Are Cost Reductions Enough For Metcash?

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

Despite some positives in the FY18 results, brokers question the lack of organic growth in the Metcash food business and also whether a buyback is the appropriate use of the company's cash.

-Construction activity still expected to support hardware despite a slowdown in housing
-Are the structural pressures in food & grocery overplayed?
-Main negative is lack of detail regarding future commitments from key customers
 

By Eva Brocklehurst

Metcash ((MTS)) continues to address a competitive environment in food & grocery with cost reductions and while brokers found several positive aspects to the FY18 results and outlook, concerns regarding profitability remain.

The company reported underlying net profit for FY18 of $215.6m. An off-market buyback of $125m was also announced, as debt reductions over recent years provided the opportunity.

No FY19 guidance was provided, as expected, and Metcash noted weak economic conditions in Western Australia and uncertainties over the impact of the container deposit scheme in NSW.

Construction activity is expected to support the hardware business, despite a slowdown in housing. Hardware synergies have been upgraded again, now $34m annualised versus the previous estimate of $20-25m.

Deutsche Bank finds the outlook commentary simply continued recent trends. The cost savings from the Working Smarter program have slightly increased but there is an additional $10m investment coming in FY19.

The main question for the broker is whether there will be additional cost reductions beyond FY19 because, if not, it will be very difficult to avoid further earnings declines in food & grocery.

All up, Deutsche Bank believes the offsets that were originally expected are not proving strong enough. Hardware is not providing enough of a counterbalance to the food business.

While the stock has already de-rated, the broker envisages further downside risks and reduces its rating to Sell from Hold.

UBS greeted the result more positively, but was also not keen on the $10m incremental investment in food in FY19 and a softer-than-expected hardware margin, albeit still strong.

Nevertheless, structural pressures are overplayed, the broker believes, estimating the core food division is trading on an implied value/earnings basis that is at a -60% discount to the market.More Capital Management?

Citi asserts the company lacks organic growth and agrees with Deutsche Bank the cost reductions have now run their course. The broker also questions whether a share buyback was the appropriate use of the company's cash.

Credit Suisse believes there is a low likelihood of any repeat of the FY18 buyback announcement, whereas Ord Minnett suggests the potential for more capital management exists as food deflation is easing and the loss of the Drakes contract is factored into the stock.

The broker concedes its recent upgrade from Lighten to Accumulate was ineffective and poorly timed but maintains the recommendation.

Moreover, growth in competitor Aldi is observed to be slowing and the proposed Coles ((WES)) spin-off creates an environment where food deflation can ease.

Morgan Stanley believes the buyback and the lift in hardware synergies should fuel an earnings upgrade cycle. The broker contends that the market under-appreciates the liquor/hardware story that is building and overestimates the structural pressures in food & grocery.

While the housing market appears set to cool the broker believes company-specific drivers will insulate earnings.

Morgan Stanley also agrees with Ord Minnett that as grocery competition moderates through 2018, food deflation will ease and this will enable an improved top line in food & grocery.

Credit Suisse takes a different tack, noting the alternative view of setting the business up for a smaller independent supermarket share of the market does not appear to feature in the company's strategy.

The broker suspects a second, and perhaps more material, phase of consolidation in WA and SA is likely, as retailers contemplate re-signing store leases on significantly reduced profits, and there is increasing vertical integration and wholesaler competition.

The company's food distribution business, in the broker's opinion, appears particularly vulnerable to a reduction in sales and the realisation of contingent liabilities on retail leases, debt guarantees and equity options.

Supermarket Customers

The main negative for brokers was the lack of certainty over future commitments from key customers, particularly in light of the news that Drakes Supermarket will exit the distribution centre in South Australia.

Credit Suisse, with an Underperform rating, believes the key issue hanging over the stock is why Drakes Supermarkets could find it financially rational to spend $80m on a new warehouse rather than being supplied by Metcash.

Citi agrees the potential for another major customer loss by 2020 is a stumbling block for the stock and retains a Sell rating.

Macquarie also highlights the limited detail on the rationale for the recent loss of the Drakes contract, but points out the company has indicated other retailers were surprised at the decision.

Total sales including tobacco to Drakes were $270m in FY18. Assuming the company achieves a 9% gross margin across the business, Macquarie calculates $24.3m in operating earnings (EBIT) is at risk and this is, therefore, a material loss.

The broker flags media articles, which have signalled the focus on cost reductions, a desire for more targeted ranges and paying fees on distribution of products sourced from other suppliers are the issues of contention between Metcash and its retailers.

Meanwhile, BP and 7-11 contracts have been renewed beyond FY19, with contracts continually rolling for the business because of the nature of the industry.

FNArena's database shows three Buy ratings, one Hold (Macquarie) and three Sell. The consensus target is $2.98, suggesting 6.5% upside to the last share price. The dividend yield on FY19 and FY20 forecasts is 5.3%.

See also, Challenges Continue For Metcash May 29, 2018.

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