Does Metcash Deserve A Re-Rating?

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Metcash is changing, no longer simply a grocery wholesaler. Does it deserve a re-rating?

-Food margins the main disappointment in the Metcash FY21 results
-Strongly capitalised customer base and a consumer still shopping locally
-Buyback still leaves potential on balance sheet for acquisitions
 

By Eva Brocklehurst

The business mix for Metcash ((MTS)) is changing, yet brokers observe the market is still viewing the company as a grocery business in structural decline. In the company's FY21 results hardware was the highlight, while Metcash appears to be holding onto the grocery market share gained during the pandemic.

Citi upgrades sales estimates by 5% to reflect a better than expected trading update for the first 8 weeks of the first half of FY22 (April year-end) and points out lockdowns also present upside risk . While Morgan Stanley highlights elevated demand as the business is benefiting from changes in consumer behaviour.

Sales were ahead of expectations while margins were weaker than forecast, the broker acknowledging it had not fully appreciated the impact of the shift in mix towards lower-margin categories within food and liquor.

While comparables may be distorted by the pandemic, the company still appears to have made a strong start to FY22 and as a result Morgan Stanley lifts estimates. The broker continues to believe the stock deserves a re-rating, given a widening discount to the market and the strong momentum.

CLSA is now more positive about the outlook and considers a narrowing of the discount is warranted, while Credit Suisse agrees the stock is now at a considerable discount to rivals Woolworths ((WOW)) and Coles Group ((COL)).

Credit Suisse also flags the absence of operating leverage (margin) in the food segment but notes a material shift in the earnings composition of the group amid increasing confidence in the operating environment, demonstrated by a higher dividend pay-out ratio and off-market buyback.

Metcash continues to incur operating inefficiencies in order to deal with volatility, the broker adds. There was a material increase in provisions during FY20 and FY21 on a number of one-off factors.

For example the loss of the Drakes and 7-11 contracts negatively affected earnings in the food segment by -$15m for FY21. Citi does not believe the provisions provide a buffer for FY22 and with low operating leverage continues to forecast a 2% margin. The broker considers earnings from food of $176m in FY22 will be a base from which the segment can grow by around 2% per annum.

The main disappointment for Jarden was also the lack of operating leverage in the second half, particularly in food. This is emphasised by the fact the fixed cost base was relatively flat in food.

The broker observes the market continues to value Metcash as a structurally challenged food wholesaler but the position of the business has changed materially and this should give rise to a re-rating because of the earnings mix moving towards hardware.

In food Metcash has lost its two "at risk" customers but has an increasing number of stores and, Jarden agues, the best capitalised customer base along with a consumer that wants to shop local. The broker believes the grocery business will benefit from trends brought on by the pandemic and while likely to "normalise" from current levels, should not return to pre-pandemic levels.

This implies Metcash retailers should retain greater share and have the ability to grow the grocery network independently of support from the Metcash balance sheet. Cash flow remains strong with cash conversion more than 100% in FY21.

CLSA agrees that some covid-led changes to shopping behaviour appear entrenched now and hardware is gathering pace, enabling Metcash to deliver a more attractive earnings stream.

Hardware

Diversification continues towards hardware and liquor, which are now 33% and 21% of earnings (EBIT), respectively, and higher multiple businesses to boot. Metcash has also increased its ownership of Total Tools to 80% from 70% for $59m.

Hardware EBIT grew 62% in FY21 and Citi expects a further 10% growth in FY22 with hardware becoming a larger contributor to earnings versus food by FY24.

Credit Suisse notes the company's total investment in Total Tools is $280m, and with earnings of $24m in FY21, on a fully consolidated basis, this implies a strong return on investment. The broker expects the hardware segment will grow at a rate that is well above trend in FY22 because of increased DIY and housing activity.

Buyback

Metcash has also announced a $175m off-market buyback, which Citi estimates is likely to be 11% accretive on an after-tax basis for super fund investors. The broker expects a post-capital raising gearing will be at around 12%. Jarden observes the buyback is dependent on the appropriate funding structure of any substantial acquisition that may be determined by Metcash.

Jarden expects a buyback process will run concurrently with the finalisation of the audited accounts of Richies and then shareholders should be able to put the business case to Metcash. The Ritchies liability was estimated at $240-260m in FY20 and is based on a fixed multiple.

The broker believes the FY21 results for Richies will be higher than FY20 and believes Metcash has the headroom on the balance sheet to continue capital management and also fund the acquisition.

Jarden, not one of the seven stockbrokers monitored daily on the FNArena database retains an Overweight rating with a target of $3.70 while CLSA, also not one of the seven upgrades to Buy from Outperform with a target of $4.50.

The database has four Buy ratings and two Hold (Macquarie, UBS yet to update on the results). The consensus target is $3.93, signalling 4.2% upside to the last share price. The dividend yield on FY22 and FY23 forecasts is 4.5% and 4.6%, respectively.

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