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Ahold Delhaize: Normalizing Lower (OTCMKTS:ADRNY)

As its latest quarter highlighted, Koninklijke Ahold Delhaize N.V. (OTCQX:ADRNY) (OTCQX:AHODF)(“AD”) remains on solid footing in the current environment, but looking ahead, the guidance indicates a worrying slowdown as COVID-19 tailwinds fade. The recently announced share buyback program should help, but leaves limited incremental optionality around capital returns in the near term. With longer-term headwinds from grocery e-commerce as well, I am concerned about the downside risk. AD currently trades in line with its grocery peers at c. 10x PE, which I think fairly reflects its limited levers for growth.

FQ3 Results In Line Amid Signs of Deceleration

AD reported in line FQ3 results, with sales/EBIT/EPS of €17.8 billion/€813 million/€0.50, backed by ongoing COVID-19-led strength in the US. The higher top line helped offset COVID-19-related costs, which amounted to c. €470 million year-to-date, and c. €140 million in FQ3. Cash flow was also strong at c. €1.9 billion YTD, supporting the €1 billion buyback announcement for fiscal 2021.

Source: Ahold Delhaize Interim Report FQ3 ‘20

However, signs of margin pressure are emerging at the EBIT level – the underlying retail operating margin expansion of +158bps Y/Y in FQ2 slowed to +21bps Y/Y in FQ3, as continued staff bonuses led to elevated COVID-19 costs in FQ3. For the overall group, the underlying operating margin was slightly lower at 4.6%.

FQ3 ’19

FQ4 ’19

FQ1 ’20

FQ2 ’20

FQ3 ’20

Adjusted underlying operating margin (%)

4.3%

4.4%

5.3%

5.3%

4.6%

Adjusted underlying retail operating margin (%)

4.5%

4.6%

5.7%

5.5%

4.8%

Adjusted underlying retail operating margin (Bps evolution)

0

16

+114

+158

+21

Source: Company Data

US Outperformance Beginning to Taper

Within the US, comparable sales growth remained elevated at +12% Y/Y for the quarter, but the relative outperformance has moderated considerably from FQ2 (+17% Y/Y) and FQ1 (+21% Y/Y). Adding to the growth is AD’s increased US online penetration, which contributed €499 million in net sales and c. 3%pts to its comparable sales growth run-rate. Excluding the online contribution, US retail sales growth would have decelerated further in FQ3.

Source: Ahold Delhaize Interim Report FQ3 ‘20

Meanwhile, total US EBIT at €547 million was up Y/Y, benefiting from the shift from out-of-home to in-home consumption. Profitability was also helped by group-wide COVID-19 costs falling to €140 million (significantly below FQ2’s €260 million costs), with guidance for a similar cost profile across FQ4. However, increased investments needed to build out e-commerce capabilities, for instance, in the supply chain, should continue to weigh on margins in the near term – in FQ3, underlying operating margins decelerated to +66bps Y/Y (down from +256bps Y/Y in FQ2).

FQ3 ’19

FQ4 ’19

FQ1 ’20

FQ2 ’20

FQ3 ’20

AD US Underlying operating margin (%)

4.4%

4.3%

6.7%

6.1%

5.0%

Bps evolution

-10

-43

+174

+256

+66

Source: Company Data

Signs of Contraction in Europe

Like the US, AD also saw its (ex-fuel) comparable sales growth decelerating from +10.2% in FQ2 to +7.5% in FQ3, with operating income down 3.2% Y/Y to €300 million. While there was some operating leverage on the back of COVID-19, this was more than offset by higher costs related to COVID-19, along with €11 million of pension expense in the Netherlands during the quarter.

Source: Ahold Delhaize Interim Report FQ3 ‘20

Disappointingly, there was limited disclosure around BOL.com, which saw net consumer sales up 45.6% Y/Y. While BOL.com continues to gain traction amid weakness in the core European retail business, it remains a relatively small top-line contributor, although separately breaking out the online operations might help shine some light on the underlying value.

FQ4 Guidance Points to Normalization Ahead

Looking ahead, AD has raised its fiscal 2020 underlying EPS growth outlook in the high-20% range, which drives free cash flow of over €1.7 billion (net of pension payments and €2.5 billion of capital expenditures). The updated guide is a raise relative to the prior quarter when the company had guided for underlying EPS growth in the low-to-mid-20% range.

Source: Ahold Delhaize Presentation Slides FQ3 ‘20

More worryingly, however, was management commentary on the call, highlighting a range of pending headwinds ahead. These include a normalization in sales trends, continued COVID-19 costs, and lower operating leverage in the US going forward. Considering the new lockdown restrictions, the call for further moderation in FQ4 sales growth was a negative surprise. Coupled with the weaker margin trends in Europe, this implies a more muted near-term margin outlook for the overall business. Beyond that, several other profitability headwinds remain – US supply chain investments, an online rollout, along with Dutch pension charges. While AD provided little insight into fiscal 2021, the planned €1 billion buyback is reassuring.

Grocery E-Commerce Disruption Remains a Longer-Term Concern

As a large grocery chain, AD is exposed to disruptive shifts away from a physical presence to groceries/ready-made meals delivered to the home. While AD is rolling out its online capabilities, the shift does require considerable investments, and therefore, is not supportive of its valuations. At present, AD plans to increase its online capacity by nearly 100% in the US (mainly Click & Collect) and nearly 50% in Europe (mainly bol.com), both of which will weigh on margins in the medium term.

Source: Ahold Delhaize Presentation Slides FQ3 ‘20

Final Take

Following the YTD run, I believe much of AD’s positive earnings momentum has already been priced into market expectations. As such, I see limited scope for upward earnings revisions in fiscal 2021. My base case is for FCF generation to weaken beyond fiscal 2020 when the COVID-19 tailwinds normalize and as e-commerce gains share in the medium term. Shares are currently trading at c. 10x PE – in line with its closest US peer Kroger (KR), and fairly reflecting its limited levers for growth.

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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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