There was something for everyone in the Metcash ((MTS)) trading update and strategy briefing, expressed in a wide range of views from brokers. Metcash will spend $300m on growth across FY20-24 and management has signalled a 15% minimum return hurdle. If this is not achieved, expenditure will slow and capital management will resume.
The growth expenditure is matched with $550m of potential funding capacity from retained cash flows and debt. This implies upside to estimates and UBS, along with several other brokers, welcomes the decision to invest more in stores and improve the network quality.
There is also a $50m cost reduction program over FY20-21 to offset cost inflation. Implementation costs are calculated to be 25% of the savings. Macquarie disputes whether the savings can be considered as outright upside to net profit but acknowledges the positive aspects.
The strategy may be well-crafted but Credit Suisse believes the positive implications for shareholders are less obvious. Moreover, the stock is likely to trade on near-term earnings guidance while capital is being committed for growth.
Credit Suisse makes no material changes to forecasts resulting from the update, although acknowledges proposed cost savings have now been pinned down. As a negative impact on valuation would arise from including $300m in capital expenditure without a commensurate earnings uplift, the broker refrains from including the additional growth expenditure in its forecasts.
Citi retains a Sell rating (along with Deutsche Bank which is yet to update on the strategy) and continues to envisage downside risk to earnings forecasts. Citi cites the structural challenges for growth in grocery and cyclical headwinds in hardware, as well as an increase in capital intensity, as reasons to be cautious.
The broker considers the growth outlook, following this strategy update, is largely neutral and not sufficient to overcome the numerous structural challenges the company faces. The elevated capital expenditure profile will also weigh on free cash flow, as the broker calculates the cash flow yield will drop to 7.9% by FY24.
In the absence of more material investment, or a return to elevated inflation, the broker asserts that, while some of the negatives are factored into the price, a wider margin of error is required.
Food/Liquor
UBS believes the outlook for the Australian supermarket sector is improving, supported by easing deflation, reduced promotional intensity and a focus on differentiation. This outlook is supportive of independent grocers and Metcash will benefit by being the most leveraged to deflation and the main supplier to independents.
Macquarie finds the outlook still challenging, noting FY20 growth will be affected by the loss of the Drakes contract. The broker also notes the company has called out intense competition in food, price deflation and the impact of Aldi.
Metcash will focus on the fresh and private-label food business, acknowledging it is under-indexed in this area and this has hurt the business. However, the bulk of capital expenditure allocated to food is for the trial in corporate liquor, and the company has flagged additional capital will be required following a decision to roll out further.
Morgan Stanley observes the company continues to close a sales growth gap to the major supermarkets as its strategy gains traction, while second half sales growth, ex tobacco, was in line with first half trends. The broker also finds significant opportunity in the liquor business, as convenience trends, corporate store trials and private-label all drive growth.
Credit Suisse is surprised by the trial of a corporate liquor store, given the success of the current independent brand network. The broker suspects the company maintains a belief it needs to participate in retail liquor to be a better wholesaler. There are three pilot stores currently in operation with 10 targeted by December.
Hardware
In hardware, trends have slowed but sales growth remains positive. There is still significant rationalising of distribution centres to come over the next two years. NSW will close by September and WA on exploration of the lease. This will be supported by the conversion of more HTH stores to the Mitre 10 banner. The company’s aim is to return to three distribution centres in total.
Even though retailer sales growth may turn negative as the housing cycle worsens, Morgan Stanley believes cost reductions can limit the impact. Macquarie assesses the company is better placed to deal with a downturn in DIY versus peers, including Bunnings ((WES)), which have around 90% earnings exposure to the segment. Tasmania is the bright spot, with sales growth of around 20%, although less material to group earnings.
The company will spend $90m on its hardware initiatives over the next three years, on refurbishing the existing network and also promoting products that are not available at Bunnings. The company does not believe Bunnings is materially competitive on price, nor that Bowens will start a price war.
The hardware strategy has also meant more corporate stores ,although Credit Suisse does not believe this is such a change in view, given these have been a large part of the segment for some time.
FNArena’s database SHOWS three Buy ratings, two Hold and two Sell for Metcash. The consensus target is $2.75, suggesting 0.4% upside to the last share. The dividend yield on FY19 and FY20 forecasts is 5.6%.
