Metcash Outlines A Costly Path To Growth

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

-Revamping IGA brand, product
-Investing in price competitiveness
-Costly and daunting task ahead
 

By Eva Brocklehurst

The day of reckoning has arrived. Metcash ((MTS)) has bitten the bullet and announced a large reinvestment in its brands and supply chain that the company hopes will return the business to a growth path.

The strategy was largely what brokers were hoping for but they remain polarised in their outlook. CIMB remains one of the more optimistic, retaining an Add rating, while Macquarie has downgraded to Underperform, acknowledging it is a somewhat belated downgrade. The strategy is considered a credible approach to address the significant problems that face the business but most brokers are concerned about the execution risk and believe the benefits will take some time to materialise.

The direction was largely expected – a revamping of the IGA brand and stores and streamlining of product ranges. Metcash will start by applying operating expenditure of $40-45m which, in FY15, will contribute to a decline in earnings with a return to growth forecast for FY16. Capital expenditure of $575-675m will be undertaken over five years, funded by a reduction in the dividend pay-out ratio to 60% from 70% and a dividend reinvestment plan.

Investment in food distribution will be made over growth in vehicle and hardware, so growth initiatives in the latter two are likely to be constrained. The strategy also entails increased retail differentiation. Credit Suisse agrees with this but considers it likely to diminish Metcash in the independent value chain. The broker considers the strategy will inevitably bring some internal buying by multi-store operators and competition with other specialist wholesalers and retail profits are likely to expand ahead of Metcash profits.

Credit Suisse also thinks improving the execution standards for IGA retailers will lead to retailer attrition and a risk of defection to competitor wholesalers, with Spar being a particular risk in Queensland and NSW. Hence, Metcash will likely emerge with a smaller but more sustainable retail network. Credit Suisse also highlights the $180m investment in automating the supply chain, suspecting it will lock Metcash into a cost structure that's commensurate with the current wholesale volume. There appears to be no net increase to earnings from the investment.

JP Morgan had not expected such a serious investment to be made and thinks this signals Metcash is in a better position to address the issues. The broker still worries about the ability of Metcash to change the independent retailers' approach and this lack of vertical integration is a key stumbling block. In the company's favour, JP Morgan believes the changes in private label should ensure that retailers remain loyal to Metcash instead of seeking product from third parties. The broker observes the risk on compliance is still there as universal execution across such a vast network remains difficult.

The prospect of a more customer-led business – responding to demand rather than simply supplying goods to the retailer – with lower prices, cleaner ranges and better stores is welcome, albeit overdue according to UBS. The broker thinks the stock will trade at a discount until results are seen, given the strength of the major competitors. The stock looks cheap but the broker agrees with the strategy and expects Metcash will be a market performer over the next six to 12 months.

Macquarie wonders whether the new strategy will be enough. It's credible but requires a substantial amount of investment on Metcash's part and the benefit will lag that of the retailers. Metcash will spend $100-125m over the next five year on refurbishing the stores alongside a co-investment from the independent retailers. Will the independents come to the party? Macquarie also observes the company now needs to catch up to the major supermarkets and invest heavily in price. This is a key factor behind the re-basing of FY15 earnings.

Metcash has indicated there's a 3% cost differential favouring the majors on everyday items and this can be exacerbated at the store if the independent retailer inflates the price further. Even greater price reductions are expected to be undertaken on the private labels such as Black & Gold and No Frills. It will be costly. Macquarie thinks there'll be little positive news over the next 12 months.

BA-Merrill Lynch was surprised at how poor the second half of FY14 will be in terms of earnings. The broker had expected the cessation of the excessive petrol discounting by the majors would have had a better impact on financials as well as the increased stock profits from rises in tobacco excise. The company appears to be targeting a price-matching strategy with its Black & Gold brand but Merrills questions whether the $40-45m in operating expenditure will be enough to make this brand competitive.

Metcash is now trading at a large discount to the consumer staples index relative to its 10-year history. CIMB thinks this is unwarranted, given the re-based earnings for FY15 and the improved outlook for food inflation after several years of deflation because of a high Australian dollar. CIMB thinks an easing of food deflation and the cessation of the majors' fuel cross subsidising will make the task less daunting. The broker believes the most notable deficiency in the company's business was the lack of co-operation with the independent retailers. This is being addressed with an investment in pricing, refurbishment and best-practice benchmarking of store standards. The onus is now on the retailers to come on board.

CIMB hails the intention to become a demand-driven, not supply-led business. The business has historically focused on maximising warehouse profits at all costs and the company now intends to reinvigorate the credibility of the IGA brand and re-brand the grocery channel into a pure full line supermarket network under IGA over time.

There are one Buy, one Hold and five Sell ratings on the FNArena database. The consensus target is $2.65, suggesting 1.4% downside to the last share price. Targets range from $2.10 to $3.20. The FY14 consensus dividend yield is 6.9%. The FY15 yield is 5.2%.
 

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