Outlook Divided On Metcash As Challenges Continue

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

-Price match, refurbishments gain traction
-Healthy balance sheet, re-start to dividend
-Questions over supermarket competition
 

By Eva Brocklehurst

Brokers remain divided over the outlook for Metcash ((MTS)) as the company's FY16 results were broadly in line with expectations but suggest that challenges continue. The company provided no comment on FY17 trading to date other than confirming competition remains intense in food & grocery.

UBS makes modest downgrades to both grocery and hardware forecasts, which are offset by an upgrade in liquor forecasts. The broker expects increased pressure on the company-supplied supermarkets (IGA), as Aldi makes strides in South and Western Australia.

Moreover, UBS considers the stock is structurally challenged, facing significant headwinds despite the efforts taken to level the playing field in terms of price matching. Long-term market share and margins are expected to fall in grocery, putting pressure on earnings, a situation which UBS does not believe is reflected in the current share price. Hence, a Sell rating is maintained.

At the other end of the spectrum is Morgan Stanley with an Overweight rating, believing the market is being overly punitive. The broker argues that there is evidence price matching and the Project Diamond refurbishment initiatives are gaining traction. This is driving IGA retailer sales growth, and Metcash earnings declines should moderate with the cost cutting initiatives.

The broker notes the price matching initiative now covers 960 IGA stores, while refurbishments have been implemented in 150 stores to deliver a 16% sales uplift. Improving sales growth makes these IGA retailers more sustainable in a competitive supermarket industry.

Morgan Stanley acknowledges the company will bear the full force of the Aldi expansion in SA and WA in FY17 and believes tight management of costs remains as critical as ever. The broker expects the cost base should stay flat over the coming three years.

The most compelling outcome of the FY16 results was lower net debt, which the broker expects should reduce even further in FY17, as no dividends will be paid (a second half FY17 dividend would be paid in FY18) and working capital efficiencies and insurance proceeds will be banked. The company also continues to divest non-core assets and Morgan Stanley estimates that Metcash, as of FY17, will have the healthiest balance sheet across its consumer staples coverage.

Ord Minnett also hails the repair job on the balance sheet and the prospect of the dividend being reinstated from the second half of FY17, yet downgrades to Lighten from Hold as the competitive environment in the food & grocery business is expected to continue to drag on the share price.

The broker observes the core supermarkets division is performing well, agreeing that the price matching and Project Diamond initiatives have taken hold. Furthermore, Ord Minnett considers the Woolworths ((WOW)) Home Timber & Hardware business will be an attractive acquisition for Metcash, supporting its strong Mitre 10 division.

There is a realistic probability that Metcash will be successful in acquiring Home Timber & Hardware, Credit Suisse asserts, which should prove a significant addition to value. Post this acquisition, hardware and liquor distribution would comprise 40% of group earnings and create a more balanced earnings stream.

The broker's investment case (Outperform) is driven by the belief there is enough in cost reductions to offset the negative competitive impact on food distribution over the next three years, with the improved clarity on the expected FY17 savings of note. The broker suspects retailer profitability will be the main effect of the heightened competition from Aldi in SA and WA.

Supermarket earnings appear to be stabilising despite the difficult trading environment, Macquarie contends, while the corner shop/convenience earnings detracted from food & grocery's performance. The broker suspects convenience earnings, traditionally 17% of food & grocery sales and 7% of earnings in FY15, will struggle to break even in FY17.

Meanwhile, hardware and liquor are doing the heavy lifting and contributing to growth over the medium term as consolidation takes place. Macquarie accepts the company has a track record of disappointment and that market confidence needs to recover on the back of strong execution in operations to realise the full value of the stock.

Deutsche Bank agrees management is doing the right things to shore up its business but, despite some benefit from weakness at Woolworths, supermarket wholesale sales are still observed declining on an underlying basis. The broker fears sales could worsen when Woolworths sales eventually improve and as Aldi's roll-out continues. The cost reduction program is expected to be diluted by cost inflation, operating de-leverage and price investment.

FNArena's database has four Buy ratings, one Hold and two Sell. The consensus target is $2.02, suggesting 5.9% upside to the last share price. Targets range from $1.30 (UBS) to $2.51 (Macquarie). The dividend yield is 3.5% on FY17 and 6.5% on FY18 forecasts.
 

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