Metcash (ASX:MTS) — the Burry observation
Summary of Key Points
- Core food business offering continues to decline
- Lowering of margins will add extra pain in the next 12 months
- Food (Convenience) business now has lost another moat — trading hour restrictions
Metcash Limited (ASX:MTS) describes itself as a ‘wholesale distribution and marketing company specialising in grocery, fresh food, liquor, hardware…’ Metcash rationalises this into three pillars: Food, Liquor, and Hardware. Several of its brands are well known household names: IGA (and its variations), Mitre 10, Cellarbrations, and Home Timber & Hardware. The fact that it operates more than 15 different banners gives an impression that Metcash is substantially diversified, similar to the likes of Wesfarmers (ASX:WES). However, of the $14.12 billion in revenue and $296.7 million in EBIT Metcash reported in FY17, the Food pillar (being mostly IGA, Super IGA and IGA-Xpress) makes up 65% and 61% of Metcash’s revenue and EBIT respectively.
Grand prospects from December 2017 onwards…or not?
Metcash delivered its HY18 update on 4 December 2017. Naturally, the presentation was upbeat and showed the group outperforming HY17 on all metrics. Taken on face value, it’s easy to see why Metcash shares shot up 31% over the following four months to a high of $3.60 last week. Metcash touted a 7.6% increase in revenue and 18.7% jump in EBIT. Even the underperformer of the group, the Food pillar, reported a 5.8% increase in EBIT.
Yet, these claims were based on some confusing (or rather, uncomfortable) grounds. The sales and EBIT reported for HY18 included 53 weeks (not adjusted for HY17). Food EBIT managed to rise 5.8% despite revenue falling 1.4% (both including the benefits of an extra trading week) raising questions of sustainability. Hardware comparisons were not adjusted, with Metcash reporting HY18 sales for the full period and HY17 sales (unadjusted) for a period of one month.
Many other anomalies were apparent, suffice to say any long view PEF Capital had for Metcash would have vaporised after the share price passed $3.10. However, the factors not discussed in detail by the group, but which are inseparable from its long-term performance, are what interests us most and, to that end, we focus on Metcash’s bread & butter; its Food pillar.
Metcash hitches itself to the payout ratio wagon
After two years of yielding nothing, Metcash began paying dividends in 2017. Shareholders were rewarded with 3.28% by the December ex-div date — 10.5 cents — in 2017, although this had fallen to 3.19% by last week. By comparison, Wesfarmers (ASX:WES) and Woolworths (ASX:WOW) were yielding 5.06% and 3.26% respectively. Metcash is aiming for a 60% dividend payout going forward; based on growth reported in FY17, this would mean a dividend of 12.5 cents in 2018. It will be interesting to see how shareholders react if projected growth in earnings do not materialise and Metcash is required to (1) begin incurring more debt to cover dividend payouts, or (2) reduce its dividend payment accordingly. A net cash holding of merely $14 million pales against an expected dividend payment of over $120 million in FY18.
Race to the bottom on prices
More concerning is Metcash management’s competition strategy of trying to beat Coles and Woolworths on price. Franchisees will be required to reduce prices (and their margins) on hundreds of core/main lines (up to 30% of stock) as part of Metcash’s range rationalisation and move to its indieDirect platform. This new process will allow Metcash to ‘clip the ticket’ on hundreds of lines franchisees have traditionally sourced directly from suppliers. Cynics would call this double-dipping: taking the franchise fee, then also a margin of franchisee’s purchase costs.
A casualty of its industry, Metcash in some sense is vindicated in its decision to compete on price; the growth of Aldi, introduction of Costco and upcoming immigration of German discounter Kaufland to the consumer staples scene has seen Metcash’s market share drop by over half in the last 15-odd years.
But who is the real client?
Let’s consider though who the real client is. Customers win with lower prices at the cash register. Metcash wins extra earnings for ‘clipping the ticket’. Franchisees lose by being squeezed on all three sides: lower sale prices, higher cost prices and smaller market share. This results in significant risk for Metcash when one considers the financial impact of losing franchisees. When was the last time you heard someone talk about the exciting prospects of becoming an IGA/Super IGA/IGA-Xpress franchisees? In this industry, store owners generally become franchisees when running a business independently becomes unviable — such businesses aren’t entering with strong balance sheets.
Between April and October 2017, the number of Metcash food stores grew by a meagre 0.9%. However, as the recent pressures on store owners transfers to their bottom line, it is likely that store numbers will begin declining — at a significant rate. This trend will prove very difficult for management to stem once it begins and already franchisees have started voicing their dissatisfaction.
The final kick in the guts
The catalyst for research by PEF Capital on Metcash was a change to the one tangible edge Metcash’s food stores have always enjoyed — the protection of trading hour restrictions. Changes to allowable trading hours across the country has altered the consumer staples landscape, with Metcash (through its Convenience offering) being a loser. Supermarkets are now permitted to trade longer (especially on weekends); competitors like Woolworths and Coles have been making the most of this by extending their opening hours. For example, the captive market Metcash used to have after 5pm on Saturdays and 9pm on weeknights (in South East Queensland at least) can now freely shop at its competitors till as late as 9pm on Saturday and 10pm on weeknights.
The strategic push into hardware is not as risky as the strategies being implemented in the food business and may help to offset the general decline of Metcash’s business core business. However, paying mid-$3.00 per share on a promise of a low yield (more suited to a company with strong growth potential), our view is that Metcash is likely to struggle to meet market expectations in the next six to twelve months and its share price could struggle to stay at or continue past its recent high.