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Canadian Retailers Go on the Defensive

Tuesday - 7/30/2013, 2:29pm  ET

Canada's Loblaw (NASDAQOTH: LBLCF) announced plans to buy Shoppers Drug Mart for $12 billion. That marries Canada's largest grocery chains with one of its largest drug chains. The move was spurred by Wal-Mart and Target .

To the North

Our northern neighbor is a large, natural resource rich, and relatively sparsely populated country. According to United North America, despite Canada's larger physical size there are over nine times more people in the United States. That said, with a population of nearly 34 million as of 2011, its an enticing market for U.S. companies.

In fact, as you cross the border, you'll see U.S. chains dotting the landscape, from retail stores to restaurants. Wal-Mart, for example, has been in the country for years. Target is just starting its incursion. That's got Canada's giant grocery chain Loblaw a little concerned.

Loblaw has more than 1,000 grocery stores across the country. Its top-line has been in slow motion over the last five years, growing from $30.8 billion Canadian to $31.6 billion Canadian. Earnings were growing between 2008 and 2011 on slow top-line growth and margin expansion, but fell in 2012 as profit margins contracted from 4.4% to 3.8%. The grocery business is a notoriously low margin one.

Watching Wal-Mart expand its grocery presence in the United States, including adding grocery items to its big-box format as well as opening smaller grocery only stores, had to be worrying to Loblaw. That move has put the squeeze on U.S. grocery profit margins. As Target is starting to move north, with plans on having over 100 stores open by year end, Loblaw management clearly chose to act.

Shoppers has over 1,200 drug stores. These are smaller stores, often in local neighborhoods. The combined companies will have a notable retail footprint that will be hard for either of the U.S. giants to replicate. And it will span both large and small formats. Although Shoppers' top-line has been growing slowly in recent years, its bottom-line has moved steadily higher over the last decade. And Loblaw will likely add more food items to Shoppers' shelves to get customers in the doors more frequently.

Both Shoppers and Loblaw rose on the news, so investors obviously like the deal. Shoppers shareholders should probably sell to lock in an over 20% windfall. Because of the large industry positions of each company, there could be government concerns about the linkup.

Loblaw, meanwhile, instantly becomes a more competitive player with its hands in smaller markets that have largely eluded big box retailers. Assuming the deal goes through, that could shift growth into a higher gear. It's a Canadian retailer definitely worth watching.

Across the Border

What about Target and Wal-Mart? Wal-Mart isn't new to Canada. In fact, it's the largest retailer in the world. With a keen focus on low prices, it has been expanding its global empire into countries as far reaching as China and several African nations. The U.S. market has probably been the weakest link of late as a slow economic recovery continues to hinder its core lower income customers.

That's not good news for Wal-Mart in the near term, but it is financially strong enough and so well run that it's only a matter of time before it works through its domestic problems. Meanwhile, it's growing nicely overseas.

The shares are up some 50% since late last year, and the price to earnings ratio is around 15, slightly higher than its five year average. So the shares are hardly cheap, but nor are they wildly expensive. Investors looking for a global retail play would do well to consider it.

Although Target's PE of around 17 is several percentage points above its five year average, the push into Canada opens up a new growth phase for the company. It has long been the only major domestic competitor to Wal-Mart, using chic stores to compete on service instead of price. Bringing that model into a market where it has no exposure today should provide a notable boost to the top-line and offers years of expansion opportunity.

Target's revenues have been trending higher since 2005, and the company's profit margin is a full percentage point above Wal-Mart's. The stock's 2.4% yield is identical to Wal-Mart's. Although Target is relatively more expensive than Wal-Mart, its Canadian expansion efforts make it worth a look for growth-oriented investors.

Attacking and Defending

As Target joins Wal-Mart in Canada, Loblaw is trying to cement its market position. The Shoppers deal is a good move and should position the company well. It's worth a look. Wal-Mart is the best choice for global retail exposure, but Target, while expensive, should see notable growth as it starts to move into new markets.

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