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Challenges Continue For Metcash

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Metcash ((MTS)) has been investigating a new distribution centre in South Australia so the news that Drakes Supermarkets will not commit to having its chain supplied is a disappointing development for brokers.

Food distribution operating earnings guidance is for a flat outcome in FY18. Subdued sales in the food distribution business counters hopes of easing deflation and a decelerating impact from Aldi in South and Western Australia.

The announcement of a new distribution centre signals an increase in capital expenditure, an undesirable development in terms of capital allocation, Credit Suisse asserts. The broker observes the company is doubling down on capital being allocated to a low-profit market with significant uncertainty.

Wholesale sales from food distribution has slipped -1.2% in FY18, which the broker suggests is but a marginal improvement on the -1.4% decline reported in the first half. Credit Suisse acknowledges the implied decline in operating earnings in the second half is not as severe as the headline suggests, given the prior corresponding half included the benefit of an extra trading week.

Still, earnings growth is not materialising to the extent CLSA requires to be confident in the stock. While price competition between supermarkets may have abated, the broker is concerned that the major players are targeting the strengths in the independent chain supplied by Metcash, IGA, such as convenience, service and community.

Continued pressure on sales, maket share and margins is likely to continue. CLSA believes management is capable, but is yet to devise a way to grow food & grocery sales, while cost savings will eventually come to an end. The broker, not one of the eight monitored daily on the FNArena database, retains a Sell rating and $2.70 target.

The company's cost reduction program is masking the underlying trend, in Deutsche Bank's view. While further reductions may be found, they will eventually run out and the potential exit of Drakes and the sharp reaction in the share price serve as a reminder, in the broker's view, of the challenges in the business. The company's customer cohort is losing market share and there is the risk that independents source product from elsewhere.

Drakes Impact

Morgan Stanley does not believe the departure of Drakes, while disappointing, will be a signal for further supermarkets to abandon Metcash as a distributor. The broker had considered the departure of Drakes a low probability, as it has no existing distribution capabilities and far less buying power than Metcash.

Therefore, the prospect of incremental independent supermarkets establishing their own distribution channels is low, given the high fixed costs and low profit margins that exist. Morgan Stanley also would not rule out the possibility that Drakes moves back to the Metcash stable in the future after negotiating terms. Drakes is contracted until June 2019 and the impact of its departure is not likely until FY20.

There is little impact on margins, as Drakes only represents 3% of food & grocery sales, and the broker considers the share price reaction to the news overdone, ascribing 51% of the stock's value to its food business and citing increasing earnings diversification.

UBS agrees it is unlikely other supermarkets will follow Drakes in the short term because of the costs and risks associated with establishing a vertical model. Nevertheless, if Drakes is successful, others may explore this option over time. Assuming the sales are lost over the next two years at an incremental earnings margin of 5-10%, UBS calculates an impact equivalent to -4-10% of Metcash FY20 estimated earnings. The broker reduces medium-term forecast by -6%.

Credit Suisse suspects the loss of distribution to Drakes likely reflects the commitment required by Metcash and the difficulty in securing retailer revenue to support its investment, while Citi continues to envisage downside risk to earnings from competitive pressures and further contract losses but believes the risk is more balanced with the share price at current levels. As long as the loss of Drakes is isolated.

The company has three contracts up for re-negotiation over the next 12 months and, if one or two of these are lost, the broker expects Metcash to de-rate from current levels. Ord Minnett is more positive, as food deflation is easing and there are some signs of inflation occurring at a faster rate than previously envisaged. The broker is confident that Metcash will retain its customers as there are few large accounts that could go vertical or be meaningful to a new entrant.

Growth at Aldi is moderating and the Coles ((WES)) de-merger creates an environment where food deflation could subside. Hence, Ord Minnett believes the independent retailer network is in better shape with the investment that is occurring, although acknowledges the risk to contracts.

Capital Management

Several brokers still believe there is capital management potential. UBS estimates Metcash should be net cash in FY18 with a large franking balance and a $150m off-market buyback would be 4% accretive to FY19 EPS. Ord Minnett notes the low earnings multiple and believes previous multiple ranges do not reflect the changing business mix. The broker suspects a buyback could be announced at the FY18 results.

The database shows three Buy ratings, three Hold and one Sell (Credit Suisse). The consensus target is $3.19, suggesting 7.1% upside to the last share price. The dividend yield on FY18 and FY19 forecasts is 4.6% and 5.0% respectively.

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