Slow Grind Continues For Metcash

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

-Can improvement be sustained?
-Competition intensifies with Aldi expansion
-Issue of incentivising fresh categories
 

By Eva Brocklehurst

Metcash ((MTS)) has delivered a gain on the sale of its automotive business in the first half and restructured its debt facilities. These two positive items and a new business simplification initiative, were the major aspects to the results but many brokers remain sceptical regarding the outlook, which is dominated by the prospect of continued price deflation.

The underlying trend in wholesale sales to supermarkets improved in the first half, with IGA store sales up 0.6%. Excluding tobacco and adjusting for the outage caused by damage at the Huntingwood distribution centre, Deutsche Bank finds sales did still decline modestly. Initiatives outlined are not expected to offset the headwinds in FY16.

The company has benefitted from weakness in Woolworths ((WOW)) but the broker suspects this will dissipate when Woolworth gets back on track. While food & grocery were in line with Deutsche Bank’s forecasts, hardware and liquor were weaker.

Sales in liquor would have grown were it not for the Huntingwood outage while the broker notes hardware grew 1.2%, well below forecasts of 9.0%, attributing this to closures in the Mitre 10 network as opposed to expansion.

The next stage of the company's transformation plan expects to deliver pre-tax savings of around $100m per annum by FY19. Investment of $50m will be required on a one-off basis. Deutsche Bank suspects much of the benefit will need to be reinvested, given market pricing has moved down significantly since price matching was started, and sales growth is not enough to avoid operating de-leverage.

Macquarie acknowledges the improvements but wonders whether this will be enough to get the company over the line. Price investment is still required in the current competitive environment and cost reductions will also be necessary to offset the margin pressure.

The broker is prepared to accept a more moderate decline in earnings into FY17, rather than a severe decline, but notes the strong positive share price reaction reflects the degree of operational leverage …and short covering, with around 25% of the stock shorted prior to the results. Macquarie upgrades FY16-19 forecasts by 14-16%. The broker expects the dividend to be reinstated in FY18.

UBS is also mindful of the structural risks that remain, citing the looming entry of Aldi into South and Western Australia, where Metcash is most profitable. The broker expects the company's food & grocery share will decline by 280 basis points over the next five years. In the light of the strong upward move in the share price UBS considers nothing has changed materially and reiterates a Sell rating.

Morgan Stanley takes another tack, upgrading to Overweight from Equal-weight, citing evidence that the food & grocery transformation is working, albeit risks remain. Nevertheless, the valuation is considered more attractive now, with the stock's multiples considered cheaper than that implied by either Coles ((WES)) or Woolworths.

Cost savings initiatives are expected to offset underlying cost inflation and even though the independent grocer network will lose share to Aldi and Costco, Morgan Stanley believes this is reflected in forecasts.

The broker believes the company's liquor and hardware businesses are well placed for growth, owing to more attractive industry structures and potential for future consolidation.

There appears to be a far stronger case for a large independent liquor network versus supermarkets, in Morgan Stanley's opinion, given a higher proportion of such products are purchased on the way to restaurants/events and consumed subsequently – so consumers rely more on convenience.

Consolidation opportunities exist in hardware, the broker suspects, with the prospect that a deal could be done in respect of Mitre 10. The company has indicated it would consider participating in industry consolidation.

Goldman Sachs is cautious, while encouraged by the signs of improvement in food & grocery. Upward revisions of 10% and 8.0% are made to FY16 and FY17 estimates respectively. The broker, not one of the eight monitored daily on FNArena's database, considers it a brave trade to go against the industry settings and sticks with a Neutral rating.

There is a little more cost cutting and a little less capital expenditure in Credit Suisse's observation. These aspects generated a positive impact but otherwise the sales risks remain intact. Given the early stages in these initiatives, Credit Suisse incorporates half of the targeted benefits in forecasts, resulting in estimates of cost growth slowing to around 1.0% per annum.

Credit Suisse expects a contraction in gross margin is likely to ensue with the opening of Aldi stores in SA and WA. Changes in private label positioning are also expected to be detrimental to the company's Black and Gold brand. The broker is also unsure as to how the company intends to incentivise its independent grocer sector in order to remain competitive on fresh categories.

The interim results were better than Citi expected. The broker upgrades estimates and expect debt will be lowered further with scope to re-commence dividend payments in FY17. Citi retains a Buy rating. JP Morgan is also more upbeat on the stock, despite the risks that prevail. The broker highlights balance sheet repairs, better control of gearing and tight management of capex.

FNArena's database has three Buy ratings, two Hold and two Sell. The consensus target is $1.61, suggesting 1.3% upside to the last share price. Targets range from $1.05 (UBS) to $2.05 (Citi).

See also Metcash Initiatives Gain Some Early Traction on September 30 2015.

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