Metcash Initiatives Gain Some Early Traction

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

-Funding change from profits unsustainable
-Hardware integration case not convincing
-Importance of getting the fresh offer right
 

By Eva Brocklehurst

Metcash ((MTS)), the battler, has updated the market on its strategic initiatives. The company is implementing substantial changes to its product offering and pricing and has made some progress, with the IGA retailer base reporting some examples of improvement. Still, brokers retain their relative preconceptions, given the extent of the challenges Metcash faces.

Credit Suisse is not enthused by the near-term outlook because of the potential for profit destruction developing the supermarket sector, as well as the prospect of a very weak first half for Metcash given the timing of its pricing initiatives. Price matching has been implemented in 900 stores and the quality and branding of its Black and Gold range has been improved in 1100 stores, with positive responses.

To date, the changes have been funded from a reduction in Metcash profits but Credit Suisse suspects this cannot be sustained for much longer. To that end some specific cost reduction initiatives have been implemented, with more detail to be presented at the first half results.

The company intends to remove duplication between wholesale and retail operations but this is not an easy strategy to implement, the broker observes, because of significant retailer sunk costs and imperfect alignment of incentives. Signals that the company is making headway, or otherwise, should come from the rate of adoption of its Diamond Store Accelerator (DSA) program, which is addressing competitive pricing and improved fresh ranges, service and store environments.

Some discussion at the briefing centred on the merits of integrating the Danks business with Mitre 10 hardware. Credit Suisse is not convinced by the strategic case for network integration. The broker believes Metcash would be better placed if it cherry picked larger retailers from the Danks network and there might also be a better opportunity for someone else to realise, perhaps via a sale of Mitre 10, given the company has its hands full with its food business.

Deutsche Bank envisages two problems from combining the networks. Firstly, the Australian Competition and Consumer Commission (ACCC) may not let it happen. Secondly, Metcash would need to raise equity to fund a deal if it were to obtain Danks customers by acquiring the business.

There are many risks remaining, JP Morgan contends, and it is too early to become more constructive. What is clear is that IGA retailers are recognising that a healthy Metcash is vital for success and this moderates the risks from a lack of vertical integration. Still, the broker notes, no division is performing at an optimum level and there remain risks from Aldi's expansion into South Australia and Western Australia.

Citi is more confident and believes the positioning as a differentiated offer in supermarket retailing will underpin the company's viability in the long term. The broker welcomes the early signs of traction from the changes being implemented. Earnings are expected to stabilise in the second half and result in a re-rating.

One aspect the broker is not convinced by is the need for separate banners under the IGA umbrella, such as Supa IGA or IGA Xpress to denote large or small stores. This confuses consumers as it is difficult to have IGA stand for a range of different attributes for different shoppers, while Supa IGA is vulnerable as it tries to compete with the major chains with a perception it is more about convenience.

The most important aspect of stabilising the food business is getting the fresh offering right, which history suggests has a low probability in Deutsche Bank's view. The broker believes, while price matching and the DSA program should assist retailer performance both are costly, and the company is chasing a moving target, as Woolworths ((WOW)) is cutting prices and Aldi has commenced its roll out into the Metcash stronghold of WA and SA.

The company's "teamwork score" may be stable but Deutsche Bank observes this is only in packaged grocery, which is not growing. Market growth is driven by fresh and specialised categories. Hence, it is critical to get fresh produce right.

The health & beauty category was one that was mentioned where there might be an opportunity to improve sales as IGA generally under-indexes relative to the market. Deutsche Bank cautions that this used to be a growth engine for the supermarket chains but a number of aggressive pharmacy chains have taken considerable share in the category now.

The liquor business is the best part of the Metcash group, in Deutsche Bank's view, and a separation is not ruled out at some point in time to extract more value, although the company has not commented on this subject.

UBS notes major retailers continue to open new stores and pass on supply-chain savings and Metcash is exposed to the threat that these retailers are growing their share of the liquor retailing market. One factor that remains in the company's favour is that the ACCC is likely to closely monitor any decline in independent food & liquor retailers and limit the extent of any reduction.

FNArena's database has one Buy, four Hold, and two Sell ratings for Metcash. The consensus target is $1.26, suggesting 19.9% upside to the last share price. Targets range from $1.00 (UBS) to $1.70 (Citi).

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