feel we're stable. Like, down 30 basis points, for us, we're in the zone, but what we spend most time focused on is the growth rate of our SG&A, okay, because if we can manage our SG&A growth rate as a percentage versus the year before, that's what will allow us to land on our financial framework. And if you look at the performance we've had, so far, this year and if I look ahead for the second half, I feel good about my SG&A cost curve. And so therefore, that gives us confidence in our ability to deliver on our plan.

That's really helpful. And how should we be thinking also about the interplay between the consumer trade-down activity, promotional intensity? Like where does that all kind of shake out in terms of gross margin? Is it a tailwind? Is it a headwind? How does all that come together?

It's noise at the margin, obviously, because we have 2 large businesses on the food side, like, a big conventional business, a big Discount business, okay? So obviously Discount has a lower gross margin rate than market, but like the -- and the growth in Discount, like, is markedly higher. Like same-store sale in Discount is markedly higher than market. So you see that at play, but more sales gets more dollars. So it's like, for us, like, we're managing on a consolidated basis. And when we look at it on a consolidated, what we lose from one, we get from the other. And so that's what we've experienced, so far, and that's what we expect going forward also.

So Richard, what I'm hearing you say is that we should be slightly less focused on the gross margin sort of changed 30 basis points up, 20 basis points down, whatever it is; and focus on the growth in the gross margin dollars relative to the top line. [ Or is that all relative ] to the top line?

Yes. Well, both -- yes, yes, yes, Irene, but we also look at both. We also look at both. And like there's been a significant effort on shrink that started a year ago because we were starting to see it creep up, okay, and it was not much noticeable. Now it's noticeable, so we talk about it, but we've taken actions a year ago. And we're starting to see the benefits from that. We're not done in our actions and -- but so with that plateauing and with what we see ahead, together, that allows us to feel decent about our performance for the second half. And by the way, we're thinking about that as we're planning for '24. So we're already well advanced in our planning cycle for '24 and all of these factors are in play as we prepare for next year.

That's great. And finally, just one last question. You bought back a fair amount of stock in Q2. How should we be thinking about the aggregate NCIB as we look in 2023?

Yes, Irene, if you look at it and you compare it to last year, we're more or less at the same place. I think we're ahead by, I don't know, maybe $50 million, so for us, like, we're on plan.

The next question comes from Mark Petrie of CIBC.

I wanted to just follow up on a couple of topics. First, at Shoppers, I know you spoke about shrink. You're no longer calling it out, Shoppers overall as a margin tailwind. How much of that would you say is its own performance? And how much is just that the growth rate is now normalizing and no longer materially exceeding the food growth?

If you were to exclude shrink, gross margin in Shoppers would have been up in the quarter. So it was a factor. That's an area where we spend a lot of efforts. Like if you go in stores, you'll see what we referred to as fragrance lockups. That's where the professional teams have been focused on, so we've locked up many of these fragrances and you're going to see more of those over the coming months. And those are high-priced items, which when they go, it hurts the bottom line. So as we put that behind, it will definitely help shrink. And interestingly, we're not losing sales. So that was a big fear as we were locking up fragrances, that we'd be losing sales, but we're not losing sales, so that's going to start to yield benefits over the coming months.

Nice. Okay, helpful. On the pharmacy services, Galen, I know you talked about it in your comments, but I'm just sort of curious. You're lapping some of the big COVID-driven services but also expanding these clinics, so where are we at in terms of the progression of that in terms of headwind versus tailwind? Obviously it's a headwind right now, but is it more of a headwind now than it was a couple quarters ago? Or -- and when does that sort of normalize, do you think?

Yes. So it is a headwind entirely because we're cycling those extraordinary COVID vaccination and COVID test numbers. And so we really focus on what's happening to the -- with the underlying growth rate of the other expanded scope of practice services, and we see very encouraging growth trajectories underneath it all. And so it will take until we cycle through the last of that COVID period before we see, call it, meaningful growth in the business on an absolute basis. And remember the way to think about our expanded scope of practice initiative, which includes the pharmacy-led clinics and the expanded scope of practice across all of these provinces. Think about it as a fast-growing, accretive contributor to the business that will drive or will help us drive our financial framework. It's not going to deliver a step change in growth in sales or in profitability, but it will give us that long-term tailwind that will allow us to continue to perform as we have for the last number of years in that business.

Yes, understood. And just maybe just to follow up on that: Are these pharmacy care clinics -- like how do the economics on these sort of stack up versus other investment opportunities in the store network? And I'm sort of thinking of just regular store renovations or new stores. What do the paybacks look like for those care clinics?

So it depends. There's a pharmacist-led clinic inside a pharmacy. And that has a very high payback relative to what you would consider, say, on a new store. Think about it as an incremental renovation with meaningful sales upside, so that would be superior to the sort of regular return rate. And then you have the standalones which are far less in number than the in-stores. And they have slight what I'd describe as slightly pressured core returns until you add the pharmacy prescription on top of it, which has always been a major amplifier for any investment that we've made in medical clinics. And then it delivers a very healthy return that would be in line with or above return rates that we get for Shoppers Drug Mart.

Yes, Mark. Just to give you some order of magnitude, though. Like we've built two of these up. And it's our first two, so we didn't spend much time to focus on the return, but like we're talking a few hundred thousand dollars. This is not millions of dollars, though. And I can tell you, the first two, I'm sure they look amazing because they want to make it look good for us, but the next ones that are coming, once we know that the concept is working, we're going to tighten those screws on the cost. But it's not a big cost, so it's not something that you should worry about from a big CapEx standpoint.

The next question comes from Tamy Chen of BMO Capital Markets.

First, I wanted to go back to the SG&A. Richard, could you maybe elaborate a little bit more on this quarter in particular? You were able to get pretty good leverage. What were some of the areas that this came from? And how should we think about that going forward when it seems like right on the gross margin side, whether it's Shoppers or also the food side, there's limitations to which you can pass through your costs?

Yes. So obviously, when your top line goes up 7%, it's definitely helping your SG&A rate, okay, so -- but that's not typical of the growth we get normally in our business, so we don't look at it as a percentage of sales. We look at it as a percentage growth versus the year before. And if you want to drive operating leverage, you need to have your SG&A grow at a lower rate than your top line. And so that's what we're focused on and we've laid out plans that allow us to deliver on that. And our plans for '23 are quite robust. And based on what we see coming ahead, that gives us confidence that we should be able to deliver on our framework. And I was -- as I was mentioning earlier, right now we're working on 2024 and we're adopting the same approach. We need to make sure that the growth in our SG&A in dollars doesn't grow too fast because then we won't be able to deliver on 2024, so we're taking actions now to make sure that this happens. And that's how, again, in '24 we should be able to continue to deliver on our framework. So the plan is laid out, but it's not like we're going to take more initiatives now. Like we have our plan laid out, and if we just deliver on our plan, we should deliver on our framework.

Okay. And within that, I'm curious specifically on the whole labor and wage environment. I think, last quarter, you had said the number of ratified agreements over the last few months were at the higher end of the normal range. And I'm just wanting to understand if you think at this point there might be still some incremental catch-up for you and your labor costs and with respect to broader market wage inflation that we've seen over the last 2 or so years. Or are you largely through that?

So we know always what's coming, okay? Like we know when negotiations happen and so we budget that in our plan, as like everything else. And so we've budgeted what's to come. As we've answered that question -- Galen has answered that question a few times recently. And we talk about like we've been at higher end of the range, but it's at the higher end of a range that we're planning for. So that's how we're thinking about it, and right now, based on what we see, we should be within our plans on what we see ahead.

And to your question about catch-up. No, we don't have any substantial catch-up issues that we're facing. Think about them more as normal-course negotiations. And then the thing that we try and be careful of is locking in growth rates that would not be in line with the long-term inflation rates, so that's where we try and land these agreements.

The next question comes from Michael Van Aelst of TD Securities.

You mentioned about the -- some of the costs coming down or vendor costs coming down but not necessarily showing up in the cost of goods sold yet. Can you talk about what -- give us some insight as to what some of the pushback is from vendors, as to why they are pushing it down or why they're still trying to push through price increases?

Yes. So I mean a couple of things. First of all, we're seeing meaningful shifts in a whole line of commodities that are core ingredients in these products. And so that's why we expect products that are heavy in these ingredients to start to slow and ultimately turn the other way. You'll have to ask the packaged goods manufacturers what their perspective is on why they're not bringing retail prices down. They have a litany of explanations for us, but the fundamentals are that, if the costs of the inputs are starting to slow and reverse, then ultimately we should see some components of that show up in cost increases. And look. We operate -- as you know, we source a lot of control brand product, and so we have pretty good visibility into how this should evolve. Having said that, I don't think it's reasonable to expect an aggressive reversion or a shift into a deflationary environment. The reductions that we're seeing in commodities are moderate. They're notable, meaningful, but it's not at this point headed towards a cost reversal.

All right. On your private label sourcing, is that cost plus?

No. It's negotiated differently, depending on the vendor.

So does that mean you're not necessarily getting cost reductions from your -- on your private label either?

No. It's all I'm saying is that we negotiate them on a case-by-case basis. And we are seeing reductions in some cases with a couple of national brands and with control brand vendors as well.