Metcash Still Without Short Term Catalyst

This story features METCASH LIMITED, and other companies. For more info SHARE ANALYSIS: MTS

By Chris Shaw

In a trading update last week Metcash ((MTS)) reiterated full year earnings guidance for FY10 of 7-10% earnings per share (EPS) growth. This comes despite management noting trading conditions in January and February had been fairly tough.

RBS Australia expects earnings will be at the lower end of this range, reflecting what it estimates to be sustained produce price deflation of 5-8% and the re-emergence of value-conscious consumers.

At the briefing, Metcash management indicated it will be responding to the actions of major retailers such as Woolworths ((WOW)) and the Wesfarmers' owned Coles ((WES)) by introducing a supplier funded price reduction scheme.

JP Morgan suggests what is occurring in the retail sector is actually a marketing rather than a pricing war, which should work in Metcash's favour given it is more agile than the larger chains in terms of tailoring its efforts to particular markets.

For this reason Metcash has been able to enhance margins in the current tough operating environment by changing its product mix, which is offsetting the increase in discounts being offered.

Along with the price reduction scheme, Metcash has also announced a rationalisation of its Campbell's Cash & Carry warehouse network by closing 8 of the existing 20 warehouses. This will see a $15.4 million provision in FY10, but JP Morgan estimates it will deliver a $4-$5 million earnings before interest and tax benefit in FY11, increasing to around $7 million in later years.

While these were the major operational points of notes in the briefing, there was also time spent in further explaining the company's strategy, something Macquarie sums up by pointing out Metcash is a wholesaler and not a retailer as it makes money from buying rather than selling.

While the company offers full support to its retail partners, Macquarie notes the key revenue drivers for Metcash remain buying and logistics. As Citi points out, the ability to differentiate and offer localised services allows the company to keep direct competition with the major chains at a minimum.

This strategy has allowed Metcash to create a monopoly distribution asset on which it has generated excess returns. The issue in Macquarie's view is some of these returns will need to be invested back into retailers to support ongoing volume growth. This supports th estockbrokers view the excess returns the company has enjoyed won't be sustainable longer-term.

Macquarie had previously rated the stock as Underperform to reflect this view but following a period of share price underperformance, the stockbroker has now upgraded to a Neutral rating on Metcash.

In Citi's view, Metcash's prospects are tied to rational behaviour in the supermarket industry. What this means is if the supermarket sector generates high returns there is more scope for independent retailers to open new stores or invest in existing stores.

Current conditions are not conducive to this as the low food inflation environment is causing an industry-wide sales slowdown, but as this passes the value equation in the stock will become more evident.

Citi notes Metcash is currently trading at a 30% earnings multiple discount to Woolworths while offering a higher dividend yield, so it continues to rate the stock as a Buy on valuation grounds.

RBS Australia agrees there is value in the stock but doesn't see any catalyst in the short-term that will see this value realised. Given this, RBS continues to rate Metcash as a Hold.

One potential catalyst longer-term is developing the Mitre 10 assets, but in the view of Credit Suisse it will be at least a year before any positive news comes out of this division. This means the tough grocery retail market conditions will be the main short-term price driver, so it shares RBS's view shorter-term outperformance is unlikely.

JP Morgan rates the stock as Underweight, justifying its rating by arguing there remains the potential for independent supermarkets to lose market share as competition intensifies. As with Macquarie, JPM sees scope for Metcash to need to redistribute system returns towards store owners to support its network, so reducing its returns.

Overall the FNArena database shows Metcash is rated as Buy once, Accumulate once, Hold seven times and Sell once. The average price target is $4.58, down from $4.66 prior to the strategy update. Consensus earnings per share forecasts according to the database are 31.3c in FY10 and 33.9c in FY11. These are little changed as a result of the briefing.

Shares in Metcash today are stronger and as at 11.40am the stock was up 5c at $4.17. This compares to a range over the past year of $3.86 to $4.74 and implies around 9% upside to the average price target.

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