Metcash Battered By Competitors’ Price War

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

-Discounting pressures earnings outlook
-Discounting intensity should wane
-Likely cut to the dividend in FY14
-Dividend yield remains healthy
 

By Eva Brocklehurst

Grocery distributor Metcash ((MTS)) is fighting hard. The supplier to IGA supermarkets has become collateral damage as the two giants in the grocery industry go hammer and tongs in their price war. At the AGM this week Metcash flagged weak consumer confidence and high promotional intensity as headwinds and a reason for an early downgrade to FY14 earnings guidance but, as Citi points out, only one of those influences is relatively new.

If fierce competition generally in the grocery space wasn't enough, the fact the major chains Woolworths ((WOW)) and Coles ((WES)) own petrol outlets and cross-discount at a furious rate makes it hard for Metcash, as the company doesn't have a petrol offer. Citi estimates that the two majors, when offering 8c per litre petrol discounts, get a combined market share gain of 0.5%. This encourages shoppers to make fewer trips to the supermarket in order to increase spending totals at the one point, so as to rack up the minimum $30 for the 8c fuel discount on offer. This reduces the number of smaller intra-week purchases, which typically might have occurred at an IGA store.

The good news for Metcash, if there is some, is that this discounting has eased because Coles and Woolies need at least 0.7 percentage points in share to pay for the promotion, so there should be less impact from discounting in Metcash's second half results. The discounting eased after Woolies decided to match Coles' 8c discount. Both retain ad hoc targeted offers for customers with large budgets. Aldi and Costco continue to take market share through store roll-outs, so the market share loss was mostly attributed to Metcash.

Deutsche Bank suspects that, while petrol discounting may subside, the majors are likely to allocate the promotional spending to sophisticated targeted offers, which Metcash will find difficult to match given its lack of customer data. The only reprieve for Metcash is a return to food inflation, as this would create some operating leverage in the business. With recent commentary from Coles and Woolworths, as well as the fall in soft commodity prices, the broker does not expect a major improvement on this front in the near term. 

UBS suspects the strong uptake of petrol discounts raises the likelihood that they’ll be re-introduced. This carries the risk that Metcash's  increased investment in marketing won't yield any benefits.The magnitude of the earnings revisions means there's a risk to the dividend, in the broker's view, particularly with cash flow likely to weaken as working capital benefits ease. Valuation still looks fair, hence UBS retains a Neutral rating. BA-Merrill Lynch actually suspects the recent aggressive price action in the petrol businesses has accelerated the market share shift away from independent grocers over the past 12 months.

Is there some hope? Well CIMB thinks the company may have hit the low point, as discounting activity is not expected to return to the recent elevated levels. In fact, the broker notes Coles pointed to the heavy discounting as a reason for its subdued second half FY13 earnings margin. Then there's the ACCC investigation on anti-competitive behaviour. This may throw up a lifeline. As well, Metcash will begin to cycle the market share losses from Western Australian trading de-regulation in the second quarter of FY14.

Citi forecasts a 1.2% sales decline in food and grocery and this will lead to a 10.7% decline in earnings in FY14. The slowdown in sales for Metcash exposes the high fixed cost base of the typical wholesaler. Metcash has limited options in Citi's view and the broker expects a cut to the final dividend. The company could increase the pay-out ratio to maintain the dividend per share, but the yield is still attractive and cutting the dividend will give new CEO Ian Morrice more flexibility to implement his new business plan. Despite the gloom Citi retains a Buy rating because the stock still represents compelling value with a fully franked dividend yield of 7.7% an attractive price/earnings multiple of 11 times.

Deutsche Bank now assume sales from the grocery division will contract by 4% in FY14, and there will be a 30 basis point margin contraction to allow for operating de-leverage. Given the business was already tight on cash, the broker has modestly reduced the forecast dividend pay-out ratio in FY14 to 67%. It all adds up to a ratings downgrade and the recommendation is reduced to Sell from Hold.

Metcash covers the spectrum of ratings on the FNArena database. There are two Buy, four Hold and two Sell. The price targets range from $2.80 to $3.90 and the consensus price target is $3.39, suggesting 7.5% upside to the last share price. The dividend yield on consensus FY14 forecasts is 7.6% and on FY15 is 7.8%.
 

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