Australia | Dec 08 2022
While Metcash delivered first half results ahead of expectations, brokers also weigh the impact of lower cash flows.
-First half results for Metcash exceed expectations
-Strong performances by Hardware and Liquor
-Strong earnings for Total Tools
-Cash flow slumps on higher working capital investment
-The impact of inflation on the company's business
Wholesale distribution and marketing company Metcash ((MTS)) has delivered first half earnings ahead of consensus expectation.
The main discordant note related to disappointing cash flow, according to brokers, as stronger growth led to greater investment in working capital.
Overall, the average 12-month target price of five brokers in the FNArena database rose slightly to $4.61 from $4.59, suggesting 7.8% upside to the latest share price.
Outside of the database, Goldman Sachs and Jarden raise their targets to $4.20 and $4.40 from $4.10 and $4.20, respectively.
The company specialises in grocery, fresh food, liquor, automotive parts & accessories and has a trade-focused hardware business.
In late 2020, the Hardware division (Mitre 10) was expanded when the group acquired 70% of the shares of Total Tools, a franchisor to the largest tool retail network in Australia. This stake was later increased to 85%.
Group revenue for the first half rose by 7.8% and underlying profit increased by 9.1% on the previous corresponding period.
Outperform-rated Macquarie points out the Hardware and Liquor divisions were the key drivers of the result, with an increase in earnings (EBIT) of 15.6% and 10.8%, respectively.
Total Tools was a standout, with earnings climbing by $14m to $47m, on an earnings margin of 15.8%, which compares to the 4.9% achieved by the company’s Independent Hardware Group (IHG).
Group sales also climbed by 6.2% for the first four weeks of the second half of FY23, compared the previous corresponding period. The trading update revealed Liquor and Food sales rose by 8.9% and 4%, respectively.
The rise in Food sales is suggestive of market share gains, according to Overweight-rated Jarden, and is consistent with independent data on supermarket foot-fall.
It may not be all plain sailing, however, as management suggested all divisions remain at risk to supply chain challenges, despite a recent easing in pressures.
Also, while Macquarie notes strong ongoing demand for both IHG and Total Tools, Goldman Sachs (Neutral) sees first signs of softening in the Hardware division, with (trading update) sales decelerating to 8% due to inclement weather impacts.
Citi (Neutral) also sees potential obstacles from easing inflation, an unwind of local shopping and impacts from a housing slowdown, which may offset earnings growth from the Total Tools rollout.
A fully franked interim dividend of 11.5cps was declared, a 9.5% increase on the first half of FY22, and ahead of the consensus forecast for 9.6cps.
The effect of inflation
Ord Minnett (Buy) points out Metcash is typically considered the largest beneficiary of inflation, given its wholesaling model and fixed cost base.
A bounce-back in food sales in the latter part of the first half, which continued into the trading update period, was partly due to rising wholesale inflation, according to UBS (Buy).
Despite the inflationary backdrop, the company delivered flat margins and no underlying earnings growth, partly due to elevated supply chain costs, explains Ord Minnett. The company is also considered to be placing a priority on price competitiveness.
Cash realisation ratio
Neutral-rated Credit Suisse stresses the importance of cash conversion via its relevance to the medium-term dividend payout. The latter is considered an important factor in the company’s positioning in income-oriented funds. It’s felt the strong interim dividend payment provides some comfort.
The broker attributes a fall in the company’s cash realisation ratio (to 36.5% from 91.6% in the previous corresponding period) to inflation (due to typically higher payables than inventory) and growth in the Hardware business. For now, it’s felt the 70% payout ratio can be sustained.
UBS (Buy) expects cash realisation will improve in the second half to 72% and will normalise back to around 90% in time as inflation moderates and growth slows. It’s noted the Hardware is the most working-capital intensive and the fastest-growing division.
Management remains confident on the volume growth trend for supermarkets and doesn’t believe the company is ceding share from local shopping behaviour gained during covid.
Jarden expects the market perception (and valuation) of Metcash as a structurally challenged food wholesaler will change.
This is expected to occur as the company establishes a growing market share in Food and as the higher-multiple Hardware business becomes a larger contributor to group earnings.
Of the five brokers in the FNArena database, three continue with a Buy (or equivalent rating), while two remain Neutral.
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