Metcash Strives For Elusive Growth Strategy

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Metcash faces challenges while striving for a growth strategy after a focus on cost reductions, and brokers suspects FY20 will still be tough.

-Earnings buffer from Working Smarter and hardware synergies depleted
-Unclear how prepared the business is for significant scale reductions in WA and SA
-Softening of new construction and DIY activity expected to impact on hardware business
 

By Eva Brocklehurst

A competitive environment and weak conditions in Western Australia continue to exert pressure on food & grocery earnings for Metcash ((MTS)). The company's hardware business remains the bright spot, although brokers question for how long.

Food deflation is showing signs of improvement and the company has pointed out that fresh food inflation observed in the market is less apparent in its business, given a higher weighting to dry grocery items. The focus on fresh food is increasing, particularly on 'ready meals'. Conditions in South Australia have improved, and while WA is still declining the worst has passed. No specific earnings guidance for FY19 was provided.

Credit Suisse does not put much store in a temporary deceleration in the rate of sales decline as well as the imminent downturn in hardware. The broker, instead, looks at the extent to which cost reductions are to be balanced by the investment in growth, a decision on which appears to have been deferred until the March investor briefing.

In March, Metcash will outline a strategy to return to growth. In order to offset declining organic earnings, Citi suspects a $50-100m investment program will be announced and, if half of this is capitalised and the remainder taken through the P&L, it will probably drive -9-17% downgrades to consensus forecasts for FY20.

The broker suspects the launch of this program prior to the FY19 result in June will eliminate any prospect of a capital return for the near term and Metcash faces challenges. The earnings buffer provided by the previous "Working Smarter" program along with hardware synergies is depleted, adding to the pressure to deliver positive sales and earnings growth, and Citi retains a Sell rating.

Macquarie downgrades to Underperform from Neutral, considering earnings growth to be reasonable but limited in FY20 because of the loss of the Drakes contract. Cash conversion is expected slow further.

The company is still investing to defend against structural threats and the broker believes the market will discount the potential returns available on current expenditure, instead becoming more concerned that extra investment will be required.

Morgan Stanley agrees that a turnaround in hardware and benign supermarket competition are the key value drivers, yet considers the valuation cheap, preferring an Overweight rating. Wholesale food & grocery sales, ex tobacco, improved, declining -1.9% in the first half following a decline of -3.5% in the prior half. Still, the underlying performance was countered by cost investment, accounting changes and reclassification of credit card profit.

Morgan Stanley acknowledges the quality of earnings was not high but believes cash generation is solid and expects a move back to a net cash position by April 2020. Ord Minnett brushes aside the revelation that lease settlements and write-back of provisions have bolstered food & grocery earnings in recent times, instead focusing on the fact that deflation has eased and the east coast is in a growth phase.

It remains unclear to Credit Suisse whether the business is adequately prepared for a significant reduction in scale in Western and South Australia, as declining retailer profits create a "second-order" effect by reducing the number of retailers in the network. The broker upgrades to Neutral from Underperform, assuming cost reductions will partly mitigate the impact of declining sales revenue in outer years.

Hardware

Hardware was the highlight of the first half and the timing of synergies meant earnings beat Citi's estimates, but growth is expected to slow markedly in the second half. Hardware sales increased 3.3% in the first half and sales under the IHG banner were up 4.2%. Further softening in new construction and DIY activity is expected over the next year which will have an impact on the hardware business.

Macquarie notes the company is trying to take share in hardware, with a focus on the 'whole of house', but points out Bunnings ((WES)) has the same strategy. The company has acknowledged it will be a tough two years ahead, given the slowdown in residential markets.

Nevertheless, recent industry feedback suggests trade conditions remain elevated and, to Metcash's advantage, trade exposure is around 65% of hardware operating earnings (EBIT) which compares with Bunnings at around 20%.

Still, some of the circa 170 Thrifty Link stores are still underperforming. The company has indicated 20% of the network is responsible for only 2% of the volume, and Macquarie anticipates further closures in the future. In hardware, Morgan Stanley estimates underlying growth of 6.3%, although expects the benefit from the housing cycle and synergies will be reduced going forward.

Cost reductions are no longer sufficient to offset inflation, Deutsche Bank observes. While hardware has been robust, the broker expects sales to decline once the construction pipeline ends and this could occur at the same time food earnings are suffering the loss of the Drakes contract, making for a tough year ahead.

Liquor

The company has called out higher costs in liquor, because of fuel prices and the introduction of the container deposit scheme in the ACT and Queensland. Liquor volume growth is expected to remain at a modest level. Operating earnings were down -1% in the first half.

FNArena's database shows three Buy, one Hold (Credit Suisse) and three Sell ratings. The consensus target is $2.75, suggesting 11.4% upside to the last share price. This compares with $2.93 ahead of the results. The dividend yield on FY19 and FY20 forecasts is 5.9% and 5.7% respectively.

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