Metcash Under Pressure

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-Metcash earnings under pressure
-Competition is fierce
-Brokers uninspired by outlook
-Franklins acquisition value looks shaky

By Eva Brocklehurst

It's tough out there for grocery wholesaler Metcash ((MTS)). A turnaround in its rival Coles, owned by Wesfarmers ((WES)), falling food inflation and problems with the Franklins stores have put the cat among the pigeons. Brokers were universally unimpressed with the company's half-year financial results. The food and grocery distributor and hardware retailer has lowered its guidance for FY13 earnings by 2-3% over FY12.

Goldman Sachs has maintained a Hold rating, noting that the core business struggled over recent years and that sent Metcash looking for acquisitions. This came in the guise of a move into hardware (Mitre 10) and automotive distribution. However, core returns have declined and the risk profile has increased and it's not a good look. The broker has revised its forecasts to reflect weak underlying trading conditions and a lower earnings contribution from Franklins. Goldman has reduced earnings forecasts for FY13 by 5% and for FY14 by 6%. The broker's price target has been reduced to $3.47 from $3.62. Goldman believes the grocery dynamic has significantly changed with the turnaround of the Coles supermarket chain and it has put significant pressure on the other players.

Bank of America-Merrill Lynch also considers Metcash has been affected by the turnaround in Coles. Overall, BA-ML sees material risk to the Australian food retailing industry earnings in the longer term as consumers return to eating out and food inflation returns. The broker believes the independents, which includes Metcash customers in the IGA network, are sustaining falling market share and declining comparative store sales growth. While the company noted that its market share slipped in response to the deregulation in trading hours in Western Australia BA-ML thinks this trend may even accelerate, given the change in regulation only took effect two months ago. For Metcash being a wholesaler, as opposed to a retailer, closing stores is a worst case scenario for the company, according to the broker, as it not only means a loss of the sales, it potentially means a loss to rental and interest income. Such a business model causes Metcash to have much higher levels of operating de-leverage than the likes of Woolworths and Coles. BA-ML has a Sell rating and has revised the price target to $3.10 from $3.20.

JP Morgan puts the blame at the door of Coles, which sought the value proposition by substantially reducing key lines and making its major competitor, Woolworths ((WOW)), raise its marketing on discounting. The broker says Metcash is at a competitive disadvantage as IGA retailers are unlikely to lead on price and the discounting war serves to enhance customer trust in larger retailers relative to smaller retailers. The broker has reduced the price target to $3.56 from $3.84.

Citi said Metcash has already sold most of its top performing Franklins stores and  is now left with smaller more marginal stores, where performance continues to decline. MetCash now expects to shut down 27 stores compared to initial expectations of 12-15. Added to the IGA market share loss and the whole outlook is under pressure. Nevertheless, Citi noted the performance from liquor, hardware and automotive segments were encouraging although not enough to counteract food & grocery. Citi said the results were in line with its expectations and it has the most favourable leaning towards the stock on the FNArena database. It has retained its Buy rating and price target of $4.25.

The condition of the Franklins business clearly deteriorated during the period when the ACCC was considering the acquisition, Deutsche Bank maintains, and industry feedback suggests issues with landlord negotiations were responsible for a number of the problematic stores. Management has suggested that it is the smaller stores which will be closing but Deutsche suspects, at least in some cases, landlords have been reluctant to hand over attractive sites given the potential to shop around to other operators. If this is correct, some lucrative stores may also be closed. The broker's major concern with this is that the sales and earnings (at a wholesale level) for all Franklins stores are already booked. When stores are closed, these sales which are already in the base are lost. Given the majority of stores will be closed this financial year, this will cause a considerable drag on sales and earnings in FY14. The broker assumes 30 stores will be closed and allows for a sales drag of around $180m on a full year basis. Acknowledging that when stores are transferred to independent operators, trading is likely to improve, Deutsche doubts it will provide an increase in wholesale sales for Metcash. The other aspect that concerns Deutsche is that Metcash is unlikely to cover its cost of capital on the Franklins investment.

It's the onerous lease provisioning associated with the Franklins stores which have not been sold that has Credit Suisse estimating the transaction metrics are now only marginally positive for Metcash. This broker estimates the total cost of acquisition to date at $300mn–$350mn (including provisioning for rental subsidies, trading losses and receipts on sale of stores). Ongoing earnings benefit is now at the low end of the expected $25m to $40m due to fewer-than-anticipated stores being transferred to the IGA network, according to Credit Suisse. Of the 90 stores acquired, 58 have been transferred to new owners, five stores are under review and 27 are to be closed or likely to be closed. Credit Suisse has a Hold rating with a target price of $3.85.

CIMB also believes the Franklins acquisition has not succeeded thus far. However, the broker believes the losses are now factored into forecasts, and should subside from FY14. From a low base, CIMB sees potential for supply chain and revenue synergies going forward and notes Metcash is increasingly focusing on sectors with more appealing industry structures such as Australian Liquor Marketers and Mitre 10, which delivered solid earnings growth in the first half of FY13. An expectation of further growth from these businesses, and therefore, earnings stability at group level, is keeping this broker with a Hold rating and price target of $3.20.

UBS said Metcash is a well run business although the same issues are making it concerned about the company's ability to outperform in the medium term. UBS believes competitive pressures driving the margin contraction are unlikely to abate. The broker retains a Hold rating and a price target of $3.30.

On the FNArena database there are six Hold ratings, one Buy (Citi) and one Sell (BA-ML).  The consensus price target is $3.56 within a range of $3.10 to $4.25. 
 

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