-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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-Funding change from profits unsustainable
-Hardware integration case not convincing
-Importance of getting the fresh offer right
 

By Eva Brocklehurst

Metcash ((MTS)), the battler, has updated the market on its strategic initiatives. The company is implementing substantial changes to its product offering and pricing and has made some progress, with the IGA retailer base reporting some examples of improvement. Still, brokers retain their relative preconceptions, given the extent of the challenges Metcash faces.

Credit Suisse is not enthused by the near-term outlook because of the potential for profit destruction developing the supermarket sector, as well as the prospect of a very weak first half for Metcash given the timing of its pricing initiatives. Price matching has been implemented in 900 stores and the quality and branding of its Black and Gold range has been improved in 1100 stores, with positive responses.

To date, the changes have been funded from a reduction in Metcash profits but Credit Suisse suspects this cannot be sustained for much longer. To that end some specific cost reduction initiatives have been implemented, with more detail to be presented at the first half results.

The company intends to remove duplication between wholesale and retail operations but this is not an easy strategy to implement, the broker observes, because of significant retailer sunk costs and imperfect alignment of incentives. Signals that the company is making headway, or otherwise, should come from the rate of adoption of its Diamond Store Accelerator (DSA) program, which is addressing competitive pricing and improved fresh ranges, service and store environments.

Some discussion at the briefing centred on the merits of integrating the Danks business with Mitre 10 hardware. Credit Suisse is not convinced by the strategic case for network integration. The broker believes Metcash would be better placed if it cherry picked larger retailers from the Danks network and there might also be a better opportunity for someone else to realise, perhaps via a sale of Mitre 10, given the company has its hands full with its food business.

Deutsche Bank envisages two problems from combining the networks. Firstly, the Australian Competition and Consumer Commission (ACCC) may not let it happen. Secondly, Metcash would need to raise equity to fund a deal if it were to obtain Danks customers by acquiring the business.

There are many risks remaining, JP Morgan contends, and it is too early to become more constructive. What is clear is that IGA retailers are recognising that a healthy Metcash is vital for success and this moderates the risks from a lack of vertical integration. Still, the broker notes, no division is performing at an optimum level and there remain risks from Aldi's expansion into South Australia and Western Australia.

Citi is more confident and believes the positioning as a differentiated offer in supermarket retailing will underpin the company's viability in the long term. The broker welcomes the early signs of traction from the changes being implemented. Earnings are expected to stabilise in the second half and result in a re-rating.

One aspect the broker is not convinced by is the need for separate banners under the IGA umbrella, such as Supa IGA or IGA Xpress to denote large or small stores. This confuses consumers as it is difficult to have IGA stand for a range of different attributes for different shoppers, while Supa IGA is vulnerable as it tries to compete with the major chains with a perception it is more about convenience.

The most important aspect of stabilising the food business is getting the fresh offering right, which history suggests has a low probability in Deutsche Bank's view. The broker believes, while price matching and the DSA program should assist retailer performance both are costly, and the company is chasing a moving target, as Woolworths ((WOW)) is cutting prices and Aldi has commenced its roll out into the Metcash stronghold of WA and SA.

The company's "teamwork score" may be stable but Deutsche Bank observes this is only in packaged grocery, which is not growing. Market growth is driven by fresh and specialised categories. Hence, it is critical to get fresh produce right.

The health & beauty category was one that was mentioned where there might be an opportunity to improve sales as IGA generally under-indexes relative to the market. Deutsche Bank cautions that this used to be a growth engine for the supermarket chains but a number of aggressive pharmacy chains have taken considerable share in the category now.

The liquor business is the best part of the Metcash group, in Deutsche Bank's view, and a separation is not ruled out at some point in time to extract more value, although the company has not commented on this subject.

UBS notes major retailers continue to open new stores and pass on supply-chain savings and Metcash is exposed to the threat that these retailers are growing their share of the liquor retailing market. One factor that remains in the company's favour is that the ACCC is likely to closely monitor any decline in independent food & liquor retailers and limit the extent of any reduction.

FNArena's database has one Buy, four Hold, and two Sell ratings for Metcash. The consensus target is $1.26, suggesting 19.9% upside to the last share price. Targets range from $1.00 (UBS) to $1.70 (Citi).

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-FY16 profit decline expected
-Dividends under threat
-CEO uncertainty
 

By Eva Brocklehurst

Woolworths ((WOW)) is flying the distress flag. While some moves are being made to address its problems, brokers remain to be convinced as to how soon the ship can be turned around.

Profit is expected to decline in FY16 on the back of continued weakness in food & liquor. Price and labour investment will increase in FY16, but sales trends remain weak. Promotional activity increased in the second half, reducing gross margins. This also showed in an acceleration in deflation to 5% in the June quarter.

Citi believes price investment needs to be better targeted, given promotional effectiveness has been poor, and suggests more staff and better marketing could help. The broker expects the decline in earnings in FY16 to be significant and a change of management is the potential catalyst for a re-set of earnings. The company has just installed a new chairman, Gordon Cairns, and the CEO, having announced his retirement in June, now has to be replaced.

The stock is expected to trade lower as the reality of its earnings downside sinks in. Citi also wonders how much the reduction in incentives will impact staff morale, suspecting the drop in bonus payments will impact execution and slow down a recovery.

There is also a disparity between the commentary regarding the home improvement division and the financial results. Credit Suisse observes the earnings loss in the division increased 16% in the second half while sales have shown minimal improvement. It appears the market will have to await the new CEO to obtain further clarity on this.

Credit Suisse believes capital risks are centred on either a prolonged downtrend in supermarket profit, which would reflect a failure to address the issues, and/or a potential call on cash if Lowe's were to put its option on the Masters JV in play.

Woolworths has provided no guidance for FY16. Credit Suisse maintains its dividend forecasts at the current level, which would result in the pay-out ratio increasing to 80%. This is not considered sustainable over the longer term and, hence, there is downside risk to dividends in the broker's opinion. Morgan Stanley concurs, expecting margins are likely to be a lot lower in the years ahead. The broker suspects dividends will be cut this year.

UBS makes modest downgrades to its FY16-18 estimates, largely because of cuts to Big W and Masters. The broker believes Woolworths has lost its way, taking margin at the expense of sales and customers. It is likely to take around 24 months to return to a defendable sales growth trajectory, UBS suspects. Along the way there is the risk of a major re-basing of earnings and margin.

Moreover, the aggressive rhetoric regarding price investment increases the risk of a reaction from competitors, in the broker's opinion. UBS, too, suspects the FY16 dividend may be at risk. The balance sheet is robust and the recent downgrades by ratings agencies do not have a material impact on funding, but this does limit the scope for the company to maintain the dividend if earnings fall.

UBS also observes there is no short list for the CEO replacement and the appointment could be some way off. Poor price perception and aggressive competitors that will not stand idly by are an enduring threat, in JP Morgan's view. The timing of the CEO's retirement is considered unfortunate as it destabilises the implementation of the company's strategy.

To Deutsche Bank the efforts so far are not resonating with customers and the path to improvement remains unclear. The "Cheap Cheap" campaign will be phased out, consistent with anecdotal evidence the broker has heard that it has not been beneficial to the company's value perception.

The broker acknowledges the value in the assets but believes it is too early to invest. The downside risk, in Deutsche Bank's view, centres on a potential inability to improve the value perception while upside risk is a smaller margin dilution than feared from the price investment strategy.

Morgans agrees that with so much uncertainty in the supermarket business and a transition to a new leadership team, investors should remain cautious for now. The broker continues to advocate a measured long-term approach to the Masters business, as there is a significant opportunity in such a market. Nevertheless, a profitable result is not foreseen until FY20.

The new format stores are delivered better average sales, which Morgans finds encouraging. Management needs to convert all stores to the new format, maintain the 30% uplift in sales in each, and hold costs flat. Then, in the broker's view, it will be able to break even. But this should take 3-5 years.

Despite the challenges, Morgans maintains a dividend forecast of $1.39 over the next few years, in line with FY16, believing the board will aim to maintain shareholder returns and underpin confidence in the turnaround.

FNArena's database has three Hold and five Sell ratings. Consensus target is $25.36, signalling 3.4% downside to the last share price. Targets range from $21.00 to $28.00. The dividend yield on both FY16 and FY17 forecasts is 5.1%.
 

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