Metcash Stuck On Struggle Street

This story features METCASH LIMITED. For more info SHARE ANALYSIS: MTS

-More focus on retail end
-Capital position a concern
-Revenue growth under pressure
-Substantial reinvestment needed
 

By Eva Brocklehurst

Metcash ((MTS)) remains on Struggle Street. Some brokers were not surprised by the half-year result and are relatively optimistic that the grocery distributor will thrash out a good plan while others have used the report to re-evaluate the stock. They all agree that food and grocery earnings will remain under pressure. If there was a positive to emerge from the company's briefing it was that management is fully aware of the situation.

CIMB took the news that the company would focus more on the retail end rather than the wholesale end as a good sign. It indicates the company is willing to make concessions, building a strategy around a shopper-led volume expansion. This will require more marketing and an increase in the private label range. The broker also liked the fact the company admitted the intense cost cutting up until now was a short-term solution and there's been a return to re-investing in the business. Retailers will need to come on board and this is the key to success. CIMB is one of two brokers maintaining a Buy rating on the FNArena database. The other is Citi.

Citi is worried about the costs of implementing a new strategy. The initial phase of the strategy requires lower shelf prices and lower private label prices. This applies to Supa IGA stores which are only 38% of the food and grocery segment. The broker expects the net cost to be $20m. This investment will be ahead of any earnings uplift. Citi expects the reinstated Dividend Reinvestment Plan will provide adequate funding for growth capex on supply chain initiatives and property development.

Citi is happy to retain a Buy rating while the stock is likely to trade at a discount to fundamentals until clarity around the strategy is provided next March. Why the delay in announcing details of the new plan? Citi thinks it's about execution. The business is reliant on thousands of suppliers and independent retailers and agreement from both sides is needed. The broker expects a trough in earnings in FY15 as this will be the first year of the new strategy. Growth of 10% is expected in FY16 amid faster sales growth and margin recovery.

Deutsche Bank is worried about the capital position. Debt levels have risen despite the strong operating cash flow and the concerns are exacerbated by the considerable capital expenditure required and investment in marketing to improve competitiveness. Earning in FY14 are expected to be lower than FY12, and historically cash conversion has been weaker in the second half. This suggests an increase to net debt. Deutsche Bank notes leverage is approaching levels where Metcash has typically come to the market for funding. The CFO suggested at the briefing that the company had other options and, while these were not spelled out, Deutsche Bank thinks one could be a hybrid instrument. The DRP is not underwritten, but if the situation deteriorates then the company could do so. This would effectively constitute an equity raising but have the advantage of distributing franking credits.

Deutsche Bank believes the reduction in the dividend pay-out, to 70% from the 86% in FY13, was inevitable, as the company has been paying dividends in excess of free cash flow for some time. The broker was disappointed with the lack of detail on the strategic review but notes that CEO Ian Morrice believes in taking more ownership at the retail level to ensure customers are being offered the right products, at the right price, in the right format. This makes sense but the broker thinks it is difficult for a wholesaler, and considerable investment in supply chain and refurbishment may be required.

UBS believes the outlook hinges on the outcome of the review in March and there's few catalysts ahead of that. The broker suspects the market is pricing in a 15-25% re-basing of earnings in FY15 and this could then prove too pessimistic. Hence, there is some scope for a re-rating and UBS thinks a Neutral rating is the best way to go at this stage. Core profit fell 1.9% but this was boosted by lower tax and interest, a weak signal in JP Morgan's opinion. The broker expects Metcash to continue to lose market share, with that share unlikely to be above 18%, down from the peak of 20% several years ago. Moreover, food inflation is unlikely. Fresh food inflation was expected at the start of 2013 but did not eventuate and deflation was the story from mid 2013. Dry grocery inflation has been modest. As a result, JP Morgan expects revenue growth will be under pressure for the time being.

A new strategy makes sense to Macquarie, as Metcash has struggled to compete effectively, but execution is the key and will take time. The first half result and the initial framework outlined for the strategic review are unlikely to reverse the downward earnings spiral and Macquarie has decided to downgrade to Neutral from Outperform. Moreover, the broker observes that food and grocery margins have contracted to 3.36%, a level not seen since 2006. Management has also stated there's no firm sign of a pick up in consumer sentiment.

The performance of the non-food segments was better than BA-Merrill Lynch expected. The broker acknowledges Metcash has made an number of positive acquisitions and gained strong supply contracts in liquor but these do make a dent in the negative aspects emanating from food and grocery, which currently makes up 75-80% of earnings. For Merrills, the key is growing top line sales but this means investing materially in support for retailers. How much? That is yet to be determined but one thing is assured for most brokers, the amount will be substantial. Merrills thinks the risk of earnings downgrades, or a future capital raising, is high. The broker believe Metcash extracted too much cost out of the business in the past couple of year and now needs to reinvest.

Ratings run the range on the FNArena database. There are two Buy, three Hold and three Sell. The consensus target is $3.26, suggesting 2.6% upside to the last share price. This compares with $3.30 ahead of the report. Targets range from $2.80 to $3.80. The dividend yield is 7.2% and 6.9% on FY14 and FY15 forecasts respectively.
 

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