Can Metcash Turn Around?

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-Fewer fuel discounts not helping
-Improvement linked to tobacco excise
-Competition rise at Metcash's expense
-Stabilisation not likely until FY17
 

By Eva Brocklehurst

After avoiding specific guidance at the FY14 result, Metcash has had to bite the bullet after its first half revealed substantial earnings weakness. Brokers are evaluating just when the earnings decline will find a floor. Convincing independent shopkeepers to come on board the transformation train has taken longer than expected but the company acknowledges, even so, earnings visibility is low.

Morgan Stanley is not optimistic, with indications that FY16 will also be lower. The company reported an 18% reduction in food and grocery profits in the first half, despite the lower levels of fuel discounting from the majors which should have led to an improved performance. Moreover, while management pointed to some improvement in the second quarter, the broker suspects this was linked to tobacco excise increases. The company had signalled it would invest $40-45m in pricing strategy through FY15 but to date has only invested $10-15m, indicating the pace of signing of independents to the transformation plan is glacial. Morgans downgrades to Hold, exhausting hope that the reduction in cross-subsidised fuel discounting would provide some important breathing space for Metcash. Now, the broker considers meaningful improvement in the earnings base is not likely until FY17.

Morgan Stanley assesses that South Australia and Western Australia, combined, contribute 40% of the profits and, as Aldi opens stores in these markets in 2016 and Coles ((WES))/Woolworths ((WOW)) invest in price ahead of Aldi's entry, the earnings impact for Metcash will be significant. Aldi has reached a critical mass in Australia such that Morgan Stanley believes its impact on industry profitability will only increase. Metcash's undemanding multiples signal to Goldman Sachs the magnitude of the transformation task and execution risks. The relationship between wholesaler and retailer adds significant complexity to the transformation strategy and the broker does not expect competition within the industry to abate materially. UBS similarly wonders whether the transformation plan, while the right one, is occurring too late. With earnings and market share falling the majors are also stepping up promotional intensity.

This is the "faith" stage of the transformation plan, in Credit Suisse's view, with significant uncertainty as to the level of earnings to which the company will re-base and the sustainability of the initiatives. The broker also worries revenue is weak in a period in which the company's customers, IGA retailers, benefited from a significant reduction in fuel discounting and a pull-forward of inflation because of the earlier increase in tobacco excise. Convenience, hardware and automotive trends are positive but not material enough to make a difference at the group level. Second half results will provide the first reading on the transformation initiatives but, over the medium term, Credit Suisse believes Metcash will be challenged to generate sufficient business improvement.

Deutsche Bank could also find no sign earnings were stabilising in the first half, with the company performing even worse because of customer purchases outside its distribution channel. Price investment will constitute a larger drag in the second half and the balance sheet is also a concern to the broker. In summary, Deutsche Bank finds no evidence that undermines its thesis that Coles and Woolworths can continue to gain share despite Aldi's roll out, and this will be at the expense of independents.

Macquarie considers the sales results of the initial pilot stores were encouraging but the roll out has been very gradual. The share price reaction to the half year result was severe in the broker's opinion, and there is limited opportunity for management to materially turn around the operations in FY15 and FY16. Benefits are likely to be long-dated and an Underperform rating is retained. Citi is the only broker on FNArena's database with a Buy rating. The broker concedes earnings are set to worsen and does not expect an improvement until the second half of FY16, given the timing of strategic initiatives. The dividend reinvestment plan further dilutes earnings, underwritten to the tune of 75%. Citi expect this underwriting will need to continue over the next 18 months.

Why a Buy rating? The broker bases this on valuation and the latent potential in the store network. Profit margins are depressed and the shares should find support as underlying grocery sales turn positive in the second half. The broker believes more opportunity becomes available as the price investment is marketed more widely to shoppers.The remaining ratings on the database constitute two Hold and five Sell positions. The consensus target is $2.26, suggesting 14.0% upside to the last share price, and compares with $2.75 ahead of the results. Dividend yield on FY15 and FY16 forecasts is 6.5% and 6.3% respectively.
 

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