LOBLAW COMPANIES LTD. $48 (Toronto symbol L; Conservative Growth Portfolio, Consumer sector; Shares outstanding: 412.7 million; Market cap: $19.8 billion; Price-to-sales ratio: 0.4; Dividend yield: 2.0%; TSINetwork Rating: Above Average; www.loblaw.ca) is Canada’s largest food retailer, with roughly 1,200 stores. Its banners include Loblaws, Provigo, Fortinos, Real Canadian Superstore and No Frills.

The company recently acquired the 1,250-store Shoppers Drug Mart chain. Loblaw paid $12.3 billion, consisting of $6.6 billion in cash and $5.7 billion in Loblaw common shares. Shoppers shareholders now own 29% of the combined company.

Loblaw’s parent company, George Weston Ltd. (Toronto symbol WN), agreed to help it pay for this acquisition by purchasing $500 million worth of new shares. Due to the extra shares outstanding, Weston now owns 46% of Loblaw, down from 63% prior to the purchase.

Shoppers should add $11 billion to Loblaw’s annual sales. To put that in perspective, the company’s sales rose 5.3%, from $30.7 billion in 2009 to $32.4 billion in 2009.

Earnings rose 17.2%, from $656 million in 2009 to $769 million in 2011. Earnings per share rose at a slower rate of 14.2%, from $2.39 to $2.73, on more shares outstanding.

Loblaw’s earnings then fell to $2.25 a share (or a total of $634 million) in 2012, and to $2.24 a share (or $630 million) in 2013. That’s because of costs related to a multi-year plan to streamline its supply chain and avoid product shortages. Without all unusual items, Loblaw’s earnings per share rose 3.2%, from $2.52 in 2012 to $2.60 in 2013.

The company feels it can save $100 million this year by combining its marketing and distribution functions with those of Shoppers Drug Mart. By the end of the third year, it expects annual savings of $300 million.

Loblaw will operate Shoppers as a separate chain. That makes sense, as most Shoppers stores are in urban areas while many of Loblaw’s supermarkets are in suburban areas.

Finding new ways to compete

The company continues to find ways to encourage repeat visits and boost per-shopper spending. For example, it has renovated 60% of its stores in the past three years, including adding more space for fresh produce, and for non-food goods. It should complete these upgrades by the end of 2014.

At the same time, the company continues to expand its popular President’s Choice line of private label products, which now supply 30% of its sales. It recently launched a line of gluten-free PC products, as well as organic foods and meats without antibiotics or hormones. These products should help Loblaw appeal to increasingly health-conscious consumers.

Another of Loblaw’s top private labels is its Joe Fresh line of casual clothing and accessories. The company mainly sells these goods in over 300 of its supermarkets, as well as through 17 stand-alone stores in the U.S. and Canada. Joe Fresh recently opened its first store outside North America, in South Korea. It plans to open 140 more outlets in 23 countries over the next four years.

New loyalty plan looks like a hit

Loblaw is also attracting customers with its popular PC Points loyalty plan, which lets shoppers earn points and redeem them for free groceries. It recently launched PC Plus, which matches promotions to individual customers’ shopping patterns. PC Plus now has over 5 million users.

PC Plus’s success should help spur demand for the company’s President’s Choice MasterCard credit cards and other financial services, such as bank accounts and insurance. Earnings at this business jumped 49.5% in 2013 and accounted for 8% of Loblaw’s total.

Loblaw continues to benefit from last year’s transfer of most of its real estate holdings to a new real estate investment trust (REIT) called Choice Properties (Toronto symbol CHP.UN). Loblaw owns 82.6% of Choice Properties and accounts for 89.5% of the REIT’s rental income.

REITs pay no income taxes, which gives them more cash to develop and expand their existing properties and buy land for new stores. The REIT structure will also make it easier for Loblaw to attract a wider variety of tenants to its new developments.

Loblaw had to borrow the cash it needed to buy Shoppers Drug Mart. As of March 22, 2014, its long-term debt was $7.2 billion. That’s a high, but still manageable, 36% of its market cap. It also held cash of $2.6 billion, or $9.11 a share.

Higher earnings will cut p/e in 2015

The addition of Shoppers Drug Mart should increase Loblaw’s earnings to $2.82 a share in 2014. The stock trades at 17.0 times that estimate. Its 2015 earnings should reach $3.41 a share, and the stock trades at a more reasonable 14.1 times that forecast.

Cost savings from the merger will also give Loblaw more room to raise its dividend. The current annual rate of $0.98 a share yields 2.0%.

Loblaw is a buy.