Caution Prevails Over Metcash Strategy

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

-Pilot price match success
-Hardware, automobile growth
-Likely loss of share in WA, SA
-Weak cash conversion
-Transformation costs may be greater
 

By Eva Brocklehurst

Metcash ((MTS)) struggles on. It is early days in the grocery wholesaler's turnaround strategy, planned for supermarket customers, and brokers are cautious or just plain dubious. The FY14 result was in line with guidance, which confirmed a substantial decline in earnings in the second half. The company has not provided guidance for FY15 per se, simply stating that it would represent the start of a significant re-investment phase.

The transformation plan has kicked off with a pilot price matching strategy and the company has found the results encouraging enough to plan for full implementation. The strategy was focused on the top 500 stores and a narrow basket of products. Restructuring will probably extend beyond FY15, and for Credit Suisse this makes the stock hard to call as a value opportunity. Moreover, a strategy for the large group of smaller retailers is yet to be articulated. Credit Suisse understands the cost of the price match trial was borne entirely by Metcash. The impact on profit implies a fall of 100 basis points in gross margin. Feasibly, around $15m of expenditure on cost of goods would bring this decline back to 60 basis points, compared with 40bps in the first half, but the broker considers that is still a surprisingly strong fall in gross margin for a food wholesaler.

The company's liquor business and hardware and motor vehicle segments benefitted from acquisitions and, while the latter two segments are likely to provide growth over the next several years, Credit Suisse does not think they will materially influence the group result. Moreover, Credit Suisse believes the overall business is likely to shrink further before it grows. The company's solid supermarket market shares in Western and South Australia are not sustainable over the long term because of additional retail capacity in those markets. The broker does not think this significant contraction is captured in consensus forecasts and retains an Underperform rating.

Macquarie is encouraged by the price match pilot program. Expansion in the petrol and convenience segment is also a positive, with BP and 7-Eleven reported to be keen to explore similar arrangements to that which Metcash has with Night Owl in Queensland. The company is targeting revenue from food and grocery in FY15 to be at least in line with FY13. Macquarie observes the retailers were doing better than Metcash's reported 2.1% reduction in like-for-like wholesale supermarket sales. Some of the company's larger retailers were trading reasonably well, post Metcash's balance date, but the broker notes a weakening in sales after the federal budget. The second half dividend was above the broker's forecast, albeit down on the prior corresponding half. In light of capex requirements the Dividend Reinvestment Plan will be underwritten to 50%, and Macquarie assumes a 60% pay-out ratio going forward with a 25% DRP take up.

To UBS, Metcash is entering the "pinch" year. The broker believes the core grocery business is structurally challenged and Coles ((WES)) and Woolworths ((WOW)) are investing heavily in value as they roll out yet more space. UBS does not think this will change. If Metcash can focus on "buy as you need" shopping and drive efficiencies it can regain momentum, but UBS is doubtful. A focus on price, shopper-led ranges, new formats and improving the fresh offering appears to be the right strategy, and one the broker believes is long overdue. Nevertheless, rival Coles has signalled increased price investment, inevitably leading to higher operating expenditure for Metcash if it sticks with the price matching strategy. All up, the broker thinks there are many risks longer term. If the transformation plan succeeds and leads to share gains, which UBS doubts, then the stock would outperform.

Sell says Deutsche Bank. The broker was surprised that the commentary was not more positive, given petrol discount restrictions put in place by the ACCC amid expectations food pricing has improved. The broker is concerned that the $40-45m budgeted operating expenditure will not be enough to stem sales weakness. Valuation may be undemanding on a multiple basis but Deutsche Bank thinks weak cash conversion makes the stock more expensive than it looks. As Metcash offers only a modestly higher yield compared with the major supermarkets the risk is not adequately priced in, in the broker's view.

CIMB is more positive, finding the current valuation appealing, and retains an Add rating. The broker believes the most notable deficiency in Metcash's model is a lack of constructive cooperation with its retailers. If that can change then an earnings recovery is more likely. Investment in retail pricing, refurbishment and improved store standards should help in this regard. CIMB notes major retailers are beginning to show support for the strategy but the scale of the turnaround required is significant. The company's annual retailer convention in July will be an important recruiting event to get smaller retailers on board. The broker does not envisage material revenue growth in FY15. Organic growth in liquor and Mitre 10 was notable and CIMB thinks these businesses will deliver solid growth in FY15, albeit at a reduced rate.

There is just so much work to do. That is BA-Merrill Lynch's take. The broker was particularly disappointed that food and grocery was unable to make headway after the restrictions forced on Woolworths and Coles to cease petrol discounts linked to supermarket purchases over 4c/litre. This broker is also concerned that the costs of the transformation strategy will be materially more than the $40-45m that has been set aside. Merrills forecasts earnings will stabilise in FY16, after another heavy fall in FY15, but thinks the risks are materially on the downside.

There are two Buy ratings, one Hold and five Sell on the FNArena database with a consensus target of $2.76, suggesting 1.9% downside to the last share price. Targets range from $2.15 (Credit Suisse) to $3.30 (CIMB). The dividend yield on FY15 and FY16 forecasts is 4.8% and 5.1% respectively.
 

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