Canadian Tire Corporation Ltd. Stock Report

Canadian Tire Corporation, Limited

The chart shows that Canadian Tire’s earnings (the blue line) and revenues (the red line) have increased steadily in the past ten years with the exception of the 2008 / 2009 recession. Adjusted earnings per share are up a compounded average of 7.8% per year in the period shown while revenue per share is up 6.4% compounded.  Book value per share (the green line) has also increased at a rapid rate but flattened more recently due to substantial share buy-backs.

Canadian Tire (CTC.a, TO)
RESEARCH SUMMARY  
Report Author(s): InvestorsFriend Inc. Analyst(s)
Author(s)’ disclosure of share ownership:  Author(s) hold shares
Based on financials from: Dec ’17 Y.E.
Last updated: 24-Feb-18
Share Price At Date of Last Update:  $                            176.15
Currency: $ Canadian
Generic Rating (This rating does not consider the circumstances of any individual investor and is therefore not specific advice for any individual): Buy rated at $176.15
SUMMARY AND RATING: This cell of the report summarizes information from cells below. Based on the graph, this qualifies as a moderately “Great Company” (relatively strong and relatively steady past trend of earnings per share growth).  The business seems to have good economics, though in part this is based on apparently high retail markups which could make it vulnerable to competition. The value ratios based on past earnings indicate a strong company available at a reasonable price indicating a Buy or (higher) Buy rating. The industry is moderately attractive (but could become unattractive if competition gets too intense).  Recent same store sales growth is quite strong. Recent earnings per share growth is very strong. Insider trading activity signal is neutral.  The company has a strong history of growth. The main risk appears to be increased pricing pressure from competitors. The outlook is for continued growth although competition could change that. Also the company faces tough comparable quarters in 2018 which make it harder to achieve high growth. Credit card bad debt could increase. Appears to do reasonably well on the factors that Warren Buffett looks for.  Management seems very strong. Overall,  we rate Canadian Tire a Buy at $176.15.
DESCRIPTION OF BUSINESS:  (Updated from 2016 annual report) Operates three Retail chains totaling 1702 stores plus a large credit card operation. The original Canadian Tire store chain accounts for 65% of the retail square footage but only 29% of the store count. In the original business, acts as wholesaler and marketing arm and (in most cases) landlord to the 500 Canadian Tire stores. Canadian Tire (including its 83% owned REIT) owns 70% of the Canadian Tire store buildings (leases the rest and leases all the stores for the other retail brands) but the independent dealers own the retail business and auto service business within each store. Canadian Tire controls the retail pricing. Also operates (through agents) 296 gas-bars (with an associated approximately 278 convenience stores and 73 car washes). PartSource has 91 stores. Also owns 382 Mark’s stores L’Equpeur in Quebec), most of these are company operated although some are franchisee operated.  Owns the 433 store former Forzani chain (Sports Check, Sports Expert, Atmosphere, Athlete’s world, Pro Hockey Life, and others) Canadian Tire also has very significant operations as a MasterCard credit card issuer. Retail Revenue is 57% from Canadian Tire  Stores (includes PartSource), 19% from the sports stores, 10% and from Mark’s, and 14% from Gas bars. Earnings before income tax in 2016 was  50% from all retail combined, 21% from the REIT (which could be considered part of Retail) and 29% from financial services.
ECONOMICS OF THE BUSINESS: The economics of the Canadian Tire Stores seem good in that they have a huge penetration in Canada which provides economies of scale. The auto service business combined with automotive retail is unique. We do have some concern that the retail markup appears high reflecting a higher cost operation. They have a unique product mix that attracts customers. The Dealer structure with individual entrepreneurs owning each store is relatively unique. It does however mean that profits are shared. The Company is a wholesaler and landlord to these stores rather than a true retailer itself. The economics of the Sports stores are strong due to being the largest chain of sports stores in Canada. The Economics of the Marks stores seem strong based on brand awareness and a focus on work wear. The Economics of the credit card operation are strong because they have had a lower cost way to sign up customers through in-store promotions. The interest rate charges on credit card receivables is very high such that annual revenue is 23% of the amounts outstanding as receivables. Overall, (updated Q2 2017)  the corporation makes a net 5.4% profit on revenue which is levered down to 4.5% on assets as assets are moderately larger than sales and leveraged up to an attractive and impressive 14.9% return on ending equity as assets are 3.3 times larger than equity.
RISKS: See Annual report.  Higher losses on the credit card business are always possible. Amazon may pose a threat at some point but to date has had minimal impact on Canadian Tire including the sports stores and Marks.
INSIDER TRADING / INSIDER HOLDING:  Checking “trades in the public market” from August 1, 2017 to February 25, 2018 there was essentially no insider buys or sells in the public market.  Therefore there is no insider trading signal at this time. In terms of insider ownership, many insiders hold shares (presumably mostly acquired through profit sharing and options) and the vast majority have not been selling, at least not in recent months. The company itself has been buying back shares heavily but appears to do so without regard to the share price but presumably they view the shares as undervalued.
WARREN BUFFETT’s CRITERIA: Buffet indicates that all investments must pass four key tests: the business is  simple to understand (pass ), has favorable long-term economics due to cost advantages or superior brand power (at least a marginal pass due to established brand power, scale, locations and entrepreneurial dealer structure), apparently able and trustworthy management (pass based on track record), a sensible price – below its intrinsic value (pass, the company is selling at a reasonable P/E), Other criteria that have been attributed to Buffett include: high profits on sales (pass good profits on sales for a retail operation) , a low debt ratio (pass), good recent profit history (pass) little chance of permanent loss of capital (pass) a low level of maintenance type capital spending required to maintain existing operations excluding growth (marginal pass as stores do require ongoing updating)
MOST RECENT EARNINGS TREND: In the past four quarters starting with the most recent (Q4, 2017), revenues per share were up 15.5%, 11.6%, 6.9% and 12.6%.  Adjusted earnings (and there are no material adjustments) per share were up 19.7%, 5.8%, 19.6% and 42.7%.  Recent growth was boosted by aggressive share buy backs. In 2017 annual revenues per share were up 11.6%  and adjusted earnings per share were up 18.0%.  In 2016 annual revenues per share were up 9.0%  and adjusted earnings per share were up 11.4%. In 2015 annual revenues per share were up 2.4% (4.4% adjusted for the extra week the prior year)  and adjusted earnings per share were up 4.5.In 2014 annual revenues per share were up 7.8% and adjusted earnings per share were up 10.9%. 2013 annual revenues per share were up 3.9% and adjusted earnings per share were up 8.8%.  Overall the recent trend is very  strong.
COMPARABLE STORE SALES: The Canadian Tire branded same store sales in the past four quarters were, starting with the most recent (Q4 2017) were up 3.5%, 4.7, 1.8%, and 0.3%. Sports stores were up 5.8%, up 0.4, up 2.6%, and down 2.7%, up 5.1%, and up 7.7%. Mark’s was up 3.4%, 4.6%, 4.0%, and 5.4%. Overall the level of same-store sales recently is very strong. However, we did not see any disclosure of the extent to which price increase, as opposed to volume, contributed to this.
Earnings Growth Scenario and Justifiable P/E: At this update the shares were trading at a P/E of about 16.3. With a current dividend payout ratio of 33%, it takes earnings growth of about 4% annually  for the next ten years to justify a P/E of about 16. This assumes that the required return is only 6.5% given low interest rates.
VALUE AND GROWTH RATIOS:  Analyzed at $176.15. Price to book value ratio seems reasonable to moderately high at 2.5. The dividend yield is relatively modest at 2.0% reflecting the still relatively low pay-out ratio of 33% of adjusted earnings combined with the 2.5 price to book ratio. Adjusted ROE is very attractive and impressive at 15.2%.  We always use adjusted earnings per share but in this case there are essentially no recent adjustments. Adjusted Earnings growth per share over the past 5 calendar  years has been quite strong at an average of 10.6%. Revenue per share growth was quite good at an average 6.9% in the past five years. Trailing 12 months adjusted P/E is perhaps moderately attractive at 16.3.  Assuming that earnings grow for five years at 4% to 9% (9% may be aggressive) per year , and the P/E ends at 14 or 18 respectively, then we calculate a present value per share of $150 to $235. This yields a price to value ratio of 118% to 75% respectively. This valuation uses a discount rate of only 6.5% reflecting today’s ultra-low interest rates.  A higher “required” return or discount rate would lead to a lower calculated valuation today. (This is not a share price prediction).  Overall, these ratios, in isolation would indicate a  Buy or (higher) Buy  rating.
SUPPORTING RESEARCH AND ANALYSIS  
Symbol and Exchange: CTC.a, TO
Currency: $ Canadian
Contact: investor.relations@cantire.com
Web-site: www.canadiantire.com
INCOME AND PRICE / EARNINGS RATIO ANALYSIS  
Latest four quarters annual sales $ millions: $13,434.9
Latest four quarters annual earnings $ millions: $735.0
P/E ratio based on latest four quarters earnings: 16.5
Latest four quarters annual earnings, adjusted, $ millions: $735.3
BASIS OR SOURCE OF ADJUSTED EARNINGS: Adjusted for certain unusual (non-operating) items identified by management and starting in 2015 adjusted for gains on property sales.
Quality of Earnings Measurement and Persistence: As a retailer, the Earnings Measurement and Persistence are not very much affected by estimated items. The credit card operations must estimate bad debts but there is no reason to think that the estimates are not reasonably accurate. There have been relatively few “unusual” items in the Earnings Measurement and Persistence over the past few years. Overall, the reported Earnings Measurement and Persistence are of good “quality” (reliable, not as subject to manipulation).
P/E ratio based on latest four quarters earnings, adjusted 16.5
Latest fiscal year annual earnings: $735.0
P/E ratio based on latest fiscal year earnings: 16.5
Fiscal earnings adjusted: $735.3
P/E ratio for fiscal earnings adjusted: 16.5
Latest four quarters profit as percent of sales 5.5%
Dividend Yield: 2.0%
Price / Sales Ratio 0.90
BALANCE SHEET ITEMS  
Price to (diluted) book value ratio:                                         2.49
Balance Sheet: Updated using Q4, 2017, Canadian Tire’s balance sheet is very different than a pure retailer because they have a very large finance operation that increases debt. The debt level seems modest given the presence of the finance operation. Canadian Tire’s equity is 88% retained earnings which is proof of a history of profitability — especially given that dividends and share buy-backs reduce retained earnings. There is only a relatively modest amount of purchased goodwill on the balance sheet. Assets consist as follows: 36% are loans receivable mostly credit card receivables, 27% is property and equipment (mostly land and buildings also leasehold improvements and fixture – these are NOT marked to market and are likely worth FAR more than book value) 11% is merchandise inventories, 6% is purchased goodwill or the equivalent 5% is trade receivables due – mostly from dealers and franchisees, 5% is longer term receivables mostly from loans to dealers, 4% is cash and short-term investments, 3% is software and the remainder is various small items including prepaid amounts and some long term investments and investment properties. On the liability and equity side of the balance sheet these assets are funded as follows: Debt 30%, deposits (remember, they own a bank) 15%, other long-term liabilities 5% (about 3% of which appears to be minority interest in substance), 27% common equity and 5% the equity of Scotia Bank in the finance business and of the publicly traded portion of the REIT, 13% trade account payables which nicely about matches the 11% of assets that are merchandise inventory). The remaining 5% is a small amount of deferred income taxes and other “provisions” and liabilities.  Overall, this is a strong balance sheet.
Quality of Net Assets and Book Value Measurement: With the share price recently trading at about 2.5 times book value and with substantial property assets not marked to market the value of the assets can provide some protection against share price drops. The assets are strong, while there is some intangible assets and goodwill and there is almost certainly substantial unrecognized (in the consolidated balance sheet) value in the land assets and favorable leases and also in the market value of the credit card operation. Considering the break-out of the balance sheet assets and liabilities discussed nearby in this report, the book value is very solid and also the leverage is modest after netting out debt associated with the credit card receivables.
Number of Diluted common shares in millions:                                  67.2
Controlling Shareholder:(May 2015)  Founding family member Martha Billes controls 40.9% of the voting shares. Owen Billes controls 20.5% of the voting shares. The Dealers association owns 20.6% of the voting shares and the profit sharing plan owns 12.2% of the voting shares. This leaves only about 6% of the voting shares available for trading. However non-voting shares also trade and are the main trading shares by far.
Market Equity Capitalization (Value) $ millions: $11,835.2
Percentage of assets supported by common equity: (remainder is debt or other liabilities) 30.4%
Interest-bearing debt as a percentage of common equity 89%
Current assets / current liabilities: 1.9
Liquidity and capital structure:   Overall liquidity is quite  strong and the debt credit rating is strong at BBB+.
RETURN ON EQUITY AND ON MARKET VALUE  
Latest four quarters adjusted (if applicable) net income return on average equity: 15.2%
Latest fiscal year adjusted (if applicable) net income return on average equity: 15.2%
Adjusted (if applicable) latest four quarters return on market capitalization: 6.2%
GROWTH RATIOS, OUTLOOK and CALCULATED INTRINSIC VALUE PER SHARE  
5 years compounded growth in sales/share 6.9%
Volatility of sales growth per share:  moderate but very steady growth
5 Years compounded growth in earnings/share 11.8%
5 years compounded growth in adjusted earnings per share 10.6%
Volatility of earnings growth:  Strong growth, some volatility
Projected current year earnings $millions: not available
Management projected price to earnings ratio: not available
Over the last ten years, has this been a truly excellent company exhibiting strong and steady growth in revenues per share and in earnings per share? Yes
Expected growth in EPS based on adjusted fiscal Return on equity times percent of earnings retained: 10.2%
More conservative estimate of compounded growth in earnings per share over the forecast period: 4.0%
More optimistic estimate of compounded growth in earnings per share over the forecast period: 9.0%
OUTLOOK FOR BUSINESS:   It seems reasonable to expect that they can continue to grow earnings at least modestly.  They continue to make improvements and adjustments to all of their retail operations with store renewals, phasing out some of the smaller former Forzani retail brands. They appear to be an active, energetic and growing company. Canadian Tire has basically been firing on all cylinders since the earnings dip of 2009. The recent growth will be hard to sustain. The REIT owns a large Sears distribution center and we would expect a loss there due to Sear’s problems.
LONG TERM PREDICTABILITY: Canadian Tire has a long history of growing at relatively good rate. It does face increased competition. But it  is in stable businesses and it seems reasonable to predict that it will continue to grow over the years.
Estimated present value per share: $136 if earnings per share grow for 5 years at the more conservative rate of 4% and the shares are then sold at a P/E of 14. $215 if earnings per share grow at the more optimistic rate of 9% annually for 5 years and the shares are then sold at a P/E of 18. (This is not a share price prediction). Both estimates use a 6.5% required rate of return.
ADDITIONAL COMMENTS  
INDUSTRY ATTRACTIVENESS: (These comments reflect Canadian Tire’s incumbent position in the industry.) Michael Porter of Harvard argues that attractive industries are those that are relatively protected from competition based on 5 key tests or forces. Retailing and Auto repair have only moderate barriers to entry in terms of attractive physical locations (marginal pass). Not subject to powerful suppliers (pass) But is possibly  subject to powerful customers since the dealers are customers, albeit they are captive customers (marginal pass) . Generally no substitute products for the industry as a whole, people have to buy the products someplace (pass). Retail is sometimes thought of as competing excessively on price, but many retailers refuse to play that game and unlike capital intensive industries they will not tend to sell below cost level but clearly there is stiff competition in some of the basic household staples (marginal pass).  At present, a number of competitors of Canadian Tire are investing heavily in stores (Wal-Mart, Home Depot, Home Hardware, Lowes). However, Canadian Tire has only some overlap in products with these competitors. Overall, it is a moderately attractive industry for Canadian Tire.
COMPETITIVE ADVANTAGE: Entrepreneurial nature of dealer owned stores is probably an asset although it means sharing profits with them, convenient store locations, unique mix of products and services under one roof. Gas Bars have the advantage of offering Canadian Tire “Money”. Gas bars help to attract customers into the stores. The Finance operation is able to attract card holders at a low acquisition cost with in-store promotions. Scale provides advantages in advertising. Strongly “goal oriented” with a longer term history of exceeding its goals. In retail its overall gross margin including the margin of dealers appears to be high. We can’t judge how competitive this is without a break-down of margins by banner, Canadian Tire, Marks and the former Forzani stores. We suspect the gross margin for the Canadian Tire retail operation is much lower than the for the other two chains which have much smaller stores on average.
COMPETITIVE POSITION: Canadian Tire Stores as well as the former Forzani Group stores have a leading position but we don’t know the market share. The other divisions (Mark’s, petroleum and Finance) would have relatively modest shares of the total Canadian Market.
RECENT EVENTS: Canadian Tire is recently more focused on integrating its various retail chains with its “one company, one customer” approach. Also recently more focused on buildings its own brands. In Q3, 2017 the dividend was increased by a hefty 38% as the company raised its earnings payout target ratio to 30 to 40%.  In July 2016, Michael Medline who was CEO for about 18 months, and a key executive before that, was abruptly ousted and replaced by the former CEO (Who was still on the Board). This change was apparently made in order to bring more focus and attention on innovation and e-commerce and all aspects of digital retail. The company has also been aggressive in buying back shares which has been a boost to earnings per share.
ACCOUNTING AND DISCLOSURE ISSUES: We have not identified any major areas of concern.  Intangible software assets are included with purchased intangibles that are more like goodwill and should be separated. The corporation’s ownership of its REIT units are placed in the retail segment rather than at the corporate level and this obscures what the profitability of the CTC stores would be if they were paying market rents. The Q1 2016 earnings release did not mention the impact of currency fluctuations even though that was the top question that analysts were interested in at that time. They do not seem consistent in presenting adjusted earnings figures and do not treat gains on property sales as unusual.
COMMON SHARE STRUCTURE USED: Unfortunately the main trading shares are non-voting. The voting shares also trade, but at a significant premium.  All else being equal, this share structure is a negative factor. Based on reading the description of the shares (and particularly what would happen in the event of a take-over offer) we don’t think the voting shares should trade at a premium, but they do, and have for many years. We would buy the non-voting shares.
MANAGEMENT QUALITY: Management appears to be very strong. They seem to have a focus on relentless modest but steady improvements and growth. A focus on shareholder value and return on equity through more cautious capital spending and better control of working capital is encouraging. Seems to have strong abilities in the finance business including the Canadian Tire MasterCard and the use of securitization of receivables. The quality of the earnings report is indicative of more intelligent management that really knows its key success factors. We were encouraged by the decision to repurchase shares in late 2012 and early 2013 given their (then) low valuation. We are concerned that the more recent aggressive share buy backs is apparently being done without regard to the share price – but so far, so good. A possible concern is that its overall costs of operations may be too high. They seem to require a relatively higher retail gross margin than some competitors. It seems that management has proven its ability to make profitable acquisitions. Management has also shown an ability to “surface” value with its REIT and more recent finance (credit card) segment transactions. Their success in maintaining margins in the face of the lower dollar and without increasing prices in 2015 and 2016 was remarkable. The July 2016 ousting of the CEO who had been on the job about 18 months to be replaced by the former CEO was a strange move.
Capital Allocation Skills: Canadian Tire has demonstrated excellent skills in capital allocation. Their past  policy of paying out only about 26% of earnings may not be popular with dividend investors but has actually served investors very well. (In 2018 they are paying out 33% of trailing earnings) They have made some large acquisitions (Marks then Forzani) which have worked out very well. The establishment of a  separate REIT while retaining some 83% thereof  appears to have been a positive move in surfacing value. The wisdom of the more recent sale of 20% of the credit card operation remains to be seen. Share buybacks at lower prices in 2013 was wise although we think it should have started much earlier at the low prices of 2011. Share buy backs since 2015 and 2016  seems to have been wise as well.
EXECUTIVE COMPENSATION:  In 2015 compensation ranged from $1.4 million to $4.0 million for the five top officers. Not a concern given the size and profits of this operation.
BOARD OF DIRECTORS: Directors are expected to hold shares. This practice aligns interests with outside shareholders but eliminates the ability to conclude that share purchases by directors are a positive indication regarding expected share price. Three directors are Canadian Tire Dealers. Two directors are from the founding family. Some directors appear to hold none or only small amounts of purchased shares. They do hold modest amounts of deferred share units given to them as compensation. We like the founding family Board members and overall it does appear to be a strong Board.
Basis and Limitations of Analysis: The following applies to all the companies rated. Conclusions are based largely on achieved earnings, balance sheet strength, earnings growth trend and industry attractiveness. We undertake a relatively detailed  analysis of the published financial statements including growth per share trends and our general view of the industry attractiveness and the company’s growth prospects. Despite this diligence our analysis is subject to limitations including the following examples. We have not met with management or discussed the long term earnings growth prospects with management. We have not reviewed all press releases. We typically have no special expertise or knowledge of the industry.
DISCLAIMER: All stock ratings presented are “generic” in nature and do not take into account the unique circumstances and risk tolerance and risk capacity of any individual. The information presented is not a recommendation for any individual to buy or sell any security. The authors are not registered investment advisors and the information presented is not to be considered investment advice to any individual. The reader should consult a registered investment advisor or registered dealer prior to making any investment decision. For ease of writing style the newsletter and articles are often written in the first person. But, legally speaking, all information and opinions are provided by InvestorsFriend Inc. and not by the authors as individuals. The author(s) of this report may have a position, as disclosed in each report. The authors’ positions may subsequently change without notice.
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