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Morningstar | Metcash Remains the Weakest Player in the Australian Grocery Industry; FVE Unchanged at AUD 2.40

No-moat rated Metcash’s network of independent grocers continues to lose market share, in line with our expectations. Stronger-than-expected liquor sales were offset by lower hardware sales in the first half of fiscal 2019, and our full-year revenue estimate for the group remains virtually unchanged. We also maintain our EBIT margin estimates and reiterate our AUD 2.40 fair value estimate. Despite the retreat in the share price following the results announcement, shares screen as slightly overvalued.

Western Australia was the weakest region for the core food division, where relatively high unemployment and the store roll-out of discount department store Aldi have been taking their toll. In South Australia, where the company is constructing a new distribution centre, sales were flat. However, we expect the exit of Drakes’ South Australian supermarkets from Metcash’s customer base to erase some AUD 270 million in sales in fiscal 2020. On the Eastern Seaboard, Metcash reported positive sales growth for its supermarkets. Supermarket sales growth was only 0.10% in the first half, in line with our full-year forecast of flat grocery sales.

The IGA banner network continues to report weaker revenue growth than Woolworths and Coles, and we expect this trend to continue in the near term. The decline in like-for-like grocery sales of 0.2% reported by a of subset of the IGA bannered store network in the six months to Oct. 31, 2018, materially underperformed like-for-like sales growth at Woolworths and Coles in the three months to Sept. 30, 2018, of 1.8% and 5.1%, respectively. We expect Metcash’s IGA network to lose 40 basis points of market share in fiscal 2019 and another 50 basis points in fiscal 2020, before stabilising at around 11% share from fiscal 2021. In the much smaller convenience segment, headline sales growth of 5.4% was slightly ahead of our unchanged full-year estimate of 4.2%.

The supermarket and convenience segment accounts for about 60% of group sales and profits. The food and grocery EBIT margin of 2.1% was in line with our estimate.

Headline sales growth in the hardware segment of 1.3% was slower than the 4.2% we had expected, due to the loss of a larger Home Timber & Hardware, or HTH, customer in Queensland and the closure of loss-making corporate stores, which Metcash acquired from Woolworths in 2016. Like-for-like retail sales of HTH and Mitre 10 stores in the Independent Hardware Group was 4.2%, which we estimate to be roughly on par with industry leader Bunnings. The hardware segment makes up about 15% of group sales but is the segment with the highest EBIT margin and hence disproportionately accounts for about a quarter of group EBIT. First-half operating margins of 3.5% are tracking our unchanged full-year estimate of 3.7%. Management has already realised AUD 31.5 million in synergy benefits from the HTH acquisition and expects another AUD 2.5 million in the second half of fiscal 2019, which is reflected in our EBIT margin estimate. Total synergy benefits of AUD 34 million are significantly greater than the AUD 15 million-AUD 20 million targeted by year-end fiscal 2018, at the time of the acquisition, speaking to management’s successful combination of the Mitre 10 and HTH businesses.

The liquor business surprised us on the upside. The segment accounted for 25% of the group’s sales but has the lowest operating margins and presented only 18% of group EBIT in the first half. Headline sales growth of 6.7% in the first half was ahead of our prior 4.2% estimate, driven by new contract customers like Thirsty Camel. Despite the strong sales growth, EBIT margins were virtually flat at 1.7%, due to cost inflation and additional costs related to the introduction of the Container Refund Scheme in Queensland and Canberra.