Metcash: Value Or Value Trap?

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Yesterday's share price reaction to an earnings miss from Metcash makes the stock look cheap, but is it a "value trap"?

-Food disappoints in improving environment
-Hardware facing challenges
-Is "cheap" cheap for a reason?

By Greg Peel

Industry conditions for supermarkets have been improving of late. Food price deflation has begun to reverse and competition intensity has waned, with less being thrown at promotions by the Big Two. Coles' ((COL)) "Little Shop" bonanza is now but a memory.

Brokers had thus assumed Metcash would also have seen improvement in its wholesale/retail grocery business in the second half (ex-tobacco), but it did not come to pass. The company reported a -3% fall in profit for FY19, below consensus forecasts.

The share price promptly fell near -10% in response, and an additional -4.9% today, the day after.

Food earnings did not improve for Metcash, as was expected. Indeed, food earnings declined in FY19 and the rate of decline pricked up pace in the second half. IGA's like-for-like sales growth deteriorated in the face of aforementioned improving industry trends.

To make matters worse, FY20 earnings will begin with a handicap given FY19 earnings were boosted by the benefits of a write-back of previously onerous lease provisions. And come September, the significant Drakes supply contract in South Australia expires, leaving an earnings hole.

The problems don't stop at food.

The company's acquisition of the Home & Hardware business was highly successful, but the benefits of that deal, including synergies, have now cycled off analyst valuations.

Meanwhile, demand in hardware in general is declining to reflect decreased construction in a weak housing market, and rival Bunnings ((WES)) is making a bigger push into the trade segment, which is H&H's bread and butter.

Metcash appears to have lost market share in trade hardware.

Management at Metcash is fighting back with cost-cutting measures, but up front, cost cutting costs money. The company spent $10m on food operating expenditure in FY19 and intends to spend the same amount in FY20. This is on top of capital expenditure of $17.5m in FY19 towards restructuring.

The question is as to whether cost cuts will ultimately lead to increased earnings, or whether they will simply serve to offset a rising cost of doing business. Macquarie believes that like consumer staples peer Coca-Cola Amatil ((CCL)), Metcash must spend money to effectively stand still.

Brokers have cut their earnings forecasts, seeing further declines ahead.

The next question then becomes: Is there any value in the stock at current levels, following the share price drubbing post FY19 results release?

Macquarie notes Metcash has recently enjoyed the benefits of what appeared (at least for competitors) to be an improving industry backdrop along with the RBA rate cut and promise of more. Metcash had joined the "bond party", as Macquarie puts it, which has seen defensive sectors (such as staples) paying reasonable cash-backed yields re-rated as alternatives to weak fixed income returns.

The share price started moving up in April from a level lower than a -10% one-day drop took it yesterday. Despite the share price fall, Macquarie has downgraded to Underperform.

While the big supermarkets may have backed off on their promotional spending, attention has now been turned to enhancing their on-line businesses. The race, this time, is in digital. In this space Metcash needs to catch up, notes Credit Suisse. And at this stage a structure within in which to implement digital is unclear.

Credit Suisse retains Underperform.

Citi believes the company's food earnings growth outlook continues to remain soft and the cost-out profile is moderating. There remains the potential for further contract losses and Citi is forecasting a further -10% fall in earnings out to FY22.

Citi retains Sell.

Deutsche Bank's assessment is no less gloomy, but being relatively insulated from economic risk (defensive) and at a valuation that stands out as "cheap in an expensive market", Deutsche retains Hold.

Ord Minnett, similarly, paints a challenging picture ahead, but also can't get past the stock's low valuation at the current share price. Ords can no longer justify its prior Accumulate recommendation, but moves to Hold.

More optimistic is Morgan Stanley, who takes into account a low PE multiple (despite lowering earnings forecasts), a healthy balance sheet and a 4.5% yield in retaining an Overweight rating, despite holding a "Cautious" view on the sector.

On the other hand, UBS believes the outlook for Metcash is improving. UBS retains Buy, as does Morgan Stanley equivalently, but UBS stands out in suggesting that easing food price deflation, lower promotional activity from rivals and a focus on differentiation are positives for the company.

The decision to utilise a strong balance sheet to support store refurbishments in grocery is another positive, as is the cost-out program, which provides time to execute. Aside from also seeing the stock's PE multiple as too low, UBS believes benefits from accelerating the company's Diamond Store Advantage program are a catalyst for outperformance.

Credit Suisse agrees Metcash "occasionally" looks attractive relative to valuation, but the broker cannot see any route to value creation. Given the scalability on offer in food wholesaling, the fact Metcash is suffering from a consistently declining market share is the sign of a business which is becoming less competitive, the broker believes.

To that end Credit Suisse retains its (equivalent) Sell rating, seeing the stock as a "value trap".

So opinions run the gamut of an optimistic UBS and a "stay away" view from Credit Suisse. The FNArena database now shows two Buy (or equivalent), two Hold and three Sell ratings. Despite the earnings miss, and subsequent earnings downgrades, the consensus target price has fallen only to $2.77 from $2.89, which implies a whisker of upside from the share price at the time of writing, which is another -4.7% lower.

Looks like the "Sells" are winning.

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