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How Will Canadian Grocers Digest Inflation?

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How Will Canadian Grocers Digest Inflation?

High and sustained inflation is a dominant risk to Canadian supermarket earnings in S&P Global Ratings' opinion. In 2021, with food inflation in the low-single-digit percentage area, Canadian grocery retailers found the sweet spot because they could easily pass on all cost increases to customers amid still-healthy demand for food at home. However, inflation picked up starting late 2021 due to high demand through the pandemic, along with supply-chain and transport disruptions, and was further exacerbated by the ongoing Russian-Ukraine conflict.

Despite Record Price Increases, Food At Home Demand Should Prevail

Canadian Consumer Price Index (CPI) growth for food at home was 9.4% in June, close to May's 9.7%, likely indicating that inflation has peaked but will probably remain high for the next few quarters; Canadian CPI growth for food has exceeded 5% since December 2021. Food inflation was spurred by higher prices in all significant food categories, such as fresh fruit and vegetables (+9.8%), meat (+8.0%), and bakery and cereal products (+11.3%). Statistics Canada has indicated that nearly three out of four Canadians have said that rising prices are affecting their ability to meet daily expenses such as transportation, housing, food, and clothing. As a result, many Canadians are adapting to this new environment: About 50% of sought out sales and promotions, 47% purchased cheaper alternatives/brands/items, and 45% delayed making a purchase.

Surprisingly, in the past few months, food at home has experienced higher-price increases relative to dining out (quick-service restaurants and fast-food casual restaurants). However, through 2021, restaurant food inflation was already in the mid-single-digit percentage area, reflecting labor shortage and associated wage increases. Advantages for restaurants include economies of scale, access to ingredients at wholesale prices with the ability to lock in lower prices through contracts, and finally, the flexibility to refresh menus based on ingredient prices. In addition, labor shortages have been relatively stable in 2022, but we believe that with rising costs and reduced discretionary spending, food at home will eventually benefit.

Chart 1

image

Weaker Purchasing Power Will Affect Retailers' Basket And Mix

With rising costs in essential areas such as shelter and transportation, Canadians have lowered discretionary spending but still need to make choices for their food budgets. In a recent Statistics Canada survey, when asked in which area they were most affected by rising prices, 43% of Canadians said food. Transportation costs were also cited by the majority of Canadians who buy gas--94% reported they are very (67%) or somewhat (27%) concerned about rising gasoline prices. In June, food and energy inflation was close to 17.5% (year over year); in comparison, the hourly wage increase was only 5.2% over the same period.

Chart 2

image

In its recent report, S&P Global Economics said that Canadian consumers' sentiment is at a 100-week low and more than half expect the economy to weaken (see "Economic Research: Canada Real-Time Data: Summer Slowdown," published Aug. 4, 2022, on RatingsDirect). Affordability remains a strong spur in the foreseeable future and price pressures will likely to weaken consumers' propensity to spend. Although the higher savings is a bright spot, price pressures, rising mortgage rates, and lower disposable income expose households to increasing vulnerabilities because much of their savings must be reallocated to nondiscretionary spending.

Pending Supplier Pass-Through Could Keep Food Inflation High For Longer

S&P Global Ratings' Canadian economic outlook has revised 2022 Canadian CPI to 6.3% from 3.4% a quarter back. We expect inflationary headwinds will continue through the year before CPI normalizes in 2023. The Producer Price Index (PPI), which measures changes in farm and wholesale prices, is generally more volatile than the CPI (which measures change in prices consumers pay). Price volatility decreases as products move from the farm sector to the wholesale sector and then to the retail sector, and the CPI typically lags movements in the PPI. As a result, the PPI serves as a leading indicator for the CPI. Fruit and vegetable PPI has been consistently more than 5% through 2021, while meat, fish, and dairy PPI has been over 5% since June 2021 until recently. Although the Canadian PPI food baskets are not the same as that of the CPI food baskets, the trend indicates that pricing pressures in the supply chain might not have plateaued and grocers will continue to depend on price pass-throughs to protect profitability.

Chart 3

image

In aggregate, PPI has been outpacing CPI (see table 1) for the past few quarters. We know that supplier cost increase pass-through has been lagging through the supply chain to the retailers (see chart 4, negative CPI-PPI), which could delay pass-through to consumers. Although we understand that in highly concentrated markets suppliers might be unable to pass on all their cost increases to retailers, retailers still face cost increases that are higher than the sweet spot in which they can pass all costs on to consumers. Amid recessionary headwinds, retailers are thus hard-pressed to pass on all these increases to consumers and will likely absorb some amount to maintain market share.

Table 1

Food CPI And PPI
(%) January 2020-June 2022 June 2021-June 2022 January 2022-June 2022
CPI
Food 11.1 8.8 4.1
Food purchased from stores 11.0 9.4 4.2
Food purchased from restaurants 10.9 7.1 3.7
Meat 12.3 8.0 0.8
Fish, seafood, and other marine products 11.8 10.3 6.3
Dairy products and eggs 13.7 8.6 6.6
Bakery and cereal products (excluding baby food) 11.9 11.3 6.4
Fruit, fruit preparations, and nuts 9.9 8.4 3.9
Vegetables and vegetable preparations 3.8 9.8 1.3
Fresh fruit and vegetables 5.2 9.8 1.6
PPI
Meat, fish, and dairy products 14.8 (0.3) 7.0
Fruit, vegetables, feed and other food products 31.3 16.6 9.1
CPI--Consumer Price Index. PPI--Producers Price Index. Source: S&P Global Ratings.

Stabilizing Tonnage Amid A Favorable Mix Shift Should Help Canadian Grocers

Although Canadian retailers will likely face temporary weakness as consumers dine out following the lift of pandemic restrictions, and will be more discerning and conscious about value propositions, ultimately, we still expect Canadian grocers to benefit from the increased tonnage from pre-pandemic levels as work-from-home practices becomes permanent; customers resume dining at home because of inflation; and as grocers benefit from increased medication, over-the-counter, and cosmetic sales (front of store) in pharmacies. However, we believe there is some uncertainty in the second half of 2022 due to recessionary trends, high energy costs, and ongoing supply-chain costs. Rising interest rates and elevated prices resulting from the Russia-Ukraine conflict will continue to affect consumer confidence.

As a result, S&P Global Ratings is cautious about the Canadian grocery industry for the next 12-18 months. In general, we believe consumers will respond to higher prices by looking for less expensive options, deferring purchases, and reducing demand for discretionary products. We also expect competition and promotional intensity will increase while consumers shop at multiple stores in 2022 as the pandemic wanes and food prices remain elevated. Higher inflation could spur topline growth but tonnage growth will likely be negative compared with that of 2021, mostly from higher promotion and private-label penetration of the basket; however, we view the tonnage weakness as temporary as consumers pivot and increase their food-at-home consumption amid macroeconomic headwinds. With multiple trips to the grocery store, increased inflation, and lower disposable income, price will be an important factor in consumer decision-making in 2022. In addition, most grocery retailers will likely face higher labor costs in 2022 as unions continue to seek better wage increases. The current levels of food at home inflation are much higher than grocers can pass on and are well above levels generally viewed as tailwinds for the group. PPI, as a leading indicator, continues to rise and we expect CPI will follow.

Although a higher savings rate during the past two years is helping consumers manage elevated prices, middle- and lower-income households are feeling the pain. Grocers have noted shifts in customer behavior, indicating a search for value, including trading down on product and size, fewer impulse buys, a higher promotional penetration in the basket, and higher private-label sales. Food retailers also have to balance higher traffic and tonnage growth with profit preservation and, as a result, are strategic with merchandising and promotional activities to balance market share and profitability. Against this difficult operating backdrop, management teams have become disciplined and proactive in their procurement/inventory strategies and nimble in their capital allocation. While we do see a path to supply-chain normalization, these headwinds will likely persist at least in the near term leading to elevated prices.

As noted earlier, the spread between the CPI-PPI metrics can be used to gauge grocers' gross profit margin trends. When PPI growth outpaces CPI growth (negative), grocers profit margins are more likely to narrow. When CPI growth outpaces PPI growth (positive), profit margins are likely to widen. Since the beginning of 2022, we note that the spread has been negative but Canadian grocers' gross profit margins remain strong, beating the general trend-profitability relationship. This indicates that Canadian grocers have been successful in using multiple tools to support margins in this environment.

Chart 4

image

Banner Diversity, Private Label, And Scale Amid Merchandizing Execution Are Keys To Protecting Margins

Canadian grocers continue to invest in the store network, but with a slowdown as customers become more price sensitive, it will be hard for them to turn EBITDA growth positive just based on tonnage improvement. In our view, grocers will focus on different tools and strategies at their disposal since there is little cushion for grocery stores and distributors to pass-through all these macroeconomic effects. These include:

  • Diversity of revenue. Discounters benefit during inflationary periods. In Canada, grocery retailers have already established discount channels, segmenting the consumer base. With convenient locations and the best value perception, along with limited assortment, strong private-label penetration, and a focus on technology (self-check outs, electronic shelves) and efficiency (less service counters in store), discounters can sell their products at low prices but still maintain EBITDA margins. Both Loblaw Cos. Ltd. and Metro Inc. are in a good position to benefit as discount stores' same-store sales (SSS; at least 50% of grocery stores) continue to outperform that of conventional stores. In addition, exposure to high-margin pharmacy sales (20%-30% of total revenue) benefit toplines. The assortment in pharmacy stores is designed for convenience, and promotional and pricing programs reflect higher margins. In addition, pharmacy services, including vaccines and medical consultations, are a good opportunity for grocers to diversify revenues and sustain gross margins. For example, in second-quarter 2022, Loblaw's retail gross margin improved by 50 basis points (bps) due to pharmacy operations while food margins remained flat.
  • Loyalty programs. A successful loyalty program not only enhances market share (incremental sales that capture a greater share of the wallet) but also enables strategic promotion pricing in a competitive industry. These program allow the company to pick promotional prices to drive sales, and identify consumers for both targeted promotions and buying opportunities that allow margin expansion over time. Optimizing the use of loyalty programs across diverse channels (including e-commerce) allows grocers to deliver value to the consumer while maintaining margins. Although volumes and mix are starting to get squeezed, Canadian grocers still maintained their gross margin performance in the first quarter of 2022, reflecting pricing and promotion strategies.
  • Private label. Mix is important and the combination of adverse sales and reduced operational leverage would be a headwind. However, increased penetration of higher-margin private labels could offset some topline headwinds as we continue to see growth in private-label brands at the expense of other branded products. In Canada, private labels are well established, with food penetration ranging from the low-double-digit percentage area to close to 40% compared with 16% penetration in the U.S. Grocers continue to expand their private-label portfolios while focusing on stockkeeping unit (SKU) rationalization to enhance margins.
  • Omnichannel presence. The pandemic accelerated a consumer shift to digital/online shopping. Although e-commerce sales have dropped since the peak of the pandemic, the channel is still important because e-commerce helps retain consumers that value convenience while allowing retailers to collect customer data. In turn, this helps to provide personalized offers and ensure convenient service and loyalty. With online consumers being relatively less price sensitive, it allows grocers to offset higher costs associated with online service. Partnerships with third-party delivery companies (Metro and Instacart, Loblaw and DoorDash) have helped retailers meet the logistical challenge of quick deliveries and customer retention.
  • Supply-chain challenges. Against the difficult operating backdrop of global supply-chain issues, management teams have to be disciplined and nimble in their procurement strategies, and collaborate with vendors to manage promotions while ensuring stockouts are limited. Although private-label products support gross margins, retailers still face supply-chain challenges as do manufacturers. We expect the supply chain will normalize, but these headwinds are likely to continue in the near term.
  • Business investment. Canadian grocers continue to invest in store networks, distribution centers, and e-commerce. Investments include upgrading supply-chain distribution systems and adding automation in the retail store network including in-store technology (self-checkouts, electronic shelf labels) that eventually saves expenses. Revamping loyalty strategies enhances the customer experience through digital platforms, while offsetting costs through optimizing operational efficiencies, deploying new technology, and streamlining delivery offerings. In addition, dark stores or hub and spoke models are forecast for further expansion to meet consumers' preferences while also being margin accretive.

Most Grocers Can Absorb A Large Margin Squeeze

Canadian retail grocers have been beneficiaries through the pandemic, posting double-digit SSS (two-year stacked), about 20% in gross profit growth, and strong margins despite incremental operating costs associated with pandemic safety measures and higher labor wages. In our view, the balance-sheet flexibility from the past few quarters places grocery retailers in a strong position to handle current headwinds. Using a broad stress case, we assumed a 250-bps impact on EBITDA margins for Canadian grocers, without any offsetting actions by them.

Table 2

Grocery Stress Test Sensitivity
Company Rating as of Aug. 8, 2022 Outlook Downgrade threshold (x) Leverage of latest quarter* (x) EBITDA* (bil. C$) EBITDA margin* (%) Current fiscal year leverage* (250-bps stress test)
Loblaw Cos. Ltd. BBB Stable 3.25§ 2.2 5.5 10.5 3.3
Metro Inc. BBB Stable Mid-3.00 2.4 1.7 9.5 3.5
Sobeys Inc. BBB- Stable Above 3.50 3.3 2.2 7.2 5.0
*S&P Global Ratings adjusted. §Loblaw's stand-alone credit profile threshold. Bps--Basis points. Sources: S&P Global Ratings, company reports.

Metro and Loblaw have sufficient flexibility in their balance sheets to withstand a margin compression. In comparison, Sobeys Inc.'s current leverage already provides less cushion for a downside scenario in relation to that of its peers. In addition, Sobeys' EBITDA is more sensitive to our stress case, given a comparatively lower EBITDA margin, reflecting a combination of lower pharmacy sales, compared with those of peers, and fuel sales (which are low margin). However, in the past few quarters when the CPI-PPI differential was the most negative, Sobeys was still able to improve its EBITDA margin. In our view, the continued execution of Project Horizon (which includes the various options discussed above) will likely support continued margin expansion, partially offsetting inflationary headwinds. Other options to restore credit measures, such as lower dividend increases, reducing share repurchases, or halting acquisitions, could also support balance-sheet strength. Given that we view the margin compression to be temporary we will likely not take a rating action immediately; however, management's overall growth philosophy during this period will dictate our ratings assessment.

Canadian food retailers have established a strong market share, creating a robust presence and banner diversity. They have also developed solid customer relationships by segmenting their customer base, and providing appropriate value or time-saving options, while engaging in customer loyalty programs. In our view, inflation and recessionary headwinds could pressure Canadian food retailers' profitability in an increasingly competitive landscape as other players vie for share in a relatively static market for food. However, we acknowledge Canadian grocers have multiple tools to manage headwinds to profitability while their balance sheets provide flexibility.

Cooper Dellorletta was a research contributor on this article.

Related Research

This report does not constitute a rating action.

Primary Credit Analyst:Aniki Saha-Yannopoulos, CFA, PhD, Toronto + 1 (416) 507 2579;
aniki.saha-yannopoulos@spglobal.com
Secondary Contacts:Madhav Hari, CFA, Toronto + 1 (416) 507 2522;
madhav.hari@spglobal.com
Archana S Rao, Toronto + 1 (416) 507 2568;
archana.rao@spglobal.com

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