Urgent Need For Metcash To Arrest Decline

This story features WOOLWORTHS GROUP LIMITED, and other companies. For more info SHARE ANALYSIS: WOW

-Need to improve IGA relations
-Need to arrest declining share
-Need to revitalise store traffic
 

By Eva Brocklehurst

Brokers are worried about the declining revenue trend and fear dividends may be reduced further. Whatever the outcome of the review, to be revealed on Friday, there will be costs, that's for sure. There is increased competition from the majors as well as Aldi in the key markets of South Australia and Western Australia. JP Morgan fears the execution of the company's plans will go awry because of the lack of vertical integration and fiercely independent retailers with a distrustful attitude.

UBS was hopeful back in December that after the re-basing of the earnings profile there would be scope for a re-rating of Metcash. CIMB was one of the most optimistic. The broker liked the stated desire to shift focus away from wholesaling to the consumer but the company had problems with the lack of constructive co-operation from its retailers. Whatever the outcome of the review, the broker noted a lower dividend and reinstated reinvestment program was a sign that Metcash was preparing the balance sheet. Macquarie was not inclined to think the strategic review would do anything to alleviate the downward pressure on the stock.

The core food and grocery division experienced a 1.5% fall in revenue in the first half and this was the second consecutive half-year of revenue decline. On an underlying revenue growth basis, adjusting for the Franklins acquisition as well as the closure of Supabarn and Campbell's Warehouse, JP Morgan is disturbed by a trend decline that's been happening since the second half of 2012. The broker concludes that market share is being lost.

One feature of Australian food retailing is the lower rates of inflation over recent years. This presents a significant historical change. Fresh food inflation was expected to materialise in 2013 but did not, and deflation appeared late in the year. Going forward, the one catalyst for dry grocery inflation is the falling Australian dollar but competitive intensity remains elevated and the company cannot count on inflation to reinstate a positive revenue trend. Discounts in the food sector, JP Morgan notes, are increasingly exceeding 50%. This suggests the use of price remains pivotal to competitor strategies to drive custom and presents a difficult position for a fixed cost business like Metcash.

Another aspect of the competition between Coles and Woolworths ((WOW)) was that Metcash enjoyed a benefit when one of these two was measurably weaker than the other. JP Morgan observes this was the case in the early stages of Wesfarmers' ((WES)) turnaround strategy for Coles. Now the gap in like-for-like sales growth between the two rivals has narrowed. Hence, Metcash is less able to drive any wedge between the majors. Notably, Woolworths has focused on growing its footprint and this expansion is having an negative impact on the independents.

Then there's the ever-present issue of petrol discounting. The elevated level of promotions hurt Metcash as consumers shunned convenience-focused independent retailers in order to increase their basket size at the major supermarkets, and get the associated petrol rewards. The Australian competition watchdog, the ACCC, stepped in to stem the bundling of petrol discounts but JP Morgan is unconvinced this will provide the necessary benefit to independents, suspecting other factors will continue to undermine market share. Aldi's aggressive expansion is a feature in this regard. Aldi has definitely affected prices, with the ACCC enquiry in 2008 noting that prices were lower in Coles and Woolworths stores that were near an Aldi. Aldi intends to expand to a network of 800 stores in NSW, Victoria and Queensland with 200 in South Australia and Western Australia.

JP Morgan does not find the risk/reward compelling and has downgraded Metcash's rating to Underweight from Neutral.

CLSA also worries the company is losing market share. The broker thinks this company's "parasitic" relationship with the independents will need to change, quickly. Regardless of what the further plans entail, the broker has outlined a course considered essential for the company's prosperity. One aspect Metcash has misjudged is food deflation. The broker notes the company's reluctance to consider the food deflation issue as a structural change in the marketplace. Metcash believes it is a cyclical issue that would be solved with the weakening of the Australian dollar. As JP Morgan also noted, CLSA is inclined to think this attitude was an oversight that missed the market challenges that were arising on the price front.

There's one essential item that must be on the company's agenda in CLSA's opinion. The decline in foot traffic across the network must be halted. To do this the company must address its relationship with the independents. It must improve the in-store experience, evolve a differentiated branding structure, innovate with ranges, address a poor private-label offering and develop a relevant loyalty scheme. An online shopping scheme would be a bonus. The broker accepts such changes would come at a cost, but they are essential.

Metcash services almost 1,500 supermarkets operating under the IGA brand as well as 1,000 or so other small stores under a variety of brands such as Friendly Grocer, Eziway and FoodWorks. There are a host of reasons why consumers might prefer to shop at these stores, including preference for local product, freshness, support for the underdog, or convenience. It's a matter of harnessing this sentiment, in CLSA's view.

The broker agrees with JP Morgan in that Metcash was able to make headway when Coles was stumbling, consolidating much of the wholesale sector and pooling the buying power of the independents. Then, price wars reared in 2011 and the business model started to buckle. CLSA also notes that Metcash has materially de-rated over the past three years and, while value looks to be emerging, this will only continue if the loss of market share can be arrested. Until the company proves the bull case scenario CLSA retains a Sell rating and $2.80 target.

On the FNArena data base there is one Buy rating, two Hold and four Sell. The Sell ratings have risen from two, to three and now four, as FNArena has followed the stock over the past year. The consensus price target is $3.09, suggesting just 0.1% upside to the last share price. The dividend yield on FY14 and FY15 forecasts is 7.7% and 7.0% respectively.

See also, Metcash Stuck On Struggle Street on December 3 2013.
 

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