Capital Return On The Cards For Metcash

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Metcash has ended its first half with a net cash position and will contemplate capital management by the end of the second half. Nevertheless, brokers have mixed views on the ability to turn around the supermarkets business.

-Grocery business structurally challenged in the longer term yet hardware provides a counterpoint
-Upside risks to forecasts if the company can improve IGA retail sales, increase private-label and reduce units to support margins
-Brokers expect either increased pay-out ratio and/or buyback
 

By Eva Brocklehurst

Metcash ((MTS)) expects further cost reductions in supermarkets and growth in its hardware business will provide modest growth in earnings in FY18. First half results suggest cash flow has improved, with the company moving to a net cash position.

A capital management review has been flagged for the second half. Definitive guidance was not provided and management expects difficult conditions in food & grocery will continue in the second half. Savings from the "working smarter" program are expected to provide an offset.

Morgan Stanley suggests the shares are cheap and, as the market comes to appreciate the longer-term hardware opportunity and a turnaround in food & grocery a re-rating could occur. Cost reduction initiatives, given the company is not even halfway to its target of $120m, means cost growth will likely be negative for the next 2-3 years in the food & grocery division and improvements in sales trends will help profitability.

The stock trades at a discount to intrinsic value as it continues to be viewed as a structurally challenged business yet, although part of the supermarkets business is challenged, this has always been the case, Morgan Stanley contends, and hardware is in line for structural growth from the exit of Masters and a fragmented home improvement market.

UBS upgrades FY18-20 estimates by 6-9%, with modest upgrades to hardware reflecting the upgraded synergy target of $20-25m. The broker believes the grocery business, which is 60% of operating earnings (EBIT), is structurally challenged in the long-term, yet concedes there are few catalysts for underperformance in the near-term as cost reductions and hardware synergies offset the top-line pressures for the moment.

The broker has placed the stock under review, looking at the probability that synergies from hardware and cost reductions in groceries could mean earnings growth is sustained for longer. At present UBS maintains a Sell rating.

The stock should be trading at a large discount to Woolworths ((WOW)) given the challenges and a recovery at Woolworths, in Deutsche Bank's opinion. Currently, the stock is trading at around -38% discount which compares with its long-run average of -40%.

The broker observes sales are still declining and margins would be narrowing if it were not for the cost reduction program. Conversely, there are still opportunities to grow the liquor business and hardware is benefiting from synergies. The broker expects the independent supermarkets will continue to lose share and when cost reductions come to an end operating de-leverage is likely to resume.

Macquarie is more positive. The cost reduction program is being used partially to stem cost inflation in the core business, and could be competed away, yet this is a good source of earnings in an otherwise challenging environment.

Upside risks to forecasts are envisaged should the company be able to execute on some of its strategies, such as improving IGA retail sales via Metcash to 80% from 70%, increased private-label penetration and a reduction in units to supplement margins.

Credit Suisse does not have a lot of enthusiasm for a business where sales revenue is declining by around -3-4% per annum, the issue stemming from IGA supermarkets and the wholesale business. Expansion of Aldi and cost reductions at Woolworths and Coles ((WES)) is likely to mean deflation continues over the medium term and this is negative for the company's high fixed cost model.

While the broker accepts there is a solid opportunity in the acquisition of Home Timber and Hardware (HTH) this only contributes 22% of group EBIT on a fully annualised basis.

CLSA, too, suggests a return to sustaining positive sales is eluding the business, with cost reductions required to maintain steady earnings and points out consumers continue to move away from the IGA brand and the number of Super IGA stores has fallen 23% in the last four years.

While hardware stands out with pro forma sales growth of 7% and synergies from combining Mitre 10 and HTH have been upgraded, CLSA worries that a return to growth will be hard to achieve. The broker, not one of the eight monitored daily on the FNArena database, downgrades to Sell from Underperform, with a target of $2.70.

Citi observes sales trends are weak and the food & grocery segment remains dependent on cost savings to stabilise earnings. The broker envisages several risks, particularly as the company faces revenue decline in grocery, amid potential contract losses in convenience stores or major retailer groups.

Capital Management

Capital management in the form of an off-market buyback or special dividend is likely, UBS believes, estimating a $100m buyback will be 2% accretive to earnings per share in FY19. Citi believes a higher dividend pay-out ratio is most likely but concedes a buyback could also be accretive, given the comparatively lower cost of debt. The broker forecasts a gradual lift in the pay-out ratio to 70% from 60%, subject to market conditions.

Credit Suisse agrees with the likelihood of a higher dividend pay-out, potentially 80-90% in the near-term, or a buyback at around 5% of issued equity in the absence of significant growth initiatives. The broker is not that confident that the free cash flow yield of 8% adequately compensates for medium-term earnings downside, and downgrades to Underperform from Neutral.

Given the stock is now in a net cash position, a buyback make sense to Macquarie at current multiples. A $300m buyback would take gearing to around 15% and be 7% accretive to earnings, factoring in the positive spread between the earnings yield and marginal cost of funding.

Liquor

The liquor business has been under pressure with a $1m provision for a bad debt in Western Australia and consumption trends suggesting a reduction in volumes. Moreover, operating expenditure associated with start of the new container deposit scheme in NSW affected the first half. Retailers located in northern NSW that were previously being serviced by a Queensland distribution centre have had to be re-routed to NSW given the new pricing structure.

The database has two Buy, two Hold and three Sell ratings. The consensus target is $2.82, signalling -9.9% downside to the last share price. Targets range from $1.90 (UBS) to $3.40 (Morgan Stanley). The dividend yield on FY18 and FY19 forecasts is 4.4% and 4.7% respectively.

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