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Morningstar | Metcash Introduces Much-Needed Capital Programme to Defend Market Share; FVE Unchanged at AUD 2.40

We maintain our fair value estimate of AUD 2.40 for no-moat-rated Metcash following the company's investor day. Management provided more detail on Mfuture, a five-year programme that will supersede the current Working Smarter programme. Over the next five years, the company plans to spend AUD 300 million in capital investments for growth initiatives envisioned by Mfuture, over and above a baseline of AUD 60 million in annual maintenance spending. This is slightly more expenditure, and over a shorter time frame, than our previous implicit estimate of AUD 250 million in growth capital over the next decade. We have adjusted our capital expenditure estimates, but this resulted in an immaterial impact on our intrinsic valuation. In our opinion, the Mfuture initiatives are necessary to refresh and reposition the store network and store format to keep up with the competition, which is investing too. Hence, we don’t forecast Metcash to gain significant market share in any of its three segments, and our midcycle sales growth rates of around 4% across food, liquor, and hardware are unchanged.

Management is targeting AUD 25 million in ongoing annual cost savings to offset inflationary pressures, and AUD 50 million in savings have been identified over the next two years, primarily in the core food segment. However, much of the low-hanging fruit in terms of cost savings--mainly in food--has already been achieved with the company’s successful Working Smarter programme. So far, costs have been reduced by AUD 106 million in the last two and a half years, and Metcash is on track to hit its target of AUD 125 million in savings within a three-year period. In the hardware segment, we expect synergy benefits of AUD 34 million relating to the HTH acquisition are garnered by the end of fiscal 2019.

Despite the cost savings from Working Smarter, EBIT margins in food and liquor have been virtually flat over the past two years. In hardware, we forecast the wholesaling EBIT margin to remain around 2.5%, with cost efficiencies passed on to the independent retailers. Therefore, we expect Metcash’s profit growth to be driven by top-line growth.

Hardware and liquor are currently the company’s strongest segments in term of sales growth, together accounting for just under half of the group’s operating EBIT. In line with a trading update provided at the investor day, we expect the strong momentum in liquor sales to continue in the second half of the current fiscal year, resulting in our unchanged sales growth estimate of 6.7%. Hardware is more exposed to cyclical weakness in the Australian housing sector, and sales have further softened in the second half to date. Like-for-like sales growth of the IHG network is still positive but weaker than the 4.2% posted in the first half, which was already down on the 7.4% in fiscal 2018. We continue to estimate sales growth in hardware of 1.3% for fiscal 2019, affected by closures of unprofitable company-owned stores and the loss of a large customer in Queensland.

Sales growth in food continues to underperform Metcash’s smaller segments as well as competitors Woolworths and Coles, to which the independents lost market share. However, we maintain our fiscal 2019 food sales growth forecast of 0.6%, in line with year-to-date growth.

Implementing the Mfuture initiatives in food are vital to increase sales in line with the overall Australian grocery market. These initiatives include increasing private-label penetration, expanding the network footprint, tailoring ranging and store formats to meet consumer demand, and continuing to refurbish stores with its Diamond Store Accelerator programme.

A concern of ours is the low online sales penetration of Metcash’s independent food retailers. Consumers are increasingly shopping for groceries online, which is the fastest-growing food retailing channel with sales growth of close to 30% currently. We estimate Metcash’s banner network sells less than 1% online, significantly below Woolworths and Coles, which both have online penetration of around 3%.