Metcash Delivers, Yet Challenges Remain

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This story features METCASH LIMITED, and other companies.
For more info SHARE ANALYSIS: MTS
The company is included in ASX100, ASX200, ASX300 and ALL-ORDS

Supermarket and hardware business Metcash delivered cash flow and cost reductions ahead of expectations in FY17. Nevertheless, brokers suggest structural challenges remain daunting.

-Market share losses in WA and SA and market-wide deflation continues
-Reinstatement of FY18 dividend and pay-out policy welcomed
-Opportunity in hardware may be under appreciated
 

By Eva Brocklehurst

Metcash ((MTS)) pulled a rabbit out of the hat in FY17, delivering cash flow and cost reductions ahead of expectations. Nevertheless, brokers do not overlook the structural challenges that still exist, while noting that cost reductions will necessarily come to an end.

Underlying net profit growth of 9% overstates momentum in the business, in Citi's view. Consistent treatment of the "working smarter" implementation costs and normalising for the extra trading week in the year reduces underlying FY17 net profit growth to 3.2%. The broker expects modest earnings growth, as synergies and savings offset the operating de-leverage in grocery in FY18 and FY19.

While trading is characterised by competitive pressures, Credit Suisse found the food result better than previously expected. The broker was also surprised by the reintroduction of the dividend, at a final 4.5c. The main problems continue to be market share losses in Western Australia & South Australia, and market-wide deflation. Share price appreciation and valuation adjustments lead Credit Suisse to downgrade to Neutral from Outperform.

Morgan Stanley suspects capital management will now become the focus, given the FY18 estimated net cash position, and maintains an Overweight rating. Importantly, the broker notes earnings held up as cost reduction initiatives were carried out and the convenience business was brought back to break even.

Morgan Stanley believes a surprise FY17 dividend and a reinstating of the 60% dividend pay-out policy sends a clear signal that the company is confident in the outlook. The very low price/earnings multiple, low borrowing costs and franking credit balance would make a buy-back very accretive, in the broker's opinion.

Food & Grocery

Looking forward, Morgan Stanley suspects the impact of store closures will reduce and deflation will moderate, so the comparables will get easier as the supermarket sales performance improves. When this occurs the broker expects the stock to re-rate.

Citi, on the other hand, believes the challenging conditions in WA grocery are more structural. The WA grocery market is moderating at a similar pace to the eastern seaboard but at lower levels of growth, partly affected by interstate migration. Meanwhile, ongoing competitive pressure in SA and WA as well as incremental price investment from Coles ((WES)), Woolworths ((WOW)) and Aldi suggests the company will still have to re-invest benefits from its cost-saving initiatives into prices, in order to remain competitive.

UBS believes management is controlling costs effectively and diversifying away from the challenge grocery division but agrees cost reductions are set to come to an end and there will be a need to reinvest in price. Meanwhile competitive pressures are seen emerging down the east coast which will mean top-line pressures accelerate. UBS maintains a Sell rating, acknowledging the business is not expensive, but with the stock trading on around four times FY18 operating earnings (EBIT), downgrades to expectations are needed to re-rate.

Deutsche Bank is now more comfortable that the food business can stabilise and the cost reductions continue. Hence, the broker upgrades to Hold from Sell.

The company has noted a material increase in multi-store owner activity in terms of acquisition, refurbishment and new supermarket expansion in NSW. Macquarie believes this is an important development, given the company's under-utilised distribution assets in this state and addresses and under penetrated market in New South Wales, particularly for differentiated in premium retail formats.

Hardware

The "working smarter" cost saving target has been increased to $120m from around $100m and there is a risk it could again be upgraded, although Ord Minnett observes the restructuring costs in order to achieve this appear to have also increased.

In contrast, there is a significant opportunity in hardware although it is too early to determine the reception to new buying terms from Home Timber and Hardware (HTH) members. All up, the broker considers the investment thesis mixed which underpins a Hold rating although the absence of valuation support is an increasing concern.

The company has reiterated its synergy target for HTH at $15-20m by the end of FY18, after sharing benefits with retailers. Citi expects long-run hardware margins to reach 3.75%, well above Mitre 10 and the former HTH, because of synergies and the closure of under-performing corporate-owned stores. Morgan Stanley believes growth potential in hardware is under appreciated.

While the wider hardware market will slow over the next 12-18 months with a softer housing cycle, the broker believes the company's FY18 earnings will be driven higher by the annualisation of the acquisition, incremental synergies and continued turning around of corporate stores.

Management Succession

The company has announced CEO Ian Morrice will retire in 2018. During his tenure, Mr Morrice focused on repairing the balance sheet, making efficiency gains and improving supermarket standards. As significant achievements have been made across these areas, Macquarie suspects the focus of the future CEO could swing backs towards re-asserting a growth strategy.

There are two Buy ratings, four Hold and one Sell (UBS) on FNArena's database. The consensus target is $2.39, suggesting 7.9% upside to the last share price. Targets range from $2.00 (UBS) to $2.80 (Morgan Stanley). The dividend yield on FY18 and FY19 forecasts is 6.0% and 6.4% respectively.
 

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