Australia | Nov 25 2019
Grocery wholesaler Metcash has lost its second major contract in 18 months, exacerbating speculation around the scale and sustainability of the company's distribution channel.
-Mostly lower margin convenience sales but a loss nonetheless
-Inflationary backdrop in packaged grocery improving
-Share of earnings in hardware expected to increase to 29% by FY23
By Eva Brocklehurst
A significant contract loss, the second in 18 months, has put grocery wholesaler Metcash ((MTS)) in a difficult position. The 7-Eleven convenience store supply agreement, currently representing around $800m in annualised sales, will not be renewed when it expires on August 12, 2020.
This follows the loss of the Drakes distribution contract in South Australia. Metcash remains in discussions with 7-Eleven regarding Western Australian volumes and some small categories on the east coast.
Citi expects Metcash will retain this contract in WA and anticipates an earnings impact from the loss of east coast distribution of -$14m in FY22. 7-Eleven only operates 40 stores, or around 6% of its total network, in Western Australia.
Moreover, while 7-Eleven is a larger contract in wholesale terms versus the Drakes contract, which was worth $270m, the level of profitability Metcash derives is likely to be lower than it was with Drakes. This is because of the higher volumes of tobacco products sold through the convenience channel relative to a traditional supermarket.
Supply chain proposals by 7-Eleven meant the existing deal was no longer viable for Metcash. No cost savings have been specifically attributed to 7-Eleven, nor Drakes SA for that matter, and, Citi points out, following two successive cost reduction programs, easy gains have been realised already.
Macquarie notes 7-Eleven accounted for around half the convenience sales for Metcash, with the next largest customer in this segment being BP. The broker believes margins are at risk through increased stranded costs and there is the threat of BP renegotiating its contract.
Citi upgrades to Neutral from Sell now that a key negative catalysts has played out. This Sell rating was based on the risk of Metcash losing the 7-Eleven contract. While further losses could occur, the boost from better inflation in the upcoming result in December 5 makes the outlook more balanced, in the broker's opinion.
The broker's measure of supermarket inflation has improved by 200 basis points in the September quarter versus a year ago. While Metcash typically under indexes in fresh categories, which may drive some of this inflation, packaged grocery inflation is now also improving. As a low-margin wholesaler, Metcash is the most leveraged to the inflation trend and Citi expects this to support the near-term sales outlook.
Ord Minnett estimates a -$16m earnings loss on around $700m of the $800m in sales generated by the agreement and assesses the multi-year burden of food deflation is moderating and a trend towards dry grocery inflation is building.
Moreover, the potential to lose this contract was well flagged (speculation was rife following 7-Eleven putting grocery supply up for tender). Still, the broker expects valuation and food inflation will provide support.
Contracts Under Scrutiny
Ord Minnett also notes Foodworks, the company's largest food wholesale customer, was required to give 12 months notice in September if it wished to terminate supply and no notice has been provided, as yet.
UBS downgrades to Neutral from Buy. The stock continues to screen as inexpensive but there are few catalysts for outperformance on a 12-month view. There is also the risk of further contract losses, and the broker considers the Foodworks contract is at risk, while the Drakes distribution centre provides another potential competitor in South Australia and Victoria.
The broker suspects the food distribution business will be unable to grow earnings until FY23 and there are further challenges despite an improved inflationary backdrop.
Hardware earnings are expected to grow over the next five years and the share of earnings in hardware increase to 29% in FY23 from 22% in FY18. The broker envisages marketing synergies beyond FY18 by the consolidation of the HTH and Mitre 10 brands and a more rational market.
Credit Suisse believes the loss of this latest contract fuels a debate regarding the sustainability of the food distribution business at scale. The broker calculates the loss of both the Drakes and 7-Eleven contracts appears to deliver around a -$35m impact on earnings over a three-year period, partially mitigated by further cost reductions.
However, it is the “read-through” for the distribution system that really matters and, in Credit Suisse's view, this is all about technology, scale and disintermediation.
The broker points out, while 7-Eleven could be wrong in believing it can provide daily, flexible delivery at a lower cost than Metcash, the question then arises about the cost competitiveness of other Metcash customers which also need to evolve to daily delivery to remain competitive.
Equally, while Drakes may have decided it could achieve efficiencies in supermarket operations by vertically integrating it may prove to be incorrect. If not, again the cost competitiveness of the remaining mainstream customers of Metcash is in question.
FNArena's database has one Buy rating (Morgan Stanley), three Hold and two Sell. The consensus target is $2.82, signalling -1.2% downside to the last share price. The dividend yield on FY20 and FY21 forecasts is 4.7% and 4.6% respectively.
See also, Metcash: Value Or Value Trap? on June 25, 2019.
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