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1 Jan-10 Jul-10 Jan-11 Jul-11 Jan-12 Jul-12 Jan-13 Jul-13 Jan-14 Jul-14 Jan-15 Price per Share The Sprott Equity Research The North West Company (NWC) Buy, Current: $25.63, Target: $27.25 January 13, Year Performance Nicholas Falardeau BCom Candidate 2017 Finance Equity Analyst nick1499@rogers.com $28 $26 $24 $22 $ Kyle Stolys BCom Candidate 2017 Finance $18 $16 $ Sector Manager kyle.stolys@gmail.com Daily Volume Stock Price Current Target Price Source: Yahoo Finance Investment Thesis Security of Capital 80% of revenue is generated through grocery sales. Same store sales have continuously grown at 2%. Has a beta of The Government of Canada is dedicated to the economic prosperity of northern territories due to aboriginal habitation and territory claims against other nations. Owns and operates 230 stores. (180 are Canadian). It also provides a 4.5% dividend yield. Lack of competition Due to high barriers to entry, the majority of their stores are the dominant place for food, everyday merchandise and financial services. With the exception of some mom & pop stores, the company s stores tend to have a monopoly on their communities. It has also established a loyal customer following through charitable donations in their communities. Continuous same store growth and future expansion opportunities The company s stores have been averaging a 2% growth rate. The company owns a franchising agreement to open up to 72 Giant Tigers; it currently operates 32. Lately the company s focus has been on optimizing existing markets through store renovations, taking on new goods and services, and acquiring competing small stores. Fair price for earnings and assets The company has a $1.24B market cap with $320M in CA (3.62 p/b) and a P/E ratio of 19. P/B ratios average 2.05 while P/E ratios average 26 within the company s close competitors. Through this we can see that for our dollar we may gain more through earnings and less through assets than what can be achieved at Metro, Loblaw, and Sobeys.

2 E 2015E 2016E 2017E 2018E Company Overview The North West Company (NWC) operates a chain of grocery stores across Northern Canada and Alaska. They are branded Northern, AC Value Center, and Northmart, and are the main and sometimes only access of food in their communities. Together they make up 159 of the company s operations. They span on average 7500 feet which is slightly bigger than the average bulk barn. In addition to grocery stores, it operates 20 Quickstops convenience stores and 32 Giant Tigers. It has a franchising agreement with Giant Tiger to open up to 72 stores. 65% of the company s sales come from Canada. Alaska s 30 Value Centers make up most of the international sales with the rest being from 13 Cost u Less in the Caribbean. As mentioned, The North West Company is in the grocery/retail industry. Its input costs are greatly affected by the prices of food. The company s geography is what sets it apart from the industry, as its outlets are distant from its producers. Therefore it is also strongly impacted by the price of gas due to extended transportation. Economic prosperity where the company operates is dependent on government wealth redistribution programs and mineral mining. Figure 1: Revenue by Geographic Region 1,800,000 1,600,000 1,400,000 1,200,000 1,000, , , , ,000 0 Canadian International (Mainly Alaska) Source: Bloomberg, Student Estimates Sector Outlook Consumer Staples are goods that consumers will purchase no matter the economic conditions. Thus, demand for these goods, relative to others, are generally inelastic and thus are considered non-cyclical. Consumer confidence (figure 2) has the largest impact on the sector. As consumers feel confident about their personal financial state, they are more willing to pay for premium consumer staples goods. In bad times, although still required to purchase staples, consumers tend to switch to discount items. Input prices can be tricky on the sector, as sudden changes can lead to a temporary boost or decrease in profits due to the effect of sticky prices. Page 2

3 In the event of an economic recession or stagnation we expect consumer staples as a whole to experience slight revenue drops. Some parts of the sector will drop significantly but the majority will remain resilient since many consumers need to purchase them. On an industry basis, grocery chains are part of the more resilient category as there is always a need to purchase food for your home. Grocer revenues tend to not decrease in recessions (some even increase due to restaurant spending being redirected to them). The North West Company s strategic positioning (being the only store in town) enhances its economic prosperity in tough times, as there is definitely no substitution for their goods. Figure 2: University of Michigan Consumer Sentiment Index Source: University of Michigan Industry Dynamics Due to the necessity of food for everyday life, the grocery industry s cash flows tend to be very stable (as seen in company revenues in figure 1). The grocer tactic for growth has been to increase profit margins by selling premium items over discount items. This is not reliable during bad times as consumers will switch back to discount brands. In recent years the push for growth has come out of expanding grocer services. Pharmacies, ATMs, tech gadgets, gas, and fast food are examples of this. The biggest has been financial services. Many grocers now offer credit cards and other services that tender to a customer s personal welfare. This places its growth reliance in another industry entirely. Nevertheless the idea in the industry remains the same, a store has a customer in its walls for 20 to 45 minutes and a grocer will attempt to increase customer spending as much as possible. Government intervention is a slight risk among northern businesses. A certain percentage of enterprises in native communities must be owned by natives. The company bears this risk by providing significant community donations and by making efforts to hire natives. Cost drivers for grocers are employee turnover, crude prices, and food prices (seen in figures 3 and 4). There is also a high barrier to entry in the industry as it is capital intensive. Although convenience stores cost considerably less to start and operate. Page 3

4 Government intervention is a slight risk among northern businesses. A certain percentage of enterprises in native communities must be owned by natives. The company bears this risk by providing significant community donations and through making efforts to hire natives. Cost drivers for grocers are employee turnover, crude prices, and food prices (seen below). There is also a high barrier to entry in the industry as it is capital intensive. Although convenience stores cost considerably less to start and operate. Figure 3: Crude Oil Prices (WTI) Figure 4: FAO Food Price Index Source: Federal Reserve Economic Data Source: Food and Agriculture Organization of the United Nations Competitive Positioning The major grocer players within Canada are Metro, EmpireCo(Sobey s), and Loblaw. They all contain established store brands and food item brands (Selection, Compliments, and President s Choice respectively). The competitive advantage that The North West Company has is its location of stores. Because of their remoteness, they do not have to compete with major grocers unless it sees profitability in doing so. If they choose to open a store in an urban area, they will open a Giant Tiger (as it has 32 times) which has its own competitive advantage of being recognized as a Canadian company. Loblaw Loblaw operates three types of stores: conventional for the everyday shopper, discount for lower income consumers, and emerging market stores which sell foods for recent immigrants. It operates 570 stores and franchises out another 496. It has recently acquired Shopper s Drug Mart to expand its operations to include pharmacies. It has also started a Joe Fresh clothing line. The company owns the President s Choice and No Name brands which are offered at their conventional and discount stores respectively. President s Choice has expanded to offer financial and mobile services under their brand name. Page 4

5 E 2015E 2016E 2017E 2018E CV Metro Metro operates 588 food stores and 268 drugstores aiming to provide a differentiated customer experience in each of its store formats. The company s goal is to gain as much market share as possible by adapting to different consumer needs. Metro does this through customer loyalty reward programs and is aiming to increase the frequency of communication between them in the coming year in the form of mobile applications and their website. EmpireCo EmpireCo operates over 1500 food stores across Canada. Recent boosts have come out of the acquisition of the Safeway chain in western Canada which has 213 grocery stores and 200 in or out of store pharmacies. It also owns a 40% interest in Crombie Real Estate Investment trust which owns 250 commercial properties across Canada. Figure 5: Operating Margin 100,000 90,000 80,000 70,000 60,000 50,000 40,000 30,000 20,000 10, % 9% 8% 7% 6% 5% 4% 3% 2% 1% 0% Source: Bloomberg Net Income EBITDA Margin Operating Margin Profit Margin Growth & Risk Analysis Growth Outlook Currently, the company s growth comes out of extracting more spending from their consumers by offering more products and services. If the return on those investments dry up, it will take advantage of its Giant Tiger franchise agreement and take on the urban environment. Currently, as investors, we are pleased with the 4.5% dividend it is yielding. The dividend has averaged 50% of the company s operating cash flow over the past 5 years, which we forecast to continue. This is not an exciting company but it is very well run. Of the major grocers in Canada, The North West Company has the highest margins and generates the highest Returns on Invested Capital, Equity and Assets. We appreciate that management invests capital in only high returning projects - which is mainly the current operations of the company - and returns to investors whatever capital is not needed. This results in exceptionally high payout ratios (~80% of earnings) and low growth that is generated mainly through price increases. As a result same store sales growth has remained at 1.5% over the long term and we expect sales to continue to grow at such a pace for the foreseeable future. Page 5

6 Major Risks One of the major risks to The North West Company is the government s commitment to sustaining the economic prosperity of its northern regions. If jobs were to suddenly dry out, residents would move and leave communities deserted, forcing a huge loss in capital for the company. Even if only percentages of communities abandoned, since everyone shops at the company s stores, that directly translates into percentages of sales lost. Another form of economic prosperity comes from the mineral mining industry, having the largest impact in Nunavut. This industry does not have the sustainability that the government has and therefore a loss of jobs is inevitable in bad times. Fortunately the diamond industry is one of the largest mineral producers up north and is also one of the industries strongest in today s weak commodity market. Evidence of this is the recent commitment from Rio Tinto to invest $350 million into a diamond project in Northern Canada over the next four years. Such commitments bode well for Northern Canada s economies and helps The North West Company. Native intervention is also a possibility. Since there are laws in native communities that restrict a percentage of business operations to native people, the company may run into problems if these laws were enforced more strictly. Financial Statement Analysis Income Statement The North West Company s long term revenue growth is expected to be 1.5%. This is in line with its historical growth and is similar to growth expectations for the company s competitors. Also being slightly higher than inflation is expected for grocers. Its stores sell on average $750 per square foot versus the industry average of $616. Its net profit after tax has been approximately 4.2% while the industry average is 2.3%. Due to the company s stable input costs, we estimate operating margins to remain the same for the coming years (70.5%). A large input is the transportation costs of its goods. The price of crude oil has recently dropped, but its impact on operating margins is unknown and we are not confident in predicting how long prices will remain at today s levels (currently $45). Thus, we have left any benefit from oil prices out of our forecast and in future quarters we will try to examine its impact. Three years ago the company s tax rate jumped to 30%, its highest over the last 15 years. Since then it has remained at this level and we do not see any reason for the tax rate to drop significantly. For this reason, we have used a 30% tax rate throughout our analysis. Note that in years 2009 and 2010 taxes were deferred and the implied tax rates fell to 8.7% in 2009 and 17% in This caused fluctuations in reported net income. Figure 11: Income Statement Forecast E 2015E 2016E 2017E 2018E CV Total Revenue 1,495,136 1,513,646 1,543,125 1,609,479 1,633,622 1,658,126 1,682,998 1,708,243 1,733,866 Operating Margin 5.97% 6.38% 6.48% 6.03% 6.44% 6.54% 6.74% 6.54% 6.54% Net Income 57,961 63,888 64,263 64,867 70,407 72,350 71,777 73,983 73,897 Profit Margin 3.88% 4.22% 4.16% 4.03% 4.31% 4.36% 4.26% 4.33% 4.26% EPS $1.20 $1.32 $1.33 $1.34 $1.45 $1.49 $1.48 $1.53 $1.53 Source: Bloomberg, Student Estimates Page 6

7 Balance Sheet All items within The North West Company s balance sheet are relatively stable. There is a large amount of debt maturing in 2018 but it should have no material impact on the business. The debt to capital ratio remains at approximately 30%. Meanwhile its quick ratio is at 2. Figure 12: Balance Sheet Forecast E 2015E 2016E 2017E 2018E CV Current Assets 295, , , , , , , , ,944 Current Liabilities 128, , , , , , , , ,739 Pension Liabilities 4, Long-Term Debt 175, , , , , , , , ,205 Total Equity 283, , , , , , , , ,930 Source: Bloomberg, Student Estimates Cash Flow Statement As the company s revenues and margins remain stable, so does its operating cash flows. Capital expenditures are expected to remain constant given the company s steady new-store openings and same-store renovations. They can, on the other hand, be volatile as management warns of complications that may occur when setting up new locations up north. There is no evidence to assume more common shares are going to be issued. One of the most impressive factors is its strong dividend yield. It is currently providing 50% of its operating cash flow to investors; a yield known to be even higher in the past. There is a large amount of debt maturing in 2018 at 4.23%. We do not see refinancing being an issue given the steady Canadian interest rates assigned to stable corporations like the North West Company. We did however, bring our estimate of future interest rates to 5% when calculating CV to account for a possible rise in interest rates. Figure 13: Cash Flow Forecast E 2015E 2016E 2017E 2018E CV Cash from Operations 115, ,992 80, , , , , , ,676 Cash from Investing -45,948-48,781-42,386-57,814-49,863-50,584-51,113-51,125-52,155 Cash from Financing -73,768-68,520-53,972-62,097-58,603-55,400 68, ,982-71,344 Net Change in Cash -4,247 11,691-16,322-10,223 7,864 12, , ,833-1,822 Ending Cash Balance 26,984 38,675 22,353 12,130 19,994 32, ,900 52,067 50,245 Source: Bloomberg, Student Estimates Page 7

8 Valuation Discounted Cash Flow We discounted the future cash flows at a WACC of 6.4% (pulled from Bloomberg). This is a very low WACC compared to most companies today but is not unreasonable in our opinion due to the stability of the grocery business as well as the stability of operating a grocery business up north. The adjusted beta of the company is 0.51 and using a risk free rate of 2.5%, and a market risk premium of 6.5%, we calculated a cost of equity of 5.82%. Combining this with the current 4.23% pre-tax cost of long term debt we calculated a WACC of 5.59%. Given the very low rate our calculations came to we opted to discount cash flows using the higher (6.4%) rate provided by Bloomberg. It should be noted that The North West Company has not had its enterprise debt rated yet. However the company s interest coverage ratio of 17.3 is the highest of its peers and is still an investment grade investment in our opinion. As a result of these inputs we came to a DCF value per share of $ Figure 14: DCF Calculation 2014E 2015E 2016E 2017E 2018E CV EBIT (1 - Tax) 67,977 73,679 75,930 79,397 78,181 79,399 Add: Depreciation Expense 39,481 40,137 40,759 41,411 42,054 42,620 Less: Capital Expenditures -53,386-45,166-45,819-46,299-46,309-47,242 Less: Change in Non-Cash WC -1,770-1,325-2,208-1,051-3,874-1,951 FCFF per Year 52,303 67,325 68,662 73,458 70,052 72,826 FCFF Discounted 13,076 63,275 60,651 60,984 54,658 1,159,642 PV - Future Cash Flows 1,412,285 Assumptions WACC 6.40% Excess Cash 33,049 Ke 7.30% MV of Debt 125,970 Kd 1.90% Shares Outstanding 48,418 CV Growth Rate 1.50% DCF Value Per Share $27.25 Page 8

9 Investment Recommendation Buy, Price Target $30.22 Investment Positives This investment position is one of the steadiest in the market. Its product is a necessity and its operations experience low competition. The stability of its communities are guaranteed by the government and the prosperity of the diamond mining industry. The company is providing a 4.55% dividend yield. The yield has ranged from 4 to 7% in the past 8 years and has averaged 80% of the diluted earnings per share. Growth opportunities will never cease for the company. Opportunities consist of new store openings due to population growth, use of Giant Tiger franchises in urban centers, and expansion of services offered in existing stores. Investment Negatives Small capital gains. Although secure, there is slow growth within this company. This is a norm for the grocery industry. Other firms (such as the competitors previously mentioned) have been acquiring large firms with high growth potential to compensate; a move not played by The North West Company. We calculated only a slight undervaluation for the company, therefore our hopes for the stock to rise are limited. Our thesis is that the price will stay relatively stable and we will collect a healthy dividend. Long term economic prosperity is not guaranteed. We spoke to the guaranteed prosperity in the short term, but we can not predict government policies towards the territories over the long term. The prosperity of the diamond mining industry is also not guaranteed in the long term. Overall, we feel positive about The North West Company s future. Although we expect capital gains to be limited we are extremely pleased with the high dividend this company provides, which we feel is very attractive in today s low interest rate environment. We recommend The North West Company as a buy. Disclaimer This report was written by a student currently enrolled in a program at the Sprott School of Business. The purpose of this report is to demonstrate the investment analysis skills of Sprott students. The analyst is not a registered investment advisor, broker or an officially licensed financial professional. The investment opinion contained in this report does not represent an offer or solicitation to buy or sell any securities. This report is written solely for the consideration of this student managed investment fund and should not be used by individuals to make personal investment decisions. Unless otherwise noted, facts and figures included in this report are from publicly available sources. We cannot guarantee that the information in this report is 100 percent accurate, although we believe it to be from reliable sources. Information contained in this report is only believed to be accurate as of the day it was published, and it is subject to change without notice. It cannot be guaranteed that the faculty or students do not have an investment position in the securities mentioned in this report. Page 9

10 Appendix: Comparative Analysis Table Company Average The North West Company Loblaw Metro EmpireCo Kroger Delhaize Market Cap ($MM) $10,369 $1,219 $24,464 $7,720 $8,073 $32,427 $7,705 Enterprise Value ($MM) $13,331 $1,309 $34,719 $7,298 $9,995 $39,388 $6,970 Credit Rating BBB NR BBB BBB NR BBB BBB- P/E Debt to Equity EBIT to Interest Expense P/S PEG P/B P/FCF EV/EBITDA Inventory Turnover Cash Conversion Gross Margin Operating Margin Profit Margin Current Ratio Revenue growth (1yr) Revenue growth (5yr) Net Income Growth (5yr) Dividend Yield ROE ROA ROIC Note that Loblaw has recently acquired shoppers drug mart and does not have a full year s revenue since then for proper comparison sake. Page 10

11 Figure A1: Income Statement Appendix A Pro-forma Financial Statements Page 11

12 Figure A2: Common Size Income Statement Page 12

13 Figure A3: Balance Sheet Page 13

14 Figure A4: Common Size Balance Sheet Page 14

15 Figure A5: Cash Flow Statement Page 15

16 E 2015E 2016E 2017E 2018E CV E 2015E 2016E 2017E 2018E CV Appendix B Valuation Charts and Sensitivity Figure B1: Profitability Forecast Figure B2: Dividend Payout Ratio 100,000 80,000 60,000 40,000 20, % 8% 6% 4% 2% 0% 100% 80% 60% 40% 20% 0% Net Income Operating Margin EBITDA Margin Profit Margin Dividend Payout Ratio (to OCF) Net Income to OCF Source: Bloomberg, Student Estimates Source: Bloomberg, Student Estimates Page 16

17 Figure B5: DCF Sensitivities Cost of Equity CV Profit Margin 5% 5% 5% 5% 5% 5.30% $38.10 $38.10 $38.10 $38.10 $ % $30.44 $30.44 $30.44 $30.44 $ % $25.46 $25.46 $25.46 $25.46 $ % $21.98 $21.98 $21.98 $21.98 $ % $19.41 $19.41 $19.41 $19.41 $19.41 Cost of Equity CV CAPEX as % of Operating Cash Flow 39% 39% 39% 39% 39% 5.30% $38.10 $38.10 $38.10 $38.10 $ % $30.44 $30.44 $30.44 $30.44 $ % $25.46 $25.46 $25.46 $25.46 $ % $21.98 $21.98 $21.98 $21.98 $ % $19.41 $19.41 $19.41 $19.41 $19.41 WACC CV Growth Rate 0.5% 1.0% 1.5% 2.0% 2.5% 4.40% $35.76 $40.54 $46.96 $56.05 $ % $28.17 $31.00 $34.55 $39.14 $ % $23.19 $25.03 $27.25 $29.97 $ % $19.68 $20.96 $22.46 $24.23 $ % $17.09 $18.02 $19.09 $20.32 $21.76 Page 17