Canadian Tire Corporation, Ltd.

    • Spruce Point has significant concerns about Canadian Tire (TSE: CTC or “the Company”), one of the largest retailers in Canada. Canadian Tire is a challenged brick-and-mortar retailer perceived as a dependable mid-single-digit grower on an increasingly precarious foundation of unsustainable debt. CTC is facing a credit downgrade due to its misunderstood and over-levered balance sheet, which has forced it to sell profitable assets in order to continue its capital return plan. Current leverage of ~3.5x is significantly above rating agency guidance of 2x needed to prevent a downgrade and requires debt reduction of ~C$1,600m, but has no free cash flow after promised dividends and buybacks. CTC’s stale brand and dated model, together with broader retail headwinds, have made its financial results dependent on aggressive accounting practices, which are potentially misleading investors by covering up poor organic growth. The market is blissfully ignorant to the Amazon displacement effect that our data shows is accelerating. Recent cost reduction measures and return of capital policies to investors are ill-fated, too little and too late. Outside of retail, CT Financial Services’ is a fast growing, risky business with a deteriorating credit card portfolio. We believe CTC will begin to under-perform optimistic expectations and the combination of these factors should result in a valuation at a significant discount to the market and its peers.
    • An Antiquated And Structurally Non-Competitive Brick And Mortar Retailer With No Clear Focus And No Competitive Advantage
    • CTC’s retail footprint consists of Canadian Tire, Mark’s and FGL Sports banner stores with products ranging from automotive, tools & hardware, home goods and sports & recreation.
    • While SSS (same store sales) have grown modestly, we believe a significant part of the growth is not sustainable due to the declining number of stores and a rapidly saturated market
    • CTC’s has no competitive advantage and often leaves customers “frazzled-looking” due to the vast stores and cluttered aisles. The 4 P’s of marketing suggest that CTC is at a clear disadvantage in the retail market:
    • Product: Diverse assortment with no clear focus, sweet spot is mostly lower quality, mass market products (low ticket items of ~$50). Price: Not price competitive, products are often marked down on “flyer” sales, least competitive shipping fees vs. peers (no free shipping) and offering free shipping will destroy already contracting margins. Place: Brick and mortar business model with stores often located in close proximity, or sometimes in the same shopping center as, competitors including Walmart, Costco, Home Depot and Lowe’s. Major U.S. retailers continue to expand in Canada and gain market share. As Canadian e-commerce continues to grow, and mobile adoption increases, CTC’s business lags peers. Promotion: Promotes through “old-fashion” flyers, credit card promotions and Canadian Tire Money. Weak social media presence.
    • Canadian Tire Gas+ is experiencing margin pressure due to increased competition in the market – we anticipate this to continue due to the ~9% discount Costco Gas offers its customers. Website traffic and mobile app data suggest CTC is struggling relative to its peers. Website visitors are 25x more likely to visit amazon.ca and mobile app users who use Amazon’s app too has increased from 50% to 75% over the last 2 years. Amazon’s Showroom: CTC has one of the lowest conversion rate for customers who made a purchase vs. people who visit its stores. E-commerce lags peers and CTC cannot match the level of investment in technology as its competitors.
    • Don’t Bet On Botched Acquisitions Saving CTC: Helly Hansen, acquired in Q3’19, continues to underperform expectations and we believe is losing market share outside of Canadian Tire banner stores. Yet, we believe management has led analysts to believe the deal is a raging success. We believe the acquisition of Party City Canada will be a larger failure than Helly Hansen – Party City continues to struggle in the U.S. (PRTY shares are down 70% since November 7th, 2019) and we see no reason its Canadian business will not suffer a similar fate.
    • Declining Organic Growth, Compressing Margins and Multiple Signs of Financial Stress. CTC’s underlying retail business is struggling and has experienced gross margin compression – CTC retail reported gross margin figures mask underlying weakness due to the addition of Helly Hansen, a higher margin business. Recent announcement of a $200m cost savings plan is destined to fail; management’s plan was very broad, lacking tangible specifics, and reminds us of numerous failed retail turnarounds all claiming $200m of cost savings as a magic number (Sears, JCPenney, Circuit City). CTC’s Executive leading the efforts has a history of failed turnarounds at BlackBerry and Celestica.
    • There are many signs of financial stress: Rising inventory levels in dealer channels suggests a slowdown in dealers’ ability to sell to end market customers. Receivables growth is significantly outpacing revenue growth over the past 21 months. Worsening cash flow dynamics as days inventory increase and days payable decline year-over-year. Further stress evident as cash conversion cycle is peaking over the last three quarters. Dealer model highly dependent on leverage – guarantees result in increased exposure for CTC.
    • We Believe There Is A High Probability Of A Credit Ratings Downgrade Which Is Forcing The Company To Sell Assets And Reevaluate Capital Allocation – Required Debt Reduction Of ~C$1,600m vs. FCF Of ~C$200m. Multiple rating agencies have warned of a credit downgrade if leverage is not reduced. Our analysis supports the view it will be nearly impossible to delever while maintaining current levels of dividends and share repurchases without selling assets. Current Adjusted Net Debt / Adjusted EBITDAR leverage: 3.45x; BBB rating by DBRS, BBB+ by S&P. A downgrade would result in a rating on the cusp of non-investment grade (junk) status and potentially higher cost of capital.
    • Management has stated its investment grade rating is a top priority but is acting in a different manner: CTC has continued to buyback shares while its leverage remains above the level required to prevent a credit downgrade. Management has shown no ability to create value from share repurchases. CTC is also increasing its dividend by ~9% in a period where it should be conserving cash. Forced to sell assets to delver: recent actions to conserve cash are counterproductive to accreting shareholder value. Divesting stake in CT REIT is dilutive to EPS and shareholder value – sell-side analysts believe this is a positive and shows CTC’s financial flexibility. We believe this shows Canadian Tire needs to raise cash. Recent increases in disposal of investment properties also signals the Company is in need of cash to delever. CTC was unable to fund its acquisition of Helly Hansen and Party City Canada with its current balance sheet and was required to sell down its REIT stake to finance the transactions.
    • Major Push To Grow Credit Card Business, And Fuel Retail Sales Growth, Has Resulted In Risky Lending Practices Which Should Worry Investors And Pose A Significant Threat To Overall Credit Quality. Credit risk is higher than traditional banks given the nature of Canadian Tire’s business – CTC credit card customers are typically higher risk than traditional users. CTC credit cards are used as a mean for financing a purchase, rather than traditional use as a method of payment. CTC Triangle Rewards Program has been an effort to boost retail sales and drive store traffic at the expense of higher risk lending practices. While management has said “we’re not concerned about the level of risk in the portfolio,” filings show 68% of recent loan growth came from moderate and high risk customer classifications. Net charge-offs for “seasoned” loans is at historic highs despite the majority of high risk growth over the past 12 months. This is a leading indicator for an increase in future credit losses as loans begin to mature. Delinquencies have performed worse compared to other banks over the past 2 years, a signal that should worry investors.
    • Multiple Factors Have Resulted In Reported EPS Growth Greater Than CTC’s True Underlying Earnings Growth. When adjusting CTC’s EPS for what we believe to be one-time benefits, the YoY EPS growth rates drop significantly. Recent benefits have helped CTC hit its EPS growth target of 10%+. We believe investors will be caught by surprise when this growth returns to normal levels. Many of the EPS benefits have been a result of management’s aggressive changes to its accounting practices including: altering expected credit losses by modifying model assumptions, changed estimates affecting the present value of loss recoveries and changes to the Company’s depreciation method.
    • Several Signals In CTC’s Corporate Governance Policies And Insiders’ Recent Behavior Should Concern Investors. Canadian Tire and CT REIT are uniquely hiding their credit agreements from investors and keeping their debt structure opaque. Current calculation of executive incentive compensation is not in shareholders’ best interest and is not transparent to investors. CTC’s Chairwomen was a Director and a member of the audit and corporate governance committee for Hollinger leading up to its fraud. Multiple recent insider resignations are a negative signal given the recent business struggles. Diana Chant’s, an Audit Committee member, recent ownership history at the bare minimum required as a Board member raises concerns about her trust in the future of the business – does she know something the public doesn’t?
    • Terrible Risk / Reward Opportunity And Significant Downside To Current Share Price.
    • Spruce Point has a history of successfully exposing poorly positioned Canadian companies before the market realizes fundamentals have changed (eg. Maxar, Just Energy, Dollarama). Canadian brokers incorrectly believe CTC is a best-of-breed retailer that can withstand competitive pressures, grow 4-5%, expand gross margins ~20bps and is worth C$167 per share (~10% upside). Analysts have priced in full credit for CTC’s nebulous cost cutting program.
    • Based on a sum-of-the-parts value, CTC trades at a significant premium to our downside case.
    • Spruce Point believes CTC’s retail segment should be valued on a cash flow basis which is a more accurate representation of fair value due to the segments poor cash flow conversion and distorted “normalized” results. CTC’s declining margins and weak competitive positioning to U.S. retailers and online competitors deserves a valuation multiple at a significant discount to its peers.
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