Shoppers Drug Mart Corporation announces second quarter results - continued
growth in sales and net earnings
TORONTO, July 22 /CNW/ - Shoppers Drug Mart Corporation (TSX: SC) today announced its financial results for the second quarter ended June 19, 2010.
Second Quarter Results (12 Weeks)
Second quarter sales increased 5.0% to $2.403 billion, with the Company continuing to experience sales growth in all regions of the country. On a same- store basis, sales increased 2.7% during the quarter.
Prescription sales increased 5.1% in the second quarter to $1.166 billion and accounted for 48.5% of the Company's sales mix. On a same-store basis, prescription sales increased 3.5%. Consistent with trends in recent years, prescription sales growth was driven primarily by strong growth in the number of prescriptions filled, while increased generic utilization continued to have a deflationary impact on sales growth in the category. In the second quarter of 2010, generic molecules represented 54.4% of prescriptions dispensed compared to 52.7% of prescriptions dispensed in the second quarter of 2009.
Front store sales increased 4.8% in the second quarter to $1.237 billion, with the Company continuing to experience sales gains in its core categories. On a same-store basis, front store sales increased 2.0%.
Second quarter net earnings increased 6.2% to $145 million or 66 cents per share (diluted) from $136 million or 63 cents per share (diluted) a year ago. This result was achieved prior to the impact of any proposed and/or announced provincial drug system reform initiatives, some of which came into effect on July 1, 2010. This result was driven by top line growth, improved purchasing synergies and further gains in productivity and efficiency, the benefits of which were partially offset by increased amortization and higher operating expenses at store-level associated with the Company's network growth and expansion initiatives, and continued investments in pricing and promotional activities so as to drive sales growth in the front of the store. Net earnings growth was also aided by lower interest expense and by a reduction in the Company's effective income tax rate.
Commenting on the results, Jürgen Schreiber, President and CEO stated, "We are pleased with our second quarter and year-to-date results, particularly in light of these challenging times for consumers and for the business of community pharmacy. Looking forward, I am confident that the strength of our business model, combined with the dedication and commitment of our employees and our Associate-owners and their teams at store-level, have us capably- equipped to execute upon our strategic priorities and initiatives and enhance our reputation as a service leader in community pharmacy as we adjust to the pricing and reimbursement pressures facing all participants in our industry. In spite of these challenges, I believe that we are well-positioned to gain share, grow the business and remain the cost-effective leader in patient care and customer service."
First Half Results (24 weeks)
First half sales increased 5.3% to $4.724 billion, with prescription sales up 5.7% and front store sales up 5.0%. On a same-store basis, first half sales increased 2.9%, with prescription sales up 3.8% and front store sales up 2.1%. During the first half of 2010, prescription sales accounted for 49.1% of the Company's sales mix compared to 49.0% in the same period last year.
First half net earnings increased 7.1% to $260 million or $1.20 per share (diluted) from $243 million or $1.12 per share (diluted) a year ago.
Store Network Development
During the second quarter, 21 drug stores were opened, 13 of which were relocations, and three smaller drug stores were closed. The Company also added one Murale luxury beauty store to its network during the quarter. At quarter- end, there were 1,309 stores in the system, comprised of 1,239 drug stores (1,180 Shoppers Drug Mart/Pharmaprix stores and 59 Shoppers Simply Pharmacy/Pharmaprix Simplement Santé stores), 63 Shoppers Home Health Care stores and seven Murale stores. Retail selling space was approximately 12.5 million square feet at the end of the second quarter, an increase of 8.6% compared to a year ago.
Dividend
The Company also announced today that its Board of Directors has declared a dividend of 22.5 cents per common share, payable October 15, 2010 to shareholders of record as of the close of business on September 30, 2010.
Update on Fiscal 2010 Outlook
After considering recently enacted regulations in the Province of Ontario to amend Regulation 935 under the Drug Interchangeability and Dispensing Fee Act and Regulation 201/96 under the Ontario Drug Benefit Act, along with proposed and/or announced drug system reform initiatives in other jurisdictions of Canada, principally British Columbia and Québec, and after giving further consideration to year-to-date results and its outlook for the balance of the year, it is the Company's expectation that total sales will increase by between 4.0% and 5.0% in fiscal 2010. This expectation is underpinned by anticipated same-store sales growth of between 1.0% and 2.0% in pharmacy and 2.0% to 3.0% in the front of the store. It is expected that prescription sales growth will continue to be driven by strong growth in prescription counts, with volume growth being largely offset by a decline in average values as a result of increasing generic prescription utilization rates, combined with reductions in generic prescription drug pricing in certain jurisdictions. Based on these assumptions, and assuming the successful implementation of a number of mitigating tactics and ongoing initiatives to reduce costs, enhance operating efficiencies and adjust its business and service model, the Company expects fiscal 2010 EBITDA (earnings before interest, taxes, depreciation and amortization) to be within the range of $1.170 billion to $1.190 billion. The Company now expects that the size of its fiscal 2010 capital expenditure program will be approximately $430 million and that the selling space of its retail store network will increase by approximately 7% during the year, which will drive a year-over-year increase in amortization expense of approximately 15%. At an assumed tax rate of 30%, the Company's resultant estimate of its fiscal 2010 earnings per share (diluted) is between $2.66 and $2.72.
It is also the Company's expectation that its fiscal 2010 cash flows from operating activities will be more than sufficient to fund its capital program and dividend payments. Remaining free cash flow will be directed largely towards the repayment of bank indebtedness and/or commercial paper, thereby reducing net debt and further strengthening the Company's balance sheet, credit metrics and financial position.
For a more fulsome discussion of the regulatory changes and proposed and/or announced drug system reform initiatives referenced above, please refer to the discussion on "Industry and Regulatory Developments" under "Risks and Risk Management" in the attached Management's Discussion and Analysis which forms an integral part of this news release.
Other Information
The Company will hold an analyst call at 3:00 p.m. (Eastern Daylight Time) today to discuss its second quarter results. The call may be accessed by dialing 416-340-8530 from within the Toronto area, or 1-866-240-9772 outside of Toronto. The call will also be simulcast on the Company's website for all interested parties. The webcast can be accessed via the Investor Relations section of the Shoppers Drug Mart website at www.shoppersdrugmart.ca. The conference call will be archived in the Investor Relations section of the Shoppers Drug Mart website until the Company's next analyst call. A playback of the call will also be available by telephone until 11:59 p.m. (Eastern Daylight Time) on August 5, 2010. The call playback can be accessed after 5:00 p.m. (Eastern Daylight Time) on Thursday, July 22, 2010 by dialing 416-695- 5800 from within the Toronto area, or 1-800-408-3053 outside of Toronto. The seven-digit passcode number is 5087440.
About Shoppers Drug Mart Corporation
Shoppers Drug Mart Corporation is one of the most recognized and trusted names in Canadian retailing. The Company is the licensor of full-service retail drug stores operating under the name Shoppers Drug Mart (Pharmaprix in Québec). With more than 1,180 Shoppers Drug Mart and Pharmaprix stores operating in prime locations in each province and two territories, the Company is one of the most convenient retailers in Canada. The Company also licenses or owns more than 59 medical clinic pharmacies operating under the name Shoppers Simply Pharmacy (Pharmaprix Simplement Santé in Québec) and eight luxury beauty destinations operating as Murale. As well, the Company also owns and operates 63 Shoppers Home Health Care stores, making it the largest Canadian retailer of home health care products and services. In addition to its retail store network, the Company owns Shoppers Drug Mart Specialty Health Network Inc., a provider of specialty drug distribution, pharmacy and comprehensive patient support services, and MediSystem Technologies Inc., a provider of pharmaceutical products and services to long-term care facilities in Ontario and Alberta.
For more information, visit www.shoppersdrugmart.ca.
Forward-looking Information and Statements
This news release, including the Management's Discussion and Analysis, (collectively, the "News Release"), contains forward-looking information and statements which constitute "forward-looking information" under Canadian securities law and which may be material, regarding, among other things, the Company's beliefs, plans, objectives, estimates, intentions and expectations. Forward-looking information and statements are typically identified by words such as "anticipate", "believe", "expect", "estimate", "forecast", "goal", "intend", "plan", "will", "may", "should", "could" and similar expressions. Specific forward-looking information in this News Release includes, but is not limited to, statements with respect to the Company's future operating and financial results, its capital expenditure plans, the ability to execute on its future operating, investing and financing strategies and the impact on the Company's financial results of the recently enacted regulations in the Province of Ontario to amend the Ontario drug system, along with proposed and/or announced drug system reform initiatives in other jurisdictions of Canada, principally British Columbia and Québec.
The forward-looking information and statements contained herein are based on certain factors and assumptions, certain of which appear proximate to the applicable forward-looking information and statements contained herein. Inherent in the forward-looking information and statements are known and unknown risks, uncertainties and other factors beyond the Company's ability to control or predict, which give rise to the possibility that the Company's predictions, forecasts, expectations or conclusions will not prove to be accurate, that its assumptions may not be correct and that the Company's plans, objectives and statements will not be achieved. Actual results or developments may differ materially from those contemplated by the forward- looking information and statements.
The material risk factors that could cause actual results to differ materially from the forward-looking information and statements contained herein include, without limitation: the risk of adverse changes to laws and regulations relating to prescription drugs and their sale, including pharmacy reimbursement programs and the availability of manufacturer allowances, or changes to such laws and regulations that increase compliance costs; the risk that the Company will be unable to implement successful strategies to manage the impact of the recently enacted regulations in the Province of Ontario to amend the Ontario drug system, along with the impact of the proposed and/or announced drug system reform initiatives in other jurisdictions of Canada, principally British Columbia and Québec; the risk of adverse changes in economic and financial conditions in Canada and globally; the risk of increased competition from other retailers; the risk of an inability of the Company to manage growth and maintain its profitability; the risk of exposure to fluctuations in interest rates; the risk of material adverse changes in foreign currency exchange rates; the risk of an inability to attract and retain pharmacists and key employees; the risk of an inability of the Company's information technology systems to support the requirements of the Company's business; the risk of changes to estimated contributions of the Company in respect of its pension plans or post- employment benefit plans which may adversely impact the Company's financial performance; the risk of changes to the relationships of the Company with third-party service providers; the risk that the Company will not be able to lease or obtain suitable store locations on economically favourable terms; the risk of adverse changes to the Company's results of operations due to seasonal fluctuations; risks associated with alternative arrangements for sourcing generic drug products, including intellectual property and product liability risks; the risk that new, or changes to current, federal and provincial laws, rules and regulations, including environmental and privacy laws, rules and regulations, may adversely impact the Company's business and operations; the risk that violations of law, breaches of Company policies or unethical behaviour may adversely impact the Company's financial performance; property and casualty risks; the risk of injuries at the workplace or health issues; the risk that changes in tax law, or changes in the way that tax law is expected to be interpreted, may adversely impact the Company's business and operations; the risk that new, or changes to existing, accounting pronouncements may adversely impact the Company; the risks associated with the performance of the Associate- owned store network; and the risk of damage to the reputation of brands promoted by the Company, or to the reputation of any supplier or manufacturer of these brands.
This is not an exhaustive list of the factors that may affect any of the Company's forward-looking information and statements. Investors and others should carefully consider these and other risk factors and not place undue reliance on the forward-looking information and statements. Further information regarding these and other risk factors is included in the Company's public filings with provincial securities regulatory authorities including, without limitation, the sections entitled "Risks and Risk Management" and "Risks Associated with Financial Instruments" in the Company's Management's Discussion and Analysis for the 52 week period ended January 2, 2010. The forward-looking information and statements contained in this News Release represent the Company's views only as of the date of this News Release. Forward-looking information and statements contained in this News Release about prospective results of operations, financial position or cash flows that are based upon assumptions about future economic conditions and courses of action are presented for the purpose of assisting the Company's shareholders in understanding management's current views regarding those future outcomes and may not be appropriate for other purposes. While the Company anticipates that subsequent events and developments may cause the Company's views to change, the Company does not undertake to update any forward-looking information and statements, except to the extent required by applicable securities laws.
Additional information about the Company, including the Annual Information Form, can be found at www.sedar.com.
SHOPPERS DRUG MART CORPORATION MANAGEMENT'S DISCUSSION AND ANALYSIS As at July 16, 2010
The following is a discussion of the consolidated financial condition and results of operations of Shoppers Drug Mart Corporation (the "Company") for the periods indicated and of certain factors that the Company believes may affect its prospective financial condition, cash flows and results of operations. This discussion and analysis should be read in conjunction with the unaudited consolidated financial statements of the Company and the notes thereto for the 12 and 24 week periods ended June 19, 2010. The Company's unaudited interim period financial statements and the notes thereto have been prepared in accordance with Canadian generally accepted accounting principles ("GAAP") and are reported in Canadian dollars. These financial statements do not contain all disclosures required by Canadian GAAP for annual financial statements and, accordingly, should be read in conjunction with the most recently prepared annual consolidated financial statements for the 52 week period ended January 2, 2010.
FORWARD-LOOKING INFORMATION AND STATEMENTS
This discussion of the consolidated financial condition and results of operations of the Company contains forward-looking information and statements which constitute "forward-looking information" under Canadian securities law and which may be material regarding, among other things, the Company's beliefs, plans, objectives, estimates, intentions and expectations. Forward- looking information and statements are typically identified by words such as "anticipate", "believe", "expect", "estimate", "forecast", "goal", "intend", "plan", "will", "may", "should", "could" and similar expressions. Specific forward-looking information in this document includes, but is not limited to, statements with respect to the Company's future operating and financial results, its capital expenditure plans, the ability to execute on its future operating, investing and financing strategies and the impact on the Company's financial results of the recently enacted regulations in the Province of Ontario to amend the Ontario drug system, along with proposed and/or announced drug system reform initiatives in other jurisdictions of Canada, principally British Columbia and Québec.
The forward-looking information and statements contained herein are based on certain factors and assumptions, certain of which appear proximate to the applicable forward-looking information and statements contained herein. Inherent in the forward-looking information and statements are known and unknown risks, uncertainties and other factors beyond the Company's ability to control or predict, which give rise to the possibility that the Company's predictions, forecasts, expectations or conclusions will not prove to be accurate, that its assumptions may not be correct and that the Company's plans, objectives and statements will not be achieved. Actual results or developments may differ materially from those contemplated by the forward- looking information and statements.
The material risk factors that could cause actual results to differ materially from the forward-looking information and statements contained herein include, without limitation: the risk of adverse changes to laws and regulations relating to prescription drugs and their sale, including pharmacy reimbursement programs and the availability of manufacturer allowances, or changes to such laws and regulations that increase compliance costs; the risk that the Company will be unable to implement successful strategies to manage the impact of the recently enacted regulations in the Province of Ontario to amend the Ontario drug system, along with the impact of the proposed and/or announced drug system reform initiatives in other jurisdictions of Canada, principally British Columbia and Québec; the risk of adverse changes in economic and financial conditions in Canada and globally; the risk of increased competition from other retailers; the risk of an inability of the Company to manage growth and maintain its profitability; the risk of exposure to fluctuations in interest rates; the risk of material adverse changes in foreign currency exchange rates; the risk of an inability to attract and retain pharmacists and key employees; the risk of an inability of the Company's information technology systems to support the requirements of the Company's business; the risk of changes to estimated contributions of the Company in respect of its pension plans or post-employment benefit plans which may adversely impact the Company's financial performance; the risk of changes to the relationships of the Company with third-party service providers; the risk that the Company will not be able to lease or obtain suitable store locations on economically favourable terms; the risk of adverse changes to the Company's results of operations due to seasonal fluctuations; risks associated with alternative arrangements for sourcing generic drug products, including intellectual property and product liability risks; the risk that new, or changes to current, federal and provincial laws, rules and regulations, including environmental and privacy laws, rules and regulations, may adversely impact the Company's business and operations; the risk that violations of law, breaches of Company policies or unethical behaviour may adversely impact the Company's financial performance; property and casualty risks; the risk of injuries at the workplace or health issues; the risk that changes in tax law, or changes in the way that tax law is expected to be interpreted, may adversely impact the Company's business and operations; the risk that new, or changes to existing, accounting pronouncements may adversely impact the Company; the risks associated with the performance of the Associate-owned store network; and the risk of damage to the reputation of brands promoted by the Company, or to the reputation of any supplier or manufacturer of these brands.
This is not an exhaustive list of the factors that may affect any of the Company's forward-looking information and statements. Investors and others should carefully consider these and other factors and not place undue reliance on the forward-looking information and statements. Further information regarding these and other risk factors is included in the Company's public filings with provincial securities regulatory authorities including, without limitation, the sections entitled "Risks and Risk Management" and "Risks Associated with Financial Instruments" in the Company's Management's Discussion and Analysis for the 52 week period ended January 2, 2010. The forward-looking information and statements contained in this discussion of the consolidated financial condition and results of operations of the Company represent the Company's views only as of the date hereof. Forward-looking information and statements contained in this Management's Discussion and Analysis about prospective results of operations, financial position or cash flows that are based upon assumptions about future economic conditions and courses of action are presented for the purpose of assisting the Company's shareholders in understanding management's current views regarding those future outcomes and may not be appropriate for other purposes. While the Company anticipates that subsequent events and developments may cause the Company's views to change, the Company does not undertake to update any forward-looking information and statements, except to the extent required by applicable securities laws.
Additional information about the Company, including the Annual Information Form, can be found at www.sedar.com.
OVERVIEW
The Company is the licensor of full-service retail drug stores operating under the name Shoppers Drug Mart(R) (Pharmaprix(R) in Québec). As at June 19, 2010, there were 1,180 Shoppers Drug Mart/Pharmaprix retail drug stores owned and operated by the Company's licensees ("Associates"). An Associate is a pharmacist-owner of a corporation that is licensed to operate a retail drug store at a specific location using the Company's trademarks. The Company's licensed stores are located in prime locations in each province and two territories, making Shoppers Drug Mart/Pharmaprix stores among the most convenient retail outlets in Canada. The Company also licenses or owns 59 medical clinic pharmacies operating under the name Shoppers Simply Pharmacy(R) (Pharmaprix Simplement Santé(R) in Québec) and seven luxury beauty destinations operating as Murale(TM).
The Company has successfully leveraged its leadership position in pharmacy and its convenient store locations to capture a significant share of the market in front store merchandise. Front store merchandise categories include over-the-counter medications health and beauty aids, cosmetics and fragrances (including prestige brands), everyday household needs and seasonal products. The Company also offers a broad range of high-quality private label products marketed under the trademarks Life Brand(R), Quo(R), Balea(R), Everyday Market(R), Bio-Life(R), Nativa(R) and Easypix(R), among others, and value-added services such as the HealthWATCH(R) program, which offers patient counselling and advice on medications, disease management and health and wellness, and the Shoppers Optimum(R) program, one of the largest retail loyalty card programs in Canada. In fiscal 2009, the Company recorded consolidated sales of approximately $10.0 billion.
Under the licensing arrangements with Associates, the Company provides the capital and financial support to enable Associates to operate Shoppers Drug Mart(R), Pharmaprix(R), Shoppers Simply Pharmacy(R) and Pharmaprix Simplement Santé(R) stores without any initial investment. The Company also provides a package of services to facilitate the growth and profitability of each Associate's business. These services include the use of trademarks, operational support, marketing and advertising, purchasing and distribution, information technology and accounting. In return for being provided these and other services, Associates pay fees to the Company. Fixtures, leasehold improvements and equipment are purchased by the Company and leased to Associates over periods ranging from two to 15 years, with title retained by the Company. The Company also provides its Associates with assistance in meeting their working capital and long-term financing requirements through the provision of loans and loan guarantees.
Under the licensing arrangements, the Company receives a substantial share of Associate store profits. The Company's share of Associate store profits is reflective of its investment in, and commitment to, the operations of the Associates' stores.
The Company operates in Québec primarily under the Pharmaprix(R) and Pharmaprix Simplement Santé(R) trade names. Under Québec law, profits generated from the prescription area or dispensary may only be earned by a pharmacist or a corporation controlled by a pharmacist. As a result of these restrictions, the licence agreement used for Québec Associates differs from the Associate agreement used in other provinces. Pharmaprix(R) and Pharmaprix Simplement Santé(R) stores and their Associates benefit from the same infrastructure and support provided to all other Shoppers Drug Mart(R) and Shoppers Simply Pharmacy(R) stores and Associates.
The Company has determined that the individual Associate-owned stores that comprise its store network are deemed to be variable interest entities and that the Company is the primary beneficiary in accordance with the Canadian Institute of Chartered Accountants Accounting Guideline 15, "Consolidation of Variable Interest Entities" ("AcG-15"). As such, the Associate-owned stores are subject to consolidation by the Company. However, as the Associate-owned stores remain separate legal entities from the Company, consolidation of these stores has no impact on the underlying risks facing the Company. (See note 1 to the accompanying unaudited consolidated financial statements of the Company.)
The Company also owns and operates 63 Shoppers Home Health Care(R) stores. These retail stores are engaged in the sale and service of assisted- living devices, medical equipment, home-care products and durable mobility equipment to institutional and retail customers.
In addition to its retail store network, the Company owns Shoppers Drug Mart Specialty Health Network Inc., a provider of specialty drug distribution, pharmacy and comprehensive patient support services, and MediSystem Technologies Inc., a provider of pharmaceutical products and services to long- term care facilities in Ontario and Alberta.
OVERALL FINANCIAL PERFORMANCE
Key Operating, Investing and Financial Metrics
The following provides an overview of the Company's operating performance for the 12 and 24 week periods ended June 19, 2010 compared to the 12 and 24 week periods ended June 20, 2009, as well as certain other metrics with respect to investing activities for the 12 and 24 week periods ended June 19, 2010 and financial position as at that same date.
- Second quarter sales of $2.403 billion, an increase of 5.0%. - First half sales of $4.724 billion, an increase of 5.3%. - Second quarter comparable store total sales growth of 2.7%, comprised of comparable prescription sales growth of 3.5% and comparable front store sales growth of 2.0%. - First half comparable store total sales growth of 2.9%, comprised of comparable prescription sales growth of 3.8% and comparable front store sales growth of 2.1%. - Second quarter EBITDA(1) of $286 million, an increase of 7.6%. - First half EBITDA of $528 million, an increase of 7.8%. - Second quarter EBITDA margin(2) of 11.89%, an increase of 28 basis points. - First half EBITDA margin of 11.17%, an increase of 25 basis points. - Second quarter net earnings of $145 million or $0.66 per share (diluted), an increase of 6.2%. - First half net earnings of $260 million or $1.20 per share (diluted), an increase of 7.1%. - Second quarter capital expenditure program of $111 million compared to $129 million in the prior year. Opened or acquired 21 new drug stores, 13 of which were relocations, and added one Murale(TM) luxury beauty store. - First half capital expenditure program of $210 million compared to $240 million in the prior year. Opened or acquired 48 new drug stores, 24 of which were relocations, and added one Murale(TM) luxury beauty store. - Year-over-year increase in retail selling square footage of 8.6%. - Maintained desired capital structure and financial position. - Net debt to equity ratio of 0.33:1 at June 19, 2010 compared to 0.40:1 a year ago. - Net debt to total capitalization ratio of 0.25:1 at June 19, 2010 compared to 0.29:1 a year ago. (1) Earnings before interest, taxes, depreciation and amortization. (See reconciliation to the most directly comparable GAAP measure under "Results of Operations" in this Management's Discussion and Analysis.) (2) EBITDA divided by sales.
Results of Operations
The following table presents a summary of certain selected consolidated financial information for the Company for the periods indicated.
12 Weeks Ended 24 Weeks Ended ------------------------- ------------------------- ($000s, except June 19, June 20, June 19, June 20, per share data) 2010 2009 2010 2009 ------------------------------------------------------------------------- (unaudited) (unaudited) (unaudited) (unaudited) Sales $ 2,402,539 $ 2,288,789 $ 4,723,638 $ 4,484,049 Cost of goods sold and other operating expenses 2,116,757 2,023,150 4,196,084 3,994,572 ------------------------- ------------------------- EBITDA(1) 285,782 265,639 527,554 489,477 Amortization 67,016 56,279 131,308 111,882 ------------------------- ------------------------- Operating income 218,766 209,360 396,246 377,595 Interest expense 12,965 13,881 25,843 28,387 ------------------------- ------------------------- Earnings before income taxes 205,801 195,479 370,403 349,208 Income taxes 61,225 59,367 110,194 106,254 ------------------------- ------------------------- Net earnings $ 144,576 $ 136,112 $ 260,209 $ 242,954 ------------------------- ------------------------- ------------------------- ------------------------- Per common share - Basic net earnings $ 0.66 $ 0.63 $ 1.20 $ 1.12 - Diluted net earnings $ 0.66 $ 0.63 $ 1.20 $ 1.12 (1) Earnings before interest, taxes, depreciation and amortization.
Sales
Sales represent the combination of sales of the retail drug stores owned by the Associates, sales at Murale(TM) and sales of the home health care business, Shoppers Drug Mart Specialty Health Network Inc. and MediSystem Technologies Inc.
Sales in the second quarter were $2.403 billion compared to $2.289 billion in the same period last year, an increase of $114 million or 5.0%, with the Company continuing to experience sales growth in all regions of the country, led by gains in Québec and Western Canada. The Company's store development program, which resulted in an 8.6% increase in retail selling space compared to a year ago, had a positive impact on sales growth. Effective marketing campaigns, combined with continued investments in pricing and promotions utilizing the Shoppers Optimum(R) loyalty card program, also contributed to top-line growth. On a same-store basis, sales increased 2.7% during the second quarter of 2010. Year-to-date, sales increased 5.3% to $4.724 billion. On a same-store basis, sales increased 2.9% during the first half of 2010.
Prescription sales were $1.166 billion in the second quarter compared to $1.109 billion in the second quarter of 2009, an increase of $57 million or 5.1%. During the second quarter of 2010, prescription sales accounted for 48.5% of the Company's sales mix, unchanged from the second quarter of a year ago. On a same-store basis, prescription sales increased 3.5% during the second quarter of 2010, driven primarily by strong growth in the number of prescriptions filled, while increased generic utilization continued to have a deflationary impact on sales growth in the category. In the second quarter of 2010, generic molecules represented 54.4% of prescriptions dispensed compared to 52.7% of prescriptions dispensed in the second quarter of 2009. Year-to- date, prescription sales increased 5.7% to $2.321 billion and accounted for 49.1% of the Company's sales mix compared to 49.0% in the same period last year. On a same-store basis, prescription sales increased 3.8% during the first half of 2010.
Front store sales were $1.237 billion in the second quarter compared to $1.180 billion in the second quarter of 2009, an increase of $57 million or 4.8%, with the Company continuing to experience sales gains in its core categories, led by strong growth in beauty and food and confection. On a same- store basis, front store sales increased 2.0% during the second quarter of 2010. Year-to-date, front store sales increased 5.0% to $2.403 billion. On a same-store basis, front store sales increased 2.1% during the first half of 2010.
Cost of Goods Sold and Other Operating Expenses
Cost of goods sold is comprised of the cost of goods sold at the retail drug stores owned by the Associates, the cost of goods sold at Murale(TM) and the cost of goods sold at the home health care business, Shoppers Drug Mart Specialty Health Network Inc. and MediSystem Technologies Inc. Other operating expenses include corporate selling, general and administrative expenses, operating expenses at the retail drug stores owned by the Associates, including Associates' earnings, operating expenses at Murale(TM) and operating expenses at the home health care business, Shoppers Drug Mart Specialty Health Network Inc. and MediSystem Technologies Inc.
Total cost of goods sold and other operating expenses were $2.117 billion in the second quarter compared to $2.023 billion in the same period last year, an increase of $94 million or 4.6%. Expressed as a percentage of sales, cost of goods sold declined by 80 basis points in the second quarter of 2010 versus the comparative prior year period, reflecting the benefits of improved purchasing synergies, offset somewhat by continued investments in promotional pricing and Shoppers Optimum(R) events in order to drive sales growth in the front of the store. Other operating expenses, expressed as a percentage of sales, increased by 52 basis points in the second quarter of 2010 versus the comparative prior year period. Other operating expenses were higher due in large part to increased store-level expenses, primarily occupancy, wages and benefits associated with the growth of the store network, partially offset by front-store productivity and efficiency gains resulting from the successful rollout and implementation of the Company's Project Infinity initiatives in the prior year.
Year-to-date, total cost of goods sold and other operating expenses increased by 5.0% to $4.196 billion. Expressed as a percentage of sales, cost of goods sold declined by 86 basis points in the first half of 2010 versus the comparative prior year period, while other operating expenses increased by 61 basis points.
Amortization
Amortization of capital assets and other intangible assets was $67 million in the second quarter compared to $56 million in the same period last year, an increase of $11 million or 19.1%. Expressed as a percentage of sales, amortization increased 33 basis points in the second quarter of 2010 versus the comparative prior year period, an increase which can be attributed to the Company's store development program and related infrastructure investments.
Year-to-date, amortization of capital assets and other intangible assets increased 17.4% to $131 million. Expressed as a percentage of sales, amortization increased 28 basis points in the first half of 2010 versus the comparative prior year period.
Operating Income
Operating income was $219 million in the second quarter of 2010 compared to $209 million in the same period last year, an increase of $10 million or 4.5%. This result was achieved prior to the impact of any proposed and/or announced provincial drug system reform initiatives, some of which came into effect on July 1, 2010. As described above, this increase was driven by top- line growth, improved purchasing synergies and further gains in productivity and efficiency, the benefits of which were partially offset by increased amortization and higher operating expenses at store-level associated with the Company's network growth and expansion initiatives, and continued investments in pricing and promotional activities so as to drive sales growth in the front of the store. In 2010, second quarter operating margin (operating income divided by sales) declined by 4 basis points to 9.11% compared to 9.15% in the second quarter of last year. The Company's EBITDA margin (EBITDA divided by sales) was 11.89% in the second quarter of 2010, a 28 basis point improvement over the EBITDA margin of 11.61% posted in the second quarter of last year.
Year-to-date, operating income increased 4.9% to $396 million and operating margin declined by 3 basis points to 8.39%. During the first half of 2010, EBITDA margin was 11.17%, a 25 basis point improvement over the EBITDA margin of 10.92% posted during the first half of 2009.
Interest Expense
Interest expense is comprised of interest expense arising from borrowings at the Associate-owned stores and from debt obligations of the Company.
Interest expense was $13 million in the second quarter of 2010 compared to $14 million in the same period last year, a decrease of $1 million or 6.6%. This decease can be primarily attributed to lower average consolidated net debt outstanding, partially offset by a market-driven increase in short-term interest rates on the Company's remaining floating rate debt obligations. Year- to-date, interest expense decreased 9.0% to $26 million. (See note 5 to the accompanying unaudited consolidated financial statements of the Company.)
Income Taxes
The Company's effective income tax rate in the second quarter and first half of 2010 was 29.7% compared to 30.4% in the same periods last year. This decrease in the effective income tax rate can be attributed to a reduction in statutory rates.
Net Earnings
Second quarter net earnings were $145 million compared to $136 million in the same period last year, an increase of $9 million or 6.2%. On a diluted basis, earnings per share were $0.66 in the second quarter of 2010 compared to $0.63 in the same period last year.
Year-to-date, net earnings increased 7.1% to $260 million. On a diluted basis, earnings per share were $1.20 in the first half of 2010 compared to $1.12 in the same period last year.
Capitalization and Financial Position
The following table provides a summary of certain information with respect to the Company's capitalization and consolidated financial position at the end of the periods indicated.
June 19, January 2, ($000s) 2010 2010 ------------------------------------------------------------------------- Cash $ (62,670) $ (44,391) Bank indebtedness 256,497 270,332 Commercial paper 183,590 260,386 Long-term debt 945,651 946,098 --------------------------- Net debt 1,323,068 1,432,425 Shareholders' equity 3,987,621 3,826,110 --------------------------- Total capitalization $ 5,310,689 $ 5,258,535 --------------------------- --------------------------- Net debt:Shareholders' equity 0.33:1 0.37:1 Net debt:Total capitalization 0.25:1 0.27:1 Net debt:EBITDA(1) 1.12:1 1.25:1 EBITDA:Cash interest expense(1)(2) 20.86:1 19.59:1 (1) For purposes of calculating the ratios, EBITDA is comprised of EBITDA for each of the 52 week periods then ended. (2) Cash interest expense is comprised of interest expense for each of the 52 week periods then ended and excludes the amortization of deferred financing costs, but includes capitalized interest.
Financial Ratios and Credit Ratings
The following table provides a summary of the Company's credit ratings at June 19, 2010.
Standard & Poor's DBRS Limited --------------------------------- Corporate credit rating BBB+ - Senior unsecured debt BBB+ A (low) Commercial paper - R-1 (low)
On April 8, 2010, DBRS Limited placed the short and long-term ratings of the Company under review with negative implications. The rating action was in response to the Ontario Ministry of Health and Long-Term Care's April 7, 2010 announcement with respect to further drug reform in the province. (See discussion on "Ontario Drug Reform" under "Industry and Regulatory Developments" under "Risks and Risk Management" in this Management's Discussion and Analysis.)
Outstanding Share Capital
The Company's outstanding share capital is comprised of common shares. An unlimited number of common shares is authorized and the Company had 217,434,148 common shares outstanding at July 16, 2010. As at this same date, the Company had issued options to acquire 1,167,412 of its common shares pursuant to its stock-based compensation plans, of which 745,292 were exercisable.
Liquidity and Capital Resources
Sources of Liquidity
The Company has the following sources of liquidity: (i) cash provided by operating activities; (ii) cash available from a committed $800 million revolving bank credit facility maturing June 6, 2011, less what is currently drawn and/or being utilized to support commercial paper issued and outstanding; and (iii) up to $500 million in availability under its commercial paper program, less what is currently issued. The Company's commercial paper program is rated R-1 (low) by DBRS Limited. In the event that the Company's commercial paper program is unable to maintain this rating, the program is supported by the Company's $800 million revolving bank credit facility. At June 19, 2010, $9 million of the Company's $800 million revolving bank credit facility was utilized, all of which was in respect of outstanding letters of credit, compared to $8 million at the end of the first quarter of 2010. At January 2, 2010, $10 million of this facility was utilized, including $9 million in respect of outstanding letters of credit. At June 19, 2010, the Company had $184 million of commercial paper issued and outstanding under its commercial paper program compared to $248 million at the end of the first quarter of 2010 and $261 million at the end of 2009.
The Company has also arranged for its Associates to obtain financing to facilitate their purchase of inventory and fund their working capital requirements by providing guarantees to various Canadian chartered banks that support Associate loans. At the end of the second quarter of 2010, the Company's maximum obligation in respect of such guarantees was $520 million, unchanged from the end of the first quarter of 2010 and the end of the prior year. At June 19, 2010, an aggregate amount of $438 million in available lines of credit had been allocated to the Associates by the various banks compared to $435 million at the end of the first quarter of 2010 and $431 million at the end of the prior year. At June 19, 2010, Associates had drawn an aggregate amount of $267 million against these available lines of credit compared to $261 million at the end of the first quarter of 2010 and $254 million at the end of the prior year. Any amounts drawn by the Associates are included in bank indebtedness on the Company's consolidated balance sheets. As recourse in the event that any payments are made under the guarantees, the Company holds a first-ranking security interest on all assets of Associate-owned stores, subject to certain prior-ranking statutory claims. As the Company is involved in allocating the available lines of credit to its Associates, it estimates that the net proceeds from secured assets would exceed the amount of any payments required in respect of the guarantees.
The Company has obtained additional long-term financing from the issuance of $450 million of five-year medium-term notes maturing June 3, 2013, which bear interest at a fixed rate of 4.99% per annum (the "Series 2 Notes"), $250 million of three-year medium-term notes maturing January 20, 2012, which bear interest at a fixed rate of 4.80% per annum (the "Series 3 Notes") and $250 million of five-year medium-term notes maturing January 20, 2014, which bear interest at a fixed rate of 5.19% per annum (the "Series 4 Notes"). The Series 2 Notes were issued pursuant to a final short form base shelf prospectus dated May 22, 2008 (the "Prospectus"), as supplemented by a pricing supplement dated May 28, 2008, and filed by the Company with Canadian securities regulators in all of the provinces in Canada. The Series 3 Notes and Series 4 Notes were issued pursuant to the Prospectus, as supplemented by pricing supplements dated January 14, 2009, and filed by the Company with Canadian securities regulators in all of the provinces of Canada. At the time of issuance, the Series 2 Notes, Series 3 Notes and Series 4 Notes were assigned ratings of A (low) from DBRS Limited and BBB+ from Standard & Poor's.
On June 22, 2009, the Company filed, with the securities regulators in all of the provinces of Canada, an amendment (the "Amendment") to the Prospectus (as amended, the "Amended Prospectus"), increasing the aggregate principal amount of medium-term notes that can be issued from time to time pursuant to the Amended Prospectus to $1.5 billion from $1.0 billion. As at June 19, 2010, the Company had issued an aggregate principal amount of $950 million of medium-term notes pursuant to the Amended Prospectus. On June 22, 2010, the Amended Prospectus expired and was not renewed or extended by the Company.
Cash Flows from Operating Activities
Cash flows from operating activities were $243 million in the second quarter of 2010 compared to $210 million in the same period last year. This increase can be primarily attributed to growth in net earnings adjusted for non-cash items, principally amortization and future income taxes, combined with a reduction in the amount invested in non-cash working capital balances when compared to the same period last year. The reduction in the amount invested in non-cash working capital balances was driven primarily by an increase in accounts payable and accrued liabilities, offset somewhat by the timing of accounts receivable and prepaid expenses. These amounts were partially offset by a decrease in other long-term liabilities as a result of additional pension plan contributions that were made based on actuarial valuations of the Company's registered pension plans completed in the second quarter of 2010.
Year-to-date, the Company has generated $391 million of cash from operating activities compared to $282 million in the first half of 2009.
Cash Flows Used in Investing Activities
Cash flows used in investing activities were $112 million in the second quarter of 2010 compared to $122 million in the same period last year. Of these totals, purchases of property and equipment, net of proceeds from any dispositions, amounted to $98 million in the second quarter of this year compared to $77 million in the same period last year, reflecting further investments by the Company in its store network and related infrastructure projects in information technology and distribution. The Company invested an additional $1 million in business acquisitions and a combined $13 million in the purchase and development of intangible and other assets during the second quarter of 2010 compared to $33 and $10 million, respectively, in the same period last year. During the second quarter of 2010, the balance of funds deposited and held in escrow in respect of outstanding offers to purchase drug stores and land was essentially unchanged compared to an increase of $2 million in the same period last year.
Year-to-date, cash flows used in investing activities were $175 million compared to $227 million in the first half of 2009. Of these totals, purchases of property and equipment, net of proceeds from any dispositions, amounted to $139 million in the first half of 2010 compared to $153 million in the same period last year. Included in the net purchases of property and equipment in the first half of 2010 was $37 million of proceeds resulting from dispositions, $35 million of which related to a first quarter sale/leaseback transaction of 13 retail locations (See note 4 to the accompanying unaudited consolidated financial statements of the Company.) Investments in business acquisitions and in the purchase and development of intangible and other assets were $13 million and $25 million, respectively, in the first half of 2010 compared to $60 million and $12 million, respectively, in the same period last year. These investments relate primarily to acquisitions of drug stores and prescription files, as the Company continues to pursue attractive opportunities in the marketplace, albeit at a somewhat slower pace than in 2009. During the first half of 2010, the balance of funds deposited and held in escrow in respect of outstanding offers to purchase drug stores and land decreased by $2 million compared to an increase of $1 million in the same period last year.
During the second quarter of 2010, the Company opened or acquired 21 new drug stores, 13 of which were relocations, closed three smaller drug stores, and completed six major drug store expansions. The Company also added one Murale(TM) luxury beauty store to its network during the quarter. Year-to- date, 48 new drug stores have been opened or acquired, 24 of which were relocations, four smaller drug stores were closed and 14 major drug store expansions were completed. One Murale(TM) store was added to the network during the first half of 2010. As a result of this activity, retail selling space increased by 8.6% compared to a year ago. At the end of the second quarter of 2010, there were 1,309 stores in the Company's retail network, comprised of 1,239 drug stores (1,180 Shoppers Drug Mart/Pharmaprix stores and 59 Shoppers Simply Pharmacy/Pharmaprix Simplement Santé stores), 63 Shoppers Home Health Care(R) stores and seven Murale(TM) stores.
Cash Flows Used in Financing Activities
Cash flows used in financing activities were $110 million in the second quarter of 2010. Cash outflows of $116 million were partially offset by cash inflows comprised of a $6 million increase in the amount of bank indebtedness. Cash outflows were comprised of a $64 million decrease in the amount of commercial paper issued and outstanding by the Company under its commercial paper program, a $3 million reduction in the amount of Associate investment and $49 million for the payment of dividends.
In the second quarter of 2010, the net result of the Company's operating, investing and financing activities was an increase in cash balances of $21 million.
Year-to-date, cash flows used in financing activities was $197 million and the net result of the Company's operating, investing and financing activities was an increase in cash of $18 million.
Future Liquidity
The Company believes that its current credit facilities, commercial paper program and financing programs available to its Associates, together with cash generated from operating activities, will be sufficient to fund its operations, including the operations of its Associate-owned store network, investing activities and commitments for the foreseeable future. Historically, the Company has not experienced any major difficulty in obtaining additional short or long-term financing given its investment grade credit ratings. While the Company is committed to maintaining its investment grade credit ratings, credit ratings may be revised or withdrawn at any time by the rating agencies if, in their judgment, circumstances warrant.
NEW ACCOUNTING PRONOUNCEMENTS
Transition to International Financial Reporting Standards
In January 2006, the Accounting Standards Board (the "AcSB") announced its decision to require all publicly accountable enterprises to report under International Financial Reporting Standards ("IFRS") for years beginning on or after January 1, 2011. As a result, financial reporting by Canadian publicly accountable enterprises will change significantly from current Canadian generally accepted accounting principles ("Canadian GAAP") to IFRS.
In February 2008, the AcSB confirmed that publicly accountable enterprises will be required to use IFRS, as issued by the International Accounting Standards Board ("IASB"), unless modifications or additions to the requirements of IFRS are issued by the AcSB. IFRS must be adopted for interim and annual financial statements related to fiscal years beginning on or after January 1, 2011.
The Company launched its IFRS transition project in 2008 with a high level assessment of the key areas where conversion to IFRS may have a significant impact, or present a significant challenge. The Company has engaged an external advisor, established a working team and developed documentation and status reporting protocols. The Company has delivered its initial training program and is ensuring that the working team has an in-depth understanding of relevant IFRS as well as new developments in IFRS.
The Company's working team has substantially completed its detailed assessment of IFRS, focused on the identification of differences between the Company's current policies and those under IFRS. In this regard, a topic- specific issues list was developed, identifying the activities required for resolution and timelines for completion, including potential impacts on taxation, information technology and data systems.
The Company has developed a timeline for its 2010 deliverables under its transition plan. The Company is using this timeline to monitor progress against its transition plan and meet future quarters' disclosure requirements. Activities that the Company is undertaking in 2010 include finalization of positions on accounting issues, confirmation of changes to accounting policies, the development of the opening balance sheet, performance of the impairment test on the opening balance sheet under IFRS, conversion of 2010 interim results and development of draft 2011 financial statement and annual 2010 Management's Discussion and Analysis disclosures. The Company has developed a strategy for dual internal reporting under Canadian GAAP and IFRS during 2010. The Company expects to substantially complete these activities by the end of the fourth quarter of 2010.
The Company will refine existing processes or develop any new processes for accumulating information to meet new disclosure requirements, including identifying any required information system changes by the end of the fourth quarter of 2010. The Company reports regularly to the Audit Committee of the Board of Directors on the status of its transition project. The Company expects to finalize its accounting policy and first-time adoption election recommendations and seek approval for those recommendations from the Audit Committee before the end of the fourth quarter of 2010.
Current developments and changes to IFRS will continue to be monitored throughout 2010 and the Company's transition plan and timelines will be adjusted as necessary to respond to these developments. The Company is currently progressing as planned against its 2010 timeline and has not experienced any significant changes from its original project plan.
The Company is focusing its primary efforts on the following standards:
IAS 27, Consolidated and Separate Financial Statements
Under Canadian GAAP, subsidiaries are consolidated based first on the variable interest model under Accounting Guideline 15, "Consolidation of Variable Interest Entities", and then based on the voting interest model under CICA Handbook Section 1590, "Subsidiaries".
Under Canadian GAAP, the Company concluded that the individual Associate- owned stores that comprise the Company's store network were deemed to be variable interest entities and, therefore, were subject to consolidation by the Company. Under IFRS, there is no variable interest concept and consolidation is based on the concept of control as described in IAS 27, "Consolidated and Separate Financial Statements" ("IAS 27").
Based on its assessment, the Company has made the preliminary determination that consolidation of the Associate-owned store network is still appropriate under IFRS. The IASB issued an exposure draft in December 2008 that will revise IAS 27. The exposure draft provides additional guidance regarding the definition and assessment of control. The exposure draft could however change prior to finalization and the Company is continuing to monitor the IASB's project on this standard. The IASB is expected to issue the revised standard in the fourth quarter of 2010.
IFRS 3, Business Combinations
The primary impacts of adopting IFRS 3, "Business Combinations" ("IFRS 3"), compared to the current requirements are:
a) the inability to capitalize acquisition costs which are currently considered part of the purchase price; b) any adjustments to the purchase price within the twelve month period subsequent to an acquisition will require retroactive application and a restatement of prior periods; c) additional limitations exist for establishing restructuring provisions, thereby reducing the number or amount of provisions recognized on acquisition; and d) intangible assets (liabilities) arising from favourable (unfavourable) operating leases are recognized as a component of the leased asset (under current Canadian GAAP, these are recognized as separate intangible assets or liabilities).
In addition to these accounting differences, there are incremental disclosures under IFRS. The Company expects that the only area of immediate impact will be the inability to capitalize certain acquisition costs.
IFRS 1, "First-time Adoption of International Financial Reporting Standards" ("IFRS 1"), states that a first-time adopter may elect not to apply IFRS 3 retrospectively to business combinations that occurred before the date of transition to IFRS. It is the Company's current intention to make this election and therefore, only apply IFRS 3 to business combinations prospectively (i.e. to those that occur on or after January 3, 2010). This may result in the reversal of certain acquisition costs that are capitalized in conjunction with 2010 acquisitions.
IFRIC 13, Customer Loyalty Programmes
IFRIC 13, "Customer Loyalty Programmes" ("IFRIC 13"), addresses how companies should account for the obligation to provide free or discounted goods or services under customer loyalty programs.
IFRIC 13 is based on a view that customers are implicitly paying for the points they receive when they buy goods or services and therefore, a portion of the revenue should be deferred at the time that points are issued. IFRIC 13 requires companies to estimate the value of the points to the customer and defer this amount of revenue as a liability until they have fulfilled their obligations to supply awards. IFRIC 13 will impact the measurement and recognition of the Company's Shoppers Optimum(R) loyalty card program (the "Program"). Currently, when points are earned by Program members, the Company records an expense and establishes a liability for future redemptions by multiplying the number of points issued by the estimated cost per point. The actual cost of Program redemptions is charged against the liability account.
The Company believes that under IFRS the fair value per point should represent the retail value of the award received by the customer upon redemption, whereas under the Company's current liability measurement, the cost per point represents the cost to the Company of providing the reward on redemption. The determination of fair value and cost per point are impacted by many factors, including the historical behaviour of Program members and expected future redemption patterns. The Company is currently quantifying this measurement difference and expects to complete its quantification by the end of the fourth quarter of 2010.
IAS 16, Property, Plant and Equipment
The objective of IAS 16, "Property, Plant and Equipment" ("IAS 16"), is to prescribe the accounting treatment for property, plant, and equipment. The principal issues are the recognition of assets, the determination of their carrying amounts and the depreciation charges and impairment losses to be recognized in relation to them. The Company has investigated each class of its assets and has come to the preliminary determination that IAS 16 will not significantly impact the classification or carrying amounts of its property, plant and equipment.
It is recognized that first time adopters of IFRS may have difficulty reconstructing historical information relating to property, plant and equipment in sufficient detail to retrospectively comply in full with IAS 16. IFRS 1 offers the option for entities to use fair value as deemed-cost for the opening balance of items of property, plant and equipment. As the Company does not believe any additional componentization of its assets is required, the Company believes the current carrying value of its assets is consistent with IFRS.
IAS 17, Leases
IAS 17, "Leases" ("IAS 17"), retains the concepts of capital (finance) leases versus operating leases. IAS 17 differs in the use of qualitative versus quantitative thresholds as exist under Canadian GAAP. Whether a lease is a finance lease or an operating lease depends on the substance of the transaction rather than the form of the contract. A finance lease is defined as a lease that transfers substantially all of the risks and rewards incidental to ownership of the leased asset from the lessor to the lessee. Title to the asset may or may not transfer under such a lease. An operating lease is a lease other than a finance lease.
The Company is currently assessing the impact of IAS 17 on its existing leases and expects to complete its assessment by the end of the fourth quarter of 2010.
IAS 17 also differs in its treatment of gains and losses arising from sale-leaseback transactions where the leaseback is an operating lease. Under IFRS, if the sale transaction can be demonstrated to have taken place at fair value, any gain or loss is taken into income immediately; under Canadian GAAP, gains are deferred and amortized over the term of the lease and losses are taken into income immediately. The Company has entered into several sale- leaseback transactions in the past for which gains have been deferred and amortized. The Company is currently assessing whether those sale transactions took place at fair value and expects to complete its assessment by the end of the fourth quarter of 2010.
The IASB is undertaking a long-term project. In March 2009, the IASB issued a discussion paper on leases. The primary objective of the project is to develop a new model for the recognition of assets and liabilities arising under lease contracts, with the expectation that all leases will be reflected on the balance sheet. This standard is not expected to be in effect prior to the adoption of IFRS in 2011.
IAS 39, Financial Instruments: Recognition and Measurement
The Company intends to continue to apply hedge accounting under IFRS to its interest rate derivative agreement and cash-settled equity forward agreements. The Company has formally identified, designated and documented all relationships between its hedging instruments and hedged items, as well as its risk management objective and strategy for undertaking various hedge transactions. The Company has assessed the effectiveness of the hedges as at January 3, 2010 under IFRS and has concluded that the derivatives used in hedging transactions are highly effective in offsetting future changes in cash flows and market values of the hedged items.
IAS 36, Impairment of Assets
The objective of IAS 36, "Impairment of Assets" ("IAS 36") is to ensure that assets are carried at no more than their recoverable amount, through use or sale. An asset carried at more than its recoverable amount through use or sale is considered impaired and an impairment loss must be recognized immediately in income. A previously recognized impairment loss on an asset other than goodwill is reversed if there has been a change in the factors used to determine the asset's recoverable amount since the last impairment loss was recognized. An impairment loss for goodwill is not reversed.
Assets are assessed at the end of each reporting period to determine whether there is any indication of an impairment. If any such indication exists, the recoverable amount of the asset must be determined. Goodwill and intangible assets not subject to amortization must be tested at least annually for impairment, and more frequently if an indication of impairment exists.
If there is any indication that an asset may be impaired, recoverable amount shall be estimated for the individual asset. If it is not possible to estimate the recoverable amount of the individual asset, the recoverable amount is determined for the cash-generating unit to which the asset belongs. An asset's cash-generating unit is the smallest group of assets that generates cash inflows that are largely independent of the cash inflows from other assets or groups of assets. Identification of an asset's cash-generating unit involves judgement.
The requirements of IAS 36 are similar to those that exist in Canadian GAAP however there are differences in identification of cash-generating units, reversals in previously recognized impairment losses and the methodology for calculating the recoverable amount, including the use of discounting. The Company is assessing its cash generating units and is currently performing impairment testing of its assets utilizing the IFRS testing methodology.
Other Standards
In addition to the above standards, the Company is also focusing on IAS 12, "Income Taxes", and is in the process of finalizing its preliminary determinations on this standard. This list should not be regarded as a complete list of the IFRS standards that may have an impact on the Company's results of operations, financial position and disclosures. The list is intended to highlight areas the Company believes to be the most significant. Final conclusions could change as the Company progresses through its assessments. At this point, the Company is not able to reasonably quantify the expected impacts of the changes.
Further options under IFRS 1, beyond those that have been identified above, are being analyzed as the Company progresses through its detailed assessment of the individual standards. Other IFRS 1 elections under consideration include the treatment of unrecognized actuarial gains and losses at the date of transition and the election of fair value as deemed-cost. The Company will be making its recommendations on these, and possibly other, IFRS 1 elections and seeking approval for those recommendations from the Audit Committee before the end of the fourth quarter of 2010.
The impact of the transition to IFRS on other business activities, disclosure controls and procedures and internal controls over financial reporting is being assessed as the impacts of the standards as a whole are identified.
The IASB has significant ongoing projects, which management is monitoring, that could affect the ultimate differences between Canadian GAAP and IFRS and the impact those differences have on the Company's results of operations, financial position and disclosures.
SELECTED QUARTERLY INFORMATION
Reporting Cycle
The annual reporting cycle of the Company is divided into four quarters of 12 weeks each, except for the third quarter which is 16 weeks in duration. The fiscal year of the Company consists of a 52 or 53 week period ending on the Saturday closest to December 31. When a fiscal year consists of 53 weeks, the fourth quarter is 13 weeks in duration.
Summary of Quarterly Results
The following table provides a summary of certain selected consolidated financial information for the Company for each of the eight most recently completed fiscal quarters. This information has been prepared in accordance with Canadian generally accepted accounting principles.
Second Quarter First Quarter ($000s, except -------------------------- -------------------------- per share data 2010 2009 2010 2009 - unaudited) (12 Weeks) (12 Weeks) (12 Weeks) (12 Weeks) ------------------------------------------------------------------------- Sales $ 2,402,539 $ 2,288,789 $ 2,321,099 $ 2,195,260 Net earnings $ 144,576 $ 136,112 $ 115,633 $ 106,842 Per common share - Basic net earnings $ 0.66 $ 0.63 $ 0.53 $ 0.49 - Diluted net earnings $ 0.66 $ 0.63 $ 0.53 $ 0.49 Fourth Quarter Third Quarter ($000s, except -------------------------- -------------------------- per share data 2009 2008 2009 2008 - unaudited) (12 Weeks) (13 Weeks) (16 Weeks) (16 Weeks) ------------------------------------------------------------------------- Sales $ 2,488,544 $ 2,496,799 $ 3,013,007 $ 2,793,005 Net earnings $ 171,060 $ 166,536 $ 170,894 $ 160,276 Per common share - Basic net earnings $ 0.79 $ 0.77 $ 0.79 $ 0.74 - Diluted net earnings $ 0.79 $ 0.77 $ 0.79 $ 0.74
Excluding the benefit of the extra week in the fourth quarter of 2008, which accounted for $174 million of additional sales, the Company experienced growth in sales and net earnings in each of the four most recent quarters when compared to the same quarter of the prior year. The Company has invested capital in expanded and relocated stores and in new store development, which has allowed the Company to increase the selling square footage of its store network, resulting in increased sales and profitability.
The Company's core prescription drug operations are not typically subject to seasonal fluctuations. The Company's front store operations include seasonal promotions which may have an impact on comparative quarterly results, particularly when the season, notably Easter, does not fall in the same quarter each year. Also, as the Company continues to expand its front store product and service offerings, including seasonal promotions, its results of operations may become subject to more seasonal fluctuations.
RISKS AND RISK MANAGEMENT
Industry and Regulatory Developments
Ontario Drug Reform
On May 18, 2010, the Government of Ontario passed amendments to the Ontario Drug Benefit Act (the "ODBA") and the Drug Interchangeability and Dispensing Fee Act (the "DIDFA"), and on June 7, 2010, filed amendments to Ontario Regulation 201/96 (the "ODBA Regulations") and Regulation 935 (the "DIDFA Regulations") (collectively, the "Regulatory Amendments"). More significant elements of the Regulatory Amendments include:
- the immediate lowering of the cost of most generic drugs for Ontario's public drug plan by at least 50%, to 25% of the cost of the corresponding original brand name drug, and for private payors over the next three years; - the immediate elimination of professional allowances from Ontario's public drug system and from the private payor system by April 1, 2013; and - increases to dispensing fees paid under Ontario's public drug plan for pharmacy operators, with larger increases for those operators located in rural communities and underserviced areas.
The Regulatory Amendments arise from proposals by the Ontario Ministry of Health and Long-Term Care (the "Ministry") to reform the Ontario drug system. These proposals are discussed in detail under the title "Industry and Regulatory Developments" in the Risks and Risk Management section of the Company's Management's Discussion and Analysis for 12 week period ended March 27, 2010.
Lowering the cost of most generic prescription drugs
For Ontario's public drug system, the cost of most generic drug products was reduced by at least 50%, to 25% of the cost of the corresponding original brand name drug. For most generic drug products, this cost reduction occurred on July 1, 2010.
For private payors, the cost of most generic drug products was limited to a maximum of 50% of the cost of the original brand name drug and will be further limited to a maximum of 35% on April 1, 2011 and to a maximum of 25% on April 1, 2012. After April 1, 2012 there will be parity with the drug benefit price under the public drug system. For most generic drug products, the 50% limit applied on July 1, 2010.
Eliminating professional allowances
Professional allowance funding in the public sector, rather than being reduced to 5% as was initially proposed, was eliminated as of July 1, 2010.
For the private sector, a declining cap on professional allowance funding was imposed. As of July 1, 2010, the cap on professional allowances imposed in the private sector is 50% of sales of interchangeable prescription drug products that are not reimbursed under Ontario's public drug program. The cap on professional allowance funding in the private sector will be reduced to 35% on April 1, 2011 and further reduced to 25% on April 1, 2012. Professional allowance funding will be eliminated in the private sector by April 1, 2013, a year earlier than the Ministry had previously indicated.
Increase dispensing fees for pharmacy operators
On July 1, 2010, dispensing fees paid under Ontario's public drug plan to most pharmacy operators increased from $7.00 to $8.00, and the dispensing fee for certain rural pharmacy operators in underserviced areas increased from $7.00 to between $9.00 and $12.00. Additionally, the dispensing fees paid under Ontario's public drug plan will increase annually over the next four years, ultimately reaching $8.83 for most pharmacy operators and up to $13.25 for certain pharmacy operators in underserviced and rural areas by April 1, 2014.
In recognition of the transition to a pharmacy reimbursement model aimed at supporting professional services, transitional fees will be provided to pharmacy operators, commencing July 1, 2010, in the form of an additional $1.00 on top of the dispensing fees paid under Ontario's public drug plan, providing support to pharmacy operators until they can offer additional professional services, which have yet to be defined. This transitional fee will decrease to $0.65 on April 1, 2011 and to $0.35 on April 1, 2012 and will be eliminated after March 31, 2013.
Permitted mark-up
Contrary to the original proposals, the amendments to the ODBA Regulations did not include any change to pharmacy operators' permitted mark- up on the price of prescription drug products dispensed under Ontario's public drug plan and there is no overall monetary limit imposed on the permitted mark- up for prescription drugs dispensed under Ontario's public drug plan. Pharmacy operators will receive the same mark-up on the price of the prescription drug products, which is currently set at 8%, and, in a change from the original proposals, there is no reduction in the mark-up where pharmacy operators are purchasing from an integrated wholesaler. The proposed $125 overall limit on the mark-up was not included as part of the Regulatory Amendments.
Allowance for ordinary commercial terms
Consistent with the original proposals, the Regulatory Amendments provide that the prohibition on a payment of manufacturer rebates or allowances will not apply to a benefit provided by a manufacturer in accordance with ordinary commercial terms that meet certain specified conditions including: (a) that the benefit is provided in the ordinary course of business between any of a manufacturer, a wholesaler, an operator of a pharmacy or a company that owns, operates or franchises pharmacies; (b) the value of the benefit is set out in a written agreement between the parties; and (c) the benefit is a prompt payment discount, a volume discount, or a distribution service fee. While the original proposals did not include a cap on ordinary commercial terms, the Regulatory Amendments provide that the total value of any benefits provided in accordance with ordinary commercial terms may not exceed: (i) for the purposes of Ontario's public drug system, 10% of the value of the listed drug products based on the drug benefit price and the number of units dispensed by a pharmacy and reimbursed under the ODBA; and (ii) for the purposes of the private system, 10% of the value of the interchangeable products not supplied to an eligible person under the ODBA based on the number of units dispensed by a pharmacy at each product's permitted price.
Prohibition on private label products
Consistent with the original proposals, the Regulatory Amendments provide that a drug product that falls under the definition of a "private label product" will not be designated as an interchangeable drug product or as a listed drug product for the Ontario Drug Benefit Program. Designation as an interchangeable drug product is generally necessary for market adoption of generic prescription drug products and designation as a listed drug product for the Ontario Drug Benefit Program is necessary for public reimbursement. The Company is currently pursuing a legal challenge to the validity of the prohibition under the current legislation.
Québec
In Québec, legislation provides that the selling price for prescription drug products for the provincial drug insurance program must not be higher than the selling price granted by the manufacturer for the same drug under other provincial health programs. On June 25, 2010, Québec Health Minister Yves Bolduc announced that Québec would implement pricing reductions on generic drugs to be in line with Ontario and indicated that the prices would become effective after a four to eight week consultation period with industry stakeholders.
British Columbia
The British Columbia Minister of Health Services has executed an agreement with the British Columbia Pharmacy Association and the Canadian Association of Chain Drug Stores which will lower the cost of generic drug products in the province. Effective October 15, 2010, new generic drug products, generally those generic drug products where the first generic version of the product was listed on British Columbia's public drug plan formulary on or after November 1, 2008, will be priced at 42% of the cost of the corresponding brand name drug and other generic drug products that are not new generic drug products will be priced at 50% of the cost of the corresponding original brand name drug. The cost of both new generic products and other generic drug products will be further reduced to 40% and 35% of the cost of the corresponding original brand name drug on July 4, 2011 and April 2, 2012, respectively. In British Columbia, the pricing for generic drug products will be uniform for both public and private payers. As for supply chain relationships between manufacturers, wholesalers and retailers, commercial terms are left to normal business relationships between each of the parties.
Effective July 28, 2010, the maximum dispensing fee reimbursed by the British Columbia public drug plan will increase by $0.50 to $9.10. Dispensing fees will further increase by $0.50 on October 15, 2010 to $9.60 and by $0.40 on July 4, 2011 to $10.00, reaching $10.50 on April 2, 2012. On October 1, 2010, the permitted mark-up on the price of prescription drug products reimbursed by the British Columbia public drug plan will also be increased from 7% to 8%.
Also, beginning April 1, 2012, the British Columbia will be reinvesting $35 million into new clinical pharmacy services.
RISKS ASSOCIATED WITH FINANCIAL INSTRUMENTS
The Company is exposed to a number of risks associated with financial instruments that have the potential to affect its operating and financial performance. The Company's primary financial instrument risk exposures are interest rate risk and liquidity risk. The Company's exposures to foreign currency risk, credit risk and other price risk are not considered to be material. The Company may use derivative financial instruments to manage certain of these risks but it does not use derivative financial instruments for trading or speculative purposes.
Exposure to Interest Rate Fluctuations
The Company, including its Associate-owned store network, is exposed to fluctuations in interest rates by virtue of its borrowings under its bank credit facilities, commercial paper program and financing programs available to its Associates. Increases or decreases in interest rates will positively or negatively impact the financial performance of the Company.
The Company monitors market conditions and the impact of interest rate fluctuations on its fixed and floating rate debt instruments on an ongoing basis and may use interest rate derivatives to manage this exposure. The Company is party to an interest rate derivative agreement converting an aggregate notional principal amount of $50 million (2009 - $100 million) of floating rate debt into fixed rate debt. The fixed rate payable by the Company under this agreement is 4.18% (2009 - two agreements with a range between 4.11% and 4.18%). This agreement contains reset terms of one month and matures in December 2010.
Furthermore, the Company may be exposed to losses should any counterparty to its derivative agreements fail to fulfil its obligations. The Company has sought to minimize counterparty risk by transacting with counterparties that are large financial institutions. There is no unrecognized exposure as at June 19, 2010, as the interest rate derivative agreement is in a liability position, unchanged from the end of the first quarter and the end of the prior year.
As at June 19, 2010, the Company had $401 million (2009 - $434 million) of unhedged floating rate debt. During the 12 and 24 week periods ended June 19, 2010, the Company's average outstanding unhedged floating rate debt was $580 million and $599 million (2009 - $581 million and $626 million), respectively. Had interest rates been higher or lower by 50 basis points during the 12 and 24 week periods ended June 19, 2010, net earnings would have decreased or increased, respectively, by approximately $0.5 million and $1.0 million (2009 - $0.5 million and $1.0 million), respectively, as a result of the Company's exposure to interest rate fluctuations on its unhedged floating rate debt.
Foreign Currency Exchange Risk
The Company conducts the vast majority of its business in Canadian dollars. The Company's foreign currency exchange risk principally relates to purchases made in U.S. dollars and this risk is tied to fluctuations in the exchange rate of the Canadian dollar, vis-à-vis the U.S. dollar. The Company monitors its foreign currency purchases in order to monitor and manage its foreign currency exchange risk. The Company does not consider its exposure to foreign currency exchange rate risk to be material.
Credit Risk
Accounts receivable arise primarily in respect of prescription sales billed to governments and third-party drug plans and, as a result, collection risk is low. There is no concentration of balances with debtors in the remaining accounts receivable. The Company does not consider its exposure to credit risk to be material.
Other Price Risk
The Company uses cash-settled equity forward agreements to limit its exposure to future changes in the market price of its common shares by virtue of its obligations under its Long-Term Incentive Plan ("LTIP") and Restricted Share Units Plan ("RSUP"). The income or expense arising from the use of these instruments is included in cost of goods sold and other operating expenses.
Based on market values of the equity forward agreements in place at June 19, 2010, the Company recognized a liability of $7.6 million, of which $2.4 million is presented in accounts payable and accrued liabilities and $5.2 million is presented in other long-term liabilities. Based on market values of the equity forward agreements in place at June 20, 2009, the Company recognized a net liability of $0.7 million, of which $0.9 million was presented in other assets, $0.8 million was presented in accounts payable and accrued liabilities and $0.8 million was presented in other long-term liabilities. During the 12 and 24 week periods ended June 19, 2010 and June 20, 2009, the Company assessed that the percentages of the equity forward agreements in place related to unearned units under the LTIP and the RSUP were effective hedges for the exposure to future changes in the market price of its common shares in respect of the unearned units. Market values were determined based on information received from the Company's counterparty to these equity forward agreements.
Capital Management and Liquidity Risk
The Company's primary objectives when managing its capital are to profitably grow its business while maintaining adequate financing flexibility to fund attractive new investment opportunities and other unanticipated requirements or opportunities that may arise. Profitable growth is defined as earnings growth commensurate with the additional capital being invested in the business in order that the Company earns an attractive rate of return on that capital. The primary investments undertaken by the Company to drive profitable growth include additions to the selling square footage of its store network via the construction of new, relocated and expanded stores, including related leasehold improvements and fixtures, the acquisition of sites as part of a land bank program, as well as through the acquisition of independent drug stores or their prescription files. In addition, the Company makes capital investments in information technology and its distribution capabilities to support an expanding store network. The Company also provides working capital to its Associates via loans and/or loan guarantees. The Company largely relies on its cash flow from operations to fund its capital investment program and dividend distributions to its shareholders. This cash flow is supplemented, when necessary, through the borrowing of additional debt. No changes were made to these objectives during the period.
The Company considers its total capitalization to be bank indebtedness, commercial paper, short-term debt, long-term debt (including the current portion thereof) and shareholders' equity, net of cash. The Company also gives consideration to its obligations under operating leases when assessing its total capitalization. The Company manages its capital structure with a view to maintaining investment grade credit ratings from two credit rating agencies. In order to maintain its desired capital structure, the Company may adjust the level of dividends paid to shareholders, issue additional equity, repurchase shares for cancellation or issue or repay indebtedness. The Company has certain debt covenants and is in compliance with those covenants.
The Company monitors its capital structure principally through measuring its net debt to shareholders' equity ratio and net debt to total capitalization ratio, and ensures its ability to service its debt and meet other fixed obligations by tracking its interest and other fixed charges coverage ratios. (See discussion under "Capitalization and Financial Position" in this Management's Discussion and Analysis.)
Liquidity risk is the risk that the Company will be unable to meet its obligations relating to its financial liabilities. The Company prepares cash flow budgets and forecasts to ensure that it has sufficient funds through operations, access to bank credit facilities and access to debt and capital markets to meet its financial obligations, capital investment program and fund new investment opportunities or other unanticipated requirements as they arise. The Company manages its liquidity risk as it relates to financial liabilities by monitoring its cash flow from operating activities to meet its short-term financial liability obligations and planning for the repayment of its long-term financial liability obligations through cash flow from operating activities and/or the issuance of new debt.
For a complete description of the Company's sources of liquidity, see the discussions on "Sources of Liquidity" and "Future Liquidity" under "Liquidity and Capital Resources" in this Management's Discussion and Analysis.
INTERNAL CONTROLS OVER FINANCIAL REPORTING
The Chief Executive Officer and the Chief Financial Officer have designed, or caused to be designed under their supervision, internal controls over financial reporting to provide reasonable assurance regarding the reliability of financial reporting, its compliance with Canadian GAAP and the preparation of financial statements for external purposes. Internal control systems, no matter how well designed, have inherent limitations. Therefore, even those systems determined to be designed effectively can provide only reasonable assurance with respect to financial reporting and financial statement preparation.
There were no changes in internal control over financial reporting that occurred during the Company's most recent interim period that have materially affected, or are reasonably likely to materially affect, the Company's internal control over financial reporting.
NON-GAAP FINANCIAL MEASURES
The Company reports its financial results in accordance with Canadian GAAP. However, the foregoing contains references to non-GAAP financial measures, such as operating margin, EBITDA (earnings before interest, taxes, depreciation and amortization), EBITDA margin and cash interest expense. Non- GAAP financial measures do not have standardized meanings prescribed by GAAP and, therefore, may not be comparable to similar measures presented by other reporting issuers.
These non-GAAP financial measures have been included in this Management's Discussion and Analysis as they are measures which management uses to assist in evaluating the Company's operating performance against its expectations and against other companies in the retail drug store industry. Management believes that non-GAAP financial measures assist in identifying underlying operating trends.
These non-GAAP financial measures, particularly EBITDA and EBITDA margin, are also common measures used by investors, financial analysts and rating agencies. These groups may use EBITDA and other non-GAAP financial measures to value the Company and assess the Company's ability to service its debt.
SHOPPERS DRUG MART CORPORATION Consolidated Statements of Earnings (unaudited) (in thousands of dollars except per share amounts) ------------------------------------------------------------------------- 12 Weeks Ended 24 Weeks Ended ------------------------- ------------------------- June 19, June 20, June 19, June 20, 2010 2009 2010 2009 ------------------------------------------------------------------------- Sales $ 2,402,539 $ 2,288,789 $ 4,723,638 $ 4,484,049 Operating expenses Cost of goods sold and other operating expenses (Note 2) 2,116,757 2,023,150 4,196,084 3,994,572 Amortization 67,016 56,279 131,308 111,882 ------------------------------------------------------------------------- Operating income 218,766 209,360 396,246 377,595 Interest expense (Note 5) 12,965 13,881 25,843 28,387 ------------------------------------------------------------------------- Earnings before income taxes 205,801 195,479 370,403 349,208 ------------------------------------------------------------------------- Income taxes Current 53,592 57,495 109,040 104,219 Future 7,633 1,872 1,154 2,035 ------------------------------------------------------------------------- 61,225 59,367 110,194 106,254 ------------------------------------------------------------------------- Net earnings $ 144,576 $ 136,112 $ 260,209 $ 242,954 ------------------------------------------------------------------------- ------------------------------------------------------------------------- Net earnings per common share: Basic $ 0.66 $ 0.63 $ 1.20 $ 1.12 Diluted $ 0.66 $ 0.63 $ 1.20 $ 1.12 Weighted average common shares outstanding - Basic (millions) 217.4 217.4 217.4 217.3 - Diluted (millions) 217.5 217.5 217.5 217.5 Actual common shares outstanding (millions) 217.4 217.4 217.4 217.4 SHOPPERS DRUG MART CORPORATION Consolidated Statements of Retained Earnings (unaudited) (in thousands of dollars) ------------------------------------------------------------------------- 24 Weeks Ended ------------------------- June 19, June 20, 2010 2009 ------------------------------------------------------------------------- Retained earnings, beginning of period $ 2,297,091 $ 1,899,139 Net earnings 260,209 242,954 Dividends (97,844) (93,465) ------------------------------------------------------------------------- Retained earnings, end of period $ 2,459,456 $ 2,048,628 ------------------------------------------------------------------------- ------------------------------------------------------------------------- Consolidated Statements of Comprehensive Income and Accumulated Other Comprehensive Loss (unaudited) (in thousands of dollars) ------------------------------------------------------------------------- 12 Weeks Ended 24 Weeks Ended ------------------------- ------------------------- June 19, June 20, June 19, June 20, 2010 2009 2010 2009 ------------------------------------------------------------------------- Net earnings $ 144,576 $ 136,112 $ 260,209 $ 242,954 ------------------------------------------------------------------------- Other comprehensive (loss) income, net of tax Change in unrealized loss on interest rate derivatives (net of tax of $151 and $283 (2009 - $355 and $476)) 291 516 573 773 Change in unrealized loss on equity forward derivatives (net of tax of $686 and $901 (2009 - $190 and $192)) (1,808) 447 (2,281) 456 Amount of previously unrealized loss recognized in earnings during the period (net of tax of $3 and $7 (2009 - $48 and $71)) 9 76 18 167 ------------------------------------------------------------------------- Other comprehensive (loss) income (1,508) 1,039 (1,690) 1,396 ------------------------------------------------------------------------- Comprehensive income $ 143,068 $ 137,151 $ 258,519 $ 244,350 ------------------------------------------------------------------------- ------------------------------------------------------------------------- ------------------------------------------------------------------------- Accumulated other comprehensive loss, beginning of period $ (1,125) $ (3,442) Other comprehensive (loss) income (1,690) 1,396 ------------------------------------------------------------------------- Accumulated other comprehensive loss, end of period $ (2,815) $ (2,046) ------------------------------------------------------------------------- ------------------------------------------------------------------------- SHOPPERS DRUG MART CORPORATION Consolidated Balance Sheets (unaudited) (in thousands of dollars) ------------------------------------------------------------------------- June 19, June 20, January 2, 2010 2009 2010 ------------------------------------------------------------------------- Assets Current Cash $ 62,670 $ 26,059 $ 44,391 Accounts receivable 486,517 431,678 471,029 Inventory (Note 2) 1,830,207 1,712,574 1,852,441 Income taxes recoverable 25,435 37,490 - Future income taxes 81,966 81,129 86,161 Prepaid expenses and deposits 57,332 69,101 75,573 ------------------------------------------------------------------------- 2,544,127 2,358,031 2,529,595 Property and equipment (Note 4) 1,606,197 1,396,183 1,566,024 Goodwill (Note 3) 2,493,357 2,458,884 2,481,353 Intangible assets (Note 3) 260,852 238,879 258,766 Other assets 19,635 15,160 16,716 ------------------------------------------------------------------------- Total assets $ 6,924,168 $ 6,467,137 $ 6,852,454 ------------------------------------------------------------------------- ------------------------------------------------------------------------- Liabilities Current Bank indebtedness (Note 6) $ 256,497 $ 277,617 $ 270,332 Commercial paper 183,590 240,148 260,386 Accounts payable and accrued liabilities 964,803 907,971 964,736 Income taxes payable - - 17,046 Dividends payable 48,922 46,738 46,748 ------------------------------------------------------------------------- 1,453,812 1,472,474 1,559,248 Long-term debt (Note 9) 945,651 943,809 946,098 Other long-term liabilities (Note 4) 377,806 332,589 347,951 Future income taxes 39,237 34,645 42,858 ------------------------------------------------------------------------- 2,816,506 2,783,517 2,896,155 ------------------------------------------------------------------------- Associate interest 120,041 108,588 130,189 Shareholders' equity Share capital 1,519,944 1,517,992 1,519,870 Contributed surplus 11,036 10,458 10,274 Accumulated other comprehensive loss (2,815) (2,046) (1,125) Retained earnings 2,459,456 2,048,628 2,297,091 ------------------------------------------------------------------------- 2,456,641 2,046,582 2,295,966 ------------------------------------------------------------------------- 3,987,621 3,575,032 3,826,110 ------------------------------------------------------------------------- Total liabilities and shareholders' equity $ 6,924,168 $ 6,467,137 $ 6,852,454 ------------------------------------------------------------------------- ------------------------------------------------------------------------- SHOPPERS DRUG MART CORPORATION Consolidated Statements of Cash Flows (unaudited) (in thousands of dollars) ------------------------------------------------------------------------- 12 Weeks Ended 24 Weeks Ended ------------------------- ------------------------- June 19, June 20, June 19, June 20, 2010 2009 2010 2009 ------------------------------------------------------------------------- Operating activities Net earnings $ 144,576 $ 136,112 $ 260,209 $ 242,954 Items not affecting cash Amortization 64,677 56,259 128,589 110,476 Future income taxes 7,633 1,872 1,154 2,035 Loss on disposal of property and equipment 2,951 548 4,093 2,413 Stock-based compensation 387 200 774 380 ------------------------------------------------------------------------- 220,224 194,991 394,819 358,258 Net change in non-cash working capital balances 23,245 4,121 (15,319) (97,409) (Decrease) increase in other long-term liabilities (647) 11,324 11,409 20,947 ------------------------------------------------------------------------- Cash flows from operating activities 242,822 210,436 390,909 281,796 ------------------------------------------------------------------------- Investing activities Purchase of property and equipment (98,833) (88,886) (176,235) (170,093) Proceeds from disposition of property and equipment (Note 4) 918 11,833 36,882 17,037 Business acquisitions (Note 3) (1,323) (33,152) (12,681) (60,432) Deposits 359 (1,786) 1,561 (1,231) Purchase and development of intangible assets (11,109) (7,379) (21,473) (9,805) Other assets (2,224) (2,418) (3,206) (2,176) ------------------------------------------------------------------------- Cash flows used in investing activities (112,212) (121,788) (175,152) (226,700) ------------------------------------------------------------------------- Financing activities Bank indebtedness, net (Note 6) 6,056 12,559 (13,835) 36,773 Commercial paper, net (64,000) (53,000) (77,000) (100,000) Repayment of short-term debt (Note 9) - - - (200,000) Issuance of Series 3 notes (Note 9) - - - 250,000 Issuance of Series 4 notes (Note 9) - - - 250,000 Revolving term debt, net - - (1,298) (200,000) Financing costs incurred - - - (2,088) Associate interest (2,803) (2,793) (9,737) (10,090) Proceeds from shares issued for stock options exercised - 1,165 - 3,110 Repayment of share purchase loans - 18 33 128 Issuance of share capital 29 - 29 - Dividends paid (48,922) (46,728) (95,670) (93,437) ------------------------------------------------------------------------- Cash flows used in financing activities (109,640) (88,779) (197,478) (65,604) ------------------------------------------------------------------------- Increase (decrease) in cash 20,970 (131) 18,279 (10,508) Cash, beginning of period 41,700 26,190 44,391 36,567 ------------------------------------------------------------------------- Cash, end of period $ 62,670 $ 26,059 $ 62,670 $ 26,059 ------------------------------------------------------------------------- ------------------------------------------------------------------------- Supplemental cash flow information Interest paid $ 13,628 $ 13,601 $ 28,578 $ 18,481 Income taxes paid $ 75,411 $ 85,818 $ 151,754 $ 134,094 SHOPPERS DRUG MART CORPORATION Notes to the Consolidated Financial Statements (unaudited) (in thousands of dollars except per share amounts)
1. BASIS OF PRESENTATION
The unaudited interim consolidated financial statements have been prepared in accordance with Canadian generally accepted accounting principles ("GAAP") and follow the same accounting policies and methods of application with those used in the preparation of the audited annual consolidated financial statements for the 52 week period ended January 2, 2010. These financial statements do not contain all disclosures required by Canadian GAAP for annual financial statements and, accordingly, should be read in conjunction with the most recently prepared annual consolidated financial statements and the accompanying notes included in the Company's 2009 Annual Report.
Under the Canadian Institute of Chartered Accountants ("CICA") Accounting Guideline 15, "Consolidation of Variable Interest Entities", the Company consolidates the Associate-owned stores. The individual Associate-owned stores that comprise the Company's store network are variable interest entities ("VIE") and the Company is the primary beneficiary. The Associate-owned stores remain separate legal entities and consolidation of the Associate-owned stores has no impact on the underlying risks facing the Company.
The consolidated financial statements of the Company include the accounts of Shoppers Drug Mart Corporation, its subsidiaries and the Associate-owned stores that comprise the majority of the Company's store network. All intercompany balances and transactions are eliminated on consolidation.
2. INVENTORY
During the 12 and 24 weeks ended June 19, 2010, the Company recognized cost of inventory of $1,479,804 and $2,923,320 (2009 - $1,438,920 and $2,823,242), respectively, as an expense. This expense is included in cost of goods sold and other operating expenses in the consolidated statements of earnings for the period.
During the 12 and 24 weeks ended June 19, 2010 and June 20, 2009, there were no significant write-downs of inventory as a result of net realizable value being lower than cost and no inventory write-downs recognized in previous periods were reversed.
3. ACQUISITIONS
In the normal course of business, the Company acquires the assets or shares of pharmacies. The total cost of acquisitions during the 12 and 24 weeks ended June 19, 2010 of $1,323 and $12,681 (2009 - $33,152 and $60,432), respectively, including costs incurred in connection with the acquisitions, is allocated primarily to goodwill and intangible assets based on their fair values. Purchase price allocations are preliminary when initially recognized and may change pending finalization of the valuations of the assets acquired. The operations of the acquired pharmacies have been included in the Company's results of operations from the date of acquisition.
4. SALE-LEASEBACK TRANSACTIONS
During the 12 and 24 weeks ended June 19, 2010, the Company sold certain real estate properties for net proceeds of $4,564 and $40,034 (2009 - $9,225 and $14,094), respectively, and entered into leaseback agreements for the area used by the Associate-owned stores. The leases have been accounted for as operating leases. During the 12 and 24 weeks ended June 19, 2010, the Company realized gains on disposal of $640 and $12,998 (2009 - $1,840 and $4,035), respectively. The gains have been deferred and are being amortized over the lease terms of 10 to 15 years (2009 - 15 to 20 years). The deferred gains are presented in other long-term liabilities. Proceeds attributable to a transaction that occurred during the 12 weeks ended June 19, 2010 are presented in accounts receivable.
5. INTEREST EXPENSE
The components of the Company's interest expense are as follows:
12 Weeks Ended 24 Weeks Ended ------------------------- ------------------------- June 19, June 20, June 19, June 20, 2010 2009 2010 2009 ------------------------------------------------------------------------- Interest on bank indebtedness $ 1,106 $ 1,256 $ 2,253 $ 2,790 Interest on commercial paper 990 1,372 1,840 3,372 Interest on short-term debt - - - 504 Interest on long-term debt 11,860 11,825 23,756 22,885 ------------------------------------------------------------------------- 13,956 14,453 27,849 29,551 Less: interest capitalized 991 572 2,006 1,164 ------------------------------------------------------------------------- $ 12,965 $ 13,881 $ 25,843 $ 28,387 ------------------------------------------------------------------------- -------------------------------------------------------------------------
6. BANK INDEBTEDNESS
The Associate-owned stores borrow under their bank line of credit agreements, which are guaranteed by the Company. The Company has entered into agreements with banks to guarantee a total of $520,000 (2009 - $505,000) of lines of credit. As at June 19, 2010, the Associate-owned stores have utilized $267,211 (2009 - $293,335) of the available lines of credit.
7. EMPLOYEE FUTURE BENEFITS
The net benefit expense included in the results for the 12 and 24 weeks ended June 19, 2010 for benefits provided under pension plans was $961 and $2,501 (2009 - $1,082 and $2,164), respectively, and for benefits provided under other benefit plans was $246 and $269 (2009 - $23 and $46), respectively.
8. STOCK-BASED COMPENSATION
Long-term Incentive Compensation Awards
The Company maintains a Long-Term Incentive Plan ("LTIP") pursuant to which certain employees are eligible to receive an award of share units equivalent in value to common shares of the Company ("Share Units"). Awards of Share Units under the LTIP are made in February of the fiscal year immediately following the year in respect of which the award is earned. There were no awards made under the LTIP in respect of the 2009 fiscal year. For a description of the awards, see Note 14 to the consolidated financial statements in the Company's 2009 Annual Report.
In February 2010, the Company made grants of restricted share units ("RSUs"), in respect of the 2009 fiscal year, under the Company's Restricted Share Unit Plan (the "RSU Plan") and for certain senior management, grants of RSUs, combined with grants of stock options under the Company's Share Incentive Plan (the "Share Plan").
On February 23, 2010, the Company awarded 350,384 RSUs at a grant-date fair value of $44.09, which vest 100% after three years. Full vesting of RSUs will be phased in for employees who received an award under the LTIP in respect of a fiscal year prior to the 2009 fiscal year. During the 12 and 24 weeks ended June 19, 2010, the Company recognized compensation expense of $2,001 and $4,126, respectively, associated with RSUs. As at June 19, 2010, there were 331,768 RSUs outstanding.
On February 23, 2010, the Company awarded 282,120 stock options under the Share Plan at a grant-date fair value of $6.94, which vest one-third each year. The exercise price of the stock options granted was $44.09 and upon vesting, the stock options may be exercised over a period not exceeding seven years. During the 12 and 24 weeks ended June 19, 2010, the Company recognized compensation expense of $276 and $552, respectively, measured at fair value on the date of the grant using the Black-Scholes option-pricing model.
9. DEBT REFINANCING
On January 20, 2009, the Company issued $250,000 of three-year medium- term notes maturing January 20, 2012, which bear interest at a fixed rate of 4.80% (the "Series 3 notes") and $250,000 of five-year medium-term notes maturing January 20, 2014, which bear interest at a fixed rate of 5.19% (the "Series 4 notes"). The Series 3 notes and the Series 4 notes were issued pursuant to the Company's shelf prospectus, as supplemented by pricing supplements dated January 14, 2009.
The net proceeds from the issuance of the Series 3 notes and the Series 4 notes were used to refinance existing indebtedness, including repayment of all amounts outstanding under the Company's senior unsecured 364-day bank credit facility ("short-term debt"). The Company's senior unsecured 364-day bank credit facility was terminated on January 20, 2009.
On June 22, 2009, the Company filed with the securities regulators in all of the provinces of Canada an amendment to its short form base shelf prospectus dated May 22, 2008 (the "Amended Prospectus") to increase the aggregate principal amount of medium-term notes to be issued from $1,000,000 to $1,500,000. On June 22, 2010, the Amended Prospectus expired and was not renewed or extended by the Company.
10. FINANCIAL RISK MANAGEMENT OBJECTIVES AND POLICIES RELATED TO FINANCIAL INSTRUMENTS
In the normal course of business, the Company is exposed to financial risks that have the potential to negatively impact its financial performance but it may use derivative financial instruments to manage certain of these risks. The Company does not use derivative financial instruments for trading or speculative purposes. These risks are discussed in more detail below:
Interest Rate Risk
Interest rate risk is the risk that fair value or future cash flows associated with the Company's financial assets or liabilities will fluctuate due to changes in market interest rates.
The Company, including its Associate-owned store network, is exposed to fluctuations in interest rates by virtue of its borrowings under its bank credit facilities, commercial paper program and financing programs available to its Associates. Increases or decreases in interest rates will negatively or positively impact the financial performance of the Company.
The Company uses interest rate derivatives to manage this exposure and monitors market conditions and the impact of interest rate fluctuations on its fixed and floating rate debt instruments on an ongoing basis. The Company is party to an interest rate derivative agreement converting an aggregate notional principal amount of $50,000 (2009 - $100,000) of floating rate commercial paper debt into fixed rate debt. See Note 11 for further discussion of the derivative agreement.
As at June 19, 2010, the Company had $401,211 (2009 - $434,335) of unhedged floating rate debt. During the 12 and 24 weeks ended June 19, 2010, the Company's average outstanding unhedged floating rate debt was $580,450 and $599,222 (2009 - $581,492 and $626,231), respectively. Had interest rates been higher or lower by 50 basis points during the 12 and 24 weeks ended June 19, 2010, net earnings would have decreased or increased, respectively, by approximately $470 and $970 (2009 - $462 and $994), respectively, as a result of the Company's exposure to interest rate fluctuations on its unhedged floating rate debt.
Furthermore, the Company may be exposed to losses should any counterparty to its derivative agreements fail to fulfill its obligations. The Company has sought to minimize counterparty risk by transacting with counterparties that are large financial institutions. As at June 19, 2010 and June 20, 2009, there were no net exposures, as the interest rate derivative agreements were in a liability position.
Credit Risk
Credit risk is the risk that the Company's counterparties will fail to meet their financial obligations to the Company, causing a financial loss.
Accounts receivable arise primarily in respect of prescription sales billed to governments and third-party drug plans and, as a result, collection risk is low. There is no concentration of balances with debtors in the remaining accounts receivable. The Company does not consider its exposure to credit risk to be material.
Liquidity Risk
Liquidity risk is the risk that the Company will be unable to meet its obligations relating to its financial liabilities.
The Company prepares cash flow budgets and forecasts to ensure that it has sufficient funds through operations, access to bank facilities and access to debt and capital markets to meet its financial obligations, capital investment program and fund new investment opportunities or other unanticipated requirements as they arise. The Company manages its liquidity risk as it relates to financial liabilities by monitoring its cash flow from operating activities to meet its short-term financial liability obligations and planning for the repayment of its long-term financial liability obligations through cash flow from operating activities and/or the issuance of new debt.
The contractual maturities of the Company's financial liabilities as at June 19, 2010, are as follows:
Payments Payments due due Payments between 90 between 1 due in days and year and Payments the next less than less than due after 90 days a year 2 years 2 years Total ------------------------------------------------------------------------- Bank indebtedness $ 256,497 $ - $ - $ - $ 256,497 Commercial paper 184,000 - - - 184,000 Accounts payable 881,106 61,398 - - 942,504 Dividends payable 48,922 - - - 48,922 Medium-term notes - - 250,000 700,000 950,000 Other long-term liabilities - - 10,596 20,856 31,452 ------------------------------------------------------------------------- Total $1,370,525 $ 61,398 $ 260,596 $ 720,856 $2,413,375 ------------------------------------------------------------------------- -------------------------------------------------------------------------
There is no difference between the carrying value of bank indebtedness and the amount the Company is required to pay. The accounts payable and other long-term liabilities amounts exclude certain liabilities that are not considered financial liabilities.
11. FINANCIAL INSTRUMENTS
Interest Rate Derivative
As at June 19, 2010, the Company is party to an interest rate derivative agreement converting an aggregate notional principal amount of $50,000 of floating rate commercial paper debt into fixed rate debt. The agreement has a fixed rate payable of 4.18% and matures on December 16, 2010, with reset terms of one month.
Based on market values of the interest rate derivative agreement in place at June 19, 2010, the Company recognized a liability of $788 (2009 - $3,399), all of which was presented in accounts payable and accrued liabilities (2009 - $915 was presented in accounts payable and accrued liabilities and $2,484 was presented in other long-term liabilities). During the 12 and 24 weeks ended June 19, 2010 and June 20, 2009, the Company assessed that the interest rate derivatives were effective hedges for the floating interest rates on the associated commercial paper debt.
Equity Forward Derivatives
The Company uses cash-settled equity forward agreements to limit its exposure to future price changes in the Company's share price for share unit awards under the Company's LTIP and RSU Plan. The income or expense arising from the use of these instruments is included in cost of goods sold and other operating expenses for the period.
Based on market values of the equity forward agreements in place at June 19, 2010, the Company recognized a liability of $7,584, of which $2,415 is presented in accounts payable and accrued liabilities and $5,169 is presented in other long-term liabilities. Based on market values of the equity forward agreements in place at June 20, 2009, the Company recognized a net liability of $692, of which $870 was presented in other assets, $750 was presented in accounts payable and accrued liabilities and $812 was presented in other long- term liabilities. During the 12 and 24 weeks ended June 19, 2010 and June 20, 2009, the Company assessed that the percentages of the equity forward derivatives in place related to unearned units under the LTIP and RSU Plan were effective hedges for its exposure to future changes in the market price of its common shares in respect of the unearned units.
During the 12 and 24 weeks ended June 19, 2010, amounts previously recorded in accumulated other comprehensive loss of $9 and $18 (2009 - $76 and $167), respectively, were recognized in earnings.
Fair Value of Financial Instruments
The fair value of a financial instrument is the estimated amount that the Company would receive or pay to settle the financial assets and financial liabilities as at the reporting date.
The fair values of cash, accounts receivable, deposits, bank indebtedness, commercial paper, short-term debt, accounts payable and dividends payable approximate their carrying values at June 19, 2010 and June 20, 2009 due to their short-term maturities. The fair values of long-term receivables, revolving term facility and other long-term liabilities approximate their carrying values at June 19, 2010 and June 20, 2009 due to the current market rates associated with these instruments; and the fair value of the medium-term notes at June 19, 2010 is approximately $992,087 compared to a carrying value of $950,000 (excluding transaction costs) due to decreases in market interest rates for similar instruments (2009 - the fair value of long-term debt approximated its carrying value).
The interest rate and equity forward derivatives are recognized at fair value, which is determined based on current market rates and on information received from the Company's counterparties to these agreements. The interest rate derivative is valued using the one-month Reuters Canadian Dealer Offered Rate Index. The primary valuation input for the equity forward derivatives is the Company's common share price.
12. CAPITAL MANAGEMENT
The Company's primary objectives when managing capital are to profitably grow its business while maintaining adequate financing flexibility to fund attractive new investment opportunities and other unanticipated requirements or opportunities that may arise. Profitable growth is defined as earnings growth commensurate with the additional capital being invested in the business in order that the Company earns an attractive rate of return on that capital. The primary investments undertaken by the Company to drive profitable growth include additions to the selling square footage of its store network via the construction of new, relocated and expanded stores, including related leasehold improvements and fixtures, the acquisition of sites as part of a land bank program, as well as through the acquisition of independent drug stores or their prescription files. In addition, the Company makes capital investments in information technology and its distribution capabilities to support an expanding store network. The Company also provides working capital to its Associates via loans and/or loan guarantees. The Company largely relies on its cash flow from operations to fund its capital investment program and dividend distributions to its shareholders. This cash flow is supplemented, when necessary, through the borrowing of additional debt. No changes were made to these objectives during the period.
The Company considers its total capitalization to be bank indebtedness, commercial paper, short-term debt, long-term debt (including the current portion thereof) and shareholders' equity, net of cash. The Company also gives consideration to its obligations under operating leases when assessing its total capitalization. The Company manages its capital structure with a view to maintaining investment grade credit ratings from two credit rating agencies. In order to maintain its desired capital structure, the Company may adjust the level of dividends paid to shareholders, issue additional equity, repurchase shares for cancellation or issue or repay indebtedness. The Company has certain debt covenants and was in compliance with those covenants as at June 19, 2010 and June 20, 2009.
The Company monitors its capital structure principally through measuring its net debt to shareholders' equity and net debt to total capitalization ratios, and ensures its ability to service its debt and meet other fixed obligations by tracking its interest and other fixed charges coverage ratios.
The following table provides a summary of certain information with respect to the Company's capital structure and financial position as at the dates indicated.
June 19, June 20, January 2, 2010 2009 2010 ------------------------------------------------------------------------- Cash $ (62,670) $ (26,059) $ (44,391) Bank indebtedness 256,497 277,617 270,332 Commercial paper 183,590 240,148 260,386 Long-term debt 945,651 943,809 946,098 ---------------------------------------- Net debt 1,323,068 1,435,515 1,432,425 Shareholders' equity 3,987,621 3,575,032 3,826,110 ---------------------------------------- Total capitalization $ 5,310,689 $ 5,010,547 $ 5,258,535 ---------------------------------------- ---------------------------------------- Net debt:Shareholders' equity 0.33:1 0.40:1 0.37:1 Net debt:Total capitalization 0.25:1 0.29:1 0.27:1 EBITDA:Cash interest expense(1)(2) 20.86:1 17.86:1 19.59:1 (1) For purposes of calculating the ratios, EBITDA (earnings before interest, taxes, depreciation and amortization) is comprised of EBITDA for the 52 week and 53 week periods then ended, as appropriate. EBITDA is a non-GAAP financial measure. Non-GAAP financial measures do not have standardized meanings prescribed by GAAP and therefore may not be comparable to similar measures presented by other reporting issuers. (2) Cash interest expense is also a non-GAAP measure and is comprised of interest expense for the 52 week and 53 week periods then ended, as appropriate. It excludes the amortization of deferred financing costs and includes capitalized interest.
As measured by the ratios set out above, the Company maintained its desired capital structure and financial position during the period.
The following table provides a summary of the Company's credit ratings at June 19, 2010:
Standard & Poor's DBRS Limited --------------------------------- Corporate credit rating BBB+ - Senior unsecured debt BBB+ A (low) Commercial paper - R-1 (low)
There were no changes to the Company's credit ratings during the 12 and 24 weeks ended June 19, 2010.
On April 8, 2010, DBRS Limited placed the short and long-term ratings of the Company under review with negative implications. The rating action was in response to the Ontario Ministry of Health and Long-Term Care's April 7, 2010 announcement with respect to further drug reform in the province.
Earnings Coverage Exhibit to the Consolidated Financial Statements
52 Weeks Ended June 19, 2010 ------------------------------------------------------------------------- Earnings coverage on long-term debt obligations 19.22 times -------------------------------------------------------------------------
The earnings coverage ratio on long-term debt (including any current portion) is equal to earnings (before interest and income taxes) divided by interest expense on long-term debt (including any current portion). Interest expense excludes any amounts in respect of amortization and includes amounts capitalized to property and equipment that adjusted interest expense as shown in the consolidated statement of earnings of the Company for the period.
%SEDAR: 00016987EF
For further information: Media Contact: Tammy Smitham, Director, Communications & Corporate Affairs, (416) 490-2892, or [email protected], (416) 493-1220, ext. 5500; Investor Relations: (416) 493-1220, ext. 5678, [email protected]
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