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Taking Stock in L:

Background:

As I shared in an earlier post, in March I took an early position in Canadian grocer Loblaw within my Value Portfolio. At first this might appear out of character with my long held belief and abundant public statements that Loblaw’s execution and strategy have been critically flawed for years. But in this situation I believe that the sum of the companies parts are worth substantially more than the price per share I paid for my initial position and likely the most contrarian purchase I’ve made to date. In markets such as this sometimes you have to make at least one bold move to distinguish your true strategy from all the doom & gloom we see out there.

If you’ve just tuned in from a five year vacation away from the markets and have owned Loblaw over that period of time I have the unfortunate news that you’ve lost 42% of your investment excluding dividends (and they didn’t help much). If you go back to my first post on TOC I contrasted Thomson and Loblaw and asked “What have you done for my lately?”

“…We all know the story of Loblaw. CEO’s in, CEO’s out. Strategies formed, strategies abandoned. Margins raised, margins slashed. They kinda give the term ‘futility’ a whole different perspective when you look at this company and how it’s been run. Now that might change next quarter, next year…who knows. Someone eventually in WN will get frustrated with these bozos and find someone who can restore the company to its glory days…”

The company has attempted to transform their business on more than one…wait…multiple occasions now and failed to focus on their core competencies in a failed effort to position themselves for Walmart’s entry into the grocery business. The main problem is…they’re not the same companies. Yes, they provide similar services and products, but the shopping experience is vastly different when you enter a traditional Walmart vs. a traditional Loblaw store. The Supercentres being built obviously level the playing field somewhat, but don’t adequately match the smaller, more residentially targeted locations that Loblaw has operated from for years. I hold Metro and Empire for strictly this reason: those smaller, focused locations serve a very basic need of consumers and they operate on a scale that Walmart can’t compete against effectively.

Experience & Convenience:

It all boils down to attracting the $1 customer. Time is money and as an example SC has done a wonderful job in their strategic management of locating new stores on this convenience and experience basis. Any rational consumer realizes that 50% of the products they’re going to buy are cheaper by a few cents at one of the Supercentres. The barrier is they’re often located in large suburban shopping centres and there’s little convenience or time saved in contrast to visiting a local and well placed alternative close to your home. With the price of gas now well over $1.00/litre across the country and an aging demographic to the Canadian consumer base many existing small operations are now focusing on quality and the overall shopping experience rather than absolute price. The time and convenience saved may well prove to show that Supercentres are a compliment to existing locations rather than the face of the future. Being able to find what you want, where you want, at a reasonable price with an added personal touch has allowed companies such as Empire and Metro to sustain their higher margins in the face of increased competition while continuing to grow sales at the same pace as Loblaw. I’m not disregarding Walmart as a serious competitor in the retail food market, but certainly there is a discount that can be applied to this theory in the market when you examine the shopping habits of many consumers with regards to their “Big Box” experiences.

Valuation:

After five years of stuttering, stumbling and continuing failures there’s currently only the real estate priced into this stock and the value of these holdings likely will create a floor here. The stated book value of land holdings on Loblaw’s balance sheet is around $6.4B and likely conservative when you examine the strategic location of much of this commercial real estate. When you consider these locations, new store frontage, total retail space and strong RE market in Canada these properties could easily command a 25% premium to book or $8.0B ($30.60/sh). At my initial entry price of $28/sh and a 9% discount to my FMV of the company’s RE holdings I’m essentially “getting the rest of the business for free” as per the recent theory of BNN Market Call guest Norman Levine. The dividend of 3% is also safe in my opinion. Any cut would be disastrous to the stock price over the short-term and Weston would likely rather purchase the company privately than see their stake plummet even further. I’ve also considered that revenues have steadily increased the past three years, free cashflow remains strong at $620M, net debt remains below 1.0 and in 2007 they maintained their market share without any increase to their retail square footage in the face of Walmart. That may change in the coming years as competition does become more tangible, but if or when they decide to focus on sustainable margins the increases in revenues should offer upside to their EPS growth.

The true jewel and focus I’ve found in my analysis has been the retail space. Prior to the anticipated Walmart threat Loblaw had an expansion program that developed new stores in key target locations. These went beyond the past Zehrs layouts to now include groceries, dry cleaning, photo labs, clothing, banking, home accessories and garden centres. Even if the company continues to flounder in the face of difficulties those stores hold considerable retail potential from the perspective of competitors or acquirers. Bottom Line: you can’t get the same type of retail space near residential areas any longer that Loblaw has secured over the past 10-15 years. If the company liquidated assets tomorrow there would be a long line-up of very deep pockets waiting to bid aggressively on those properties and that demonstrates to me the current share price holds significant value if one is a believer in this theory.

Stimulus:

One of the main themes among my Value Rules is something I term a “Value Stimulus” that I learnt after studying the investment philosophy and practices of Irwin Michael. At times my attention might be caught by a labour disruption, change in management, new cost controls or legal concerns, but the idea is that you’re buying a stock that is worth considerably more than its current price in the face of adversity. In an environment of continuing struggles, higher food prices and tighter margins the hands of those with a tight grip on power might be forced into an even tighter corner without even noticing it.

As many know I place a high degree of importance on competent management. Unfortunately Loblaw goes against my beliefs in this instance. Galen Weston Jr. for all his academic achievements has yet to inspire confidence within me as a competent corporate leader. This is not a situation where the successor was groomed by a corporate culture from an early age with the expectation that he/she would lead a family controlled company such as Lino Saputo Jr. GWJ today guides the ship as an outsider having never grown up in the culture of Loblaw during the strongest days of President’s Choice and Dave Nichols.

There are a number of possibilities that can occur in this situation. In the event that the Board of Directors tires of GWJ’s continued missteps there are two individuals who show promise of guiding the company to excellence and wait in the wings. Both Allan Leighton (Walmart Europe) and Mark Foote (Canadian Tire) have considerable experience at the helm of retail giants that could serve the company well beyond their current advisory roles and designations within management. When I look back to the past five years of this company it wouldn’t be a far stretch to envision internal bickering among the Board of Directors, management or significant stakeholders if there’s a continued underperformance of the company and its stock price. George Weston Company certainly didn’t purchase a controlling stake to see their investment dwindle to this degree. At a certain price it becomes worthwhile to sell or buy the remaining outstanding shares to preserve their invested capital if/when a turnaround becomes evident. Empire recently did this with Sobey’s and there’s not much stopping Weston from doing the same if they view the share price as advantageous for their own benefit. Weston has the strong financial position on their balance sheet to finance such a move, but not likely at this time with their stock price traded significantly below its own FMV at this moment and an all cash deal likely needed to gain approval.

Prior to my trip to Europe I had already begun updating my SA on Loblaw as it was hovering around a FMV I had originally pegged on its real estate holdings near the end of 2007. While on the trip I had the opportunity to tour around a few locations of UK based grocer Tesco to gain a perspective of their current operations, existing barriers for growth domestically and international initiatives. I had spoken with a few contacts associated with their 2006 foray into the US market in California, but gauged that the program had been much slower and tedious that they had previously thought. Tesco is currently the world’s third largest grocer and a likely suitor in my competitive analysis. They haven’t made a substantial acquisition since 2004 and have continued to post impressive yearly increases in profit and market share across Europe, Asia and the South Pacific. When I look into their balance sheet the company also appears to be in a strong position in light of the current credit markets.

But why focus on the slowdown in acquisitions since 2004? The biggest hurdle to their continued growth and that of many global companies (such as Walmart) is the cost of creating infrastructure for new distribution and supply. This makes purchasing a company already established in the market a much more viable option. Although costly initially, a company can inject their own managers, switch or maintain banners and continue operations more smoothly with a much faster turnover of costs and growth than if you initiated the market penetration on your own. You’re also taking a big chunk of the competition out of the market in contrast to starting up business all on your own.

I have always been of a strong opinion through observations that a company looking to gain entry into a national market will always find it easier to sell North-South than East-West in a Western-industrialized nation. With Loblaw you get an established distribution network East-West right from the beginning, key infrastructure, one of the strongest retailers in Canada and strategic real estate located close to consumers who recognize your brands well. Tesco plans to open 574 stores in 2007/2008 and has currently just over 70 million square footage of retail space worldwide at a market cap of $63B ($900/sqft). To put into perspective; Loblaw has 49.6M square footage of total retail space with a market cap of $8.6B ($173/sqft). CTC.A($267/sqft), MRU.A($150/sqft), REI.UN($142/sqft), RON($107/sqft) & EMP.A($95/sqft).

That means, in the event that Tesco was interested in purchasing Loblaw outright at ~$40/share, they would be adding 70% more retail space to their company at a price only 17.5% of their current market cap. The price of RE holdings is the key here. At a value of RE ~$30.60/sh and acquisition at $40/sh they’d be getting the entire operations of Loblaw with retail space included for only $10/sh. That represents a significant opportunity not only for a company such as Tesco, but other international grocers looking to expand into the Canadian or North American market. Of course I need to acknowledge that the higher price per square footage for Tesco is due in some part to higher RE values in their European assets, but that’s largely reflected in their margins that help to balance the equation. The company has a history of maximizing the limited amount of retail space it owns to its fullest potential which is something Loblaw in recent years has lacked focus on.

In Ending:

The bottom line that I’ve held to for some time now is that Loblaw is not a discount retailer and that is not about to change now. By focusing on leaner margins they’ve continued to hurt the company’s profitability by pulling money out of their own pockets. Walmart enters the market at a time when competition amongst Canadian grocers hadn’t traditionally forced them to be lean, mean, fighting machines. It appears that Empire and Metro have chosen their strategies successfully so far, yet Loblaw has struggled to find their own. They can attempt to protect themselves as much as they want from their own self-proclaimed “Walmart Effect” but that hasn’t been effective to date and likely won’t be in the future. Their best strategic alternative is to return to their roots and offer consumers something value-added since price has not been the ultimate driver for demand in their operations or the competition. What they need to do is change management, recognize the strength of their retail space and focus on doing what they have the ability to do best. A consumer may be influenced once on price, but is likely influenced equally through repeated benefits that they value in the shopping experience and convenience. Competing on price only ever works for the company who can survive the margin squeeze until the bitter end and with Walmarts ability to purchase on scale they’ll likely win that battle. For the moment Loblaw doesn’t have the deeper pockets and needs to focus on what worked in the past while still be conscious of cost to the consumer.

Having vision creates no value if you don’t have the capacity and knowledge to execute a strategy.

While some may have blind faith in the guidance of current management I’m staking a large portion of my confidence on this position that someone else is taking similar views as I’ve had in my analysis and realizing the bargain price they can steal the retail segment of the business for while backing the cost of re-organizing operations on the existing value of real estate.

The market might not give the stock a second chance for quite some time, but at some point investors get tired of waiting for more broken promises and repeated disappointments. Much like Thomson-Reuters I’ve taken the time to examine elements of this business that goes well beyond the tradition value perspective an investor may take. Whether right or wrong I know my style offers something different and my hope is that readers are able to take these fundamental views and apply them to their own analysis.

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