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Morningstar | Metcash’s Weak Outlook Prevails, but as Expected. We Increase Our FVE to AUD 2.50. See Updated Analyst Note from 24 Jun 2019

No-moat-rated Metcash reported a broadly in line fiscal 2019 financial result, with underlying group EBIT only 2% short of our expectations. We maintain our capital expenditures and operating profit estimates for the group. Nevertheless, our fair value estimate increases by 4% to AUD 2.50 due to the time value of money. Leading up to the full fiscal year 2019 results, investors were clearly anticipating better numbers. Metcash’s stock price declined by 10% on the announcement but shares still screen as overvalued.

The long-term outlook for Metcash’s core food business remains challenging, more so than for industry leaders Woolworths and Coles. We expect the IGA network of independent retailers to be the main donor of market share to discounter Aldi and incursions by smaller players Costco, Amazon Australia, and soon discount hypermarket Kaufland. Metcash’s now second-largest segment, hardware, is the most exposed to the soft housing market in the near term. However, the slowdown is cyclical in nature and we expect the hardware network to grow in line with the market over the next decade.

The incumbent Australian grocers are facing a period of relatively slow market growth coupled with an influx of competition from Kaufland in early fiscal 2021. Meanwhile, cost pressures from wage and energy inflation, and in the case of Woolworths and Coles higher spending on online sales, are eroding profitability. Like Coles’ recently announced Refresh Strategy, Metcash’s new business improvement programme, Mfuture, has a strong focus on cost-cutting to offset the anticipated cost inflation of some AUD 25 million per year.

The Mfuture programme follows the highly successful Working Smarter programme which eliminated AUD 25 million more in expenses than the initially targeted AUD 100 million. Yet Working Smarter didn’t have a material impact on the food segment’s profitability despite achieving significant savings.

Over the three-year life of the programme, adjusted EBIT in the food segment was virtually flat at AUD 181 million in fiscal 2019, versus AUD 180 million in fiscal 2016. Operating margins only slightly increased by 12 basis points to 2.06%, while food sales declined by 5% over the period.

We forecast the Mfuture programme to deliver similar results and expect relatively flat EBIT margins across all three business units, as savings are absorbed by cost inflation and the remaining spoils passed on to Metcash’s customers.

Sales growth was softer than we expected across all three segments in fiscal 2019. The largest miss was hardware sales--accounting for 25% of group profits, where we underestimated the impact of the loss of a large wholesale customer. The exit of Brisbane-based Bretts Timber and Hardware’s eight stores singlehandedly reduced hardware sales growth by 1.2 percentage points. The total decline in sales of 0.9% was also impacted by sluggish construction activity, whereas the do-it-yourself category was less impacted--a positive read-through for Wesfarmers’ Bunnings.

Full-year like-for-like retail sales of Metcash’s IHG banner group increased by 3.0%, lower that the 4.2% in the first half of fiscal 2019, and a significant drop from the 7.4% in fiscal 2018. This correlates with the decline in housing approvals over the period. Operating margins of 3.9% were slightly higher than the 3.7% we expected. This increase from 3.3% in fiscal 2018 was largely driven by synergy benefits and the closure of unprofitable corporate stores.

Food sales growth of 0.3% across supermarkets and convenience stores was marginally lower than our 0.6% estimate. Like-for-like sales of the IGA retail network declined by 0.5%. Among the big four Australian chains, Metcash’s banner group was the largest loser of market share in fiscal 2019. Operating margins were relatively flat at 2.06%, down 6 basis points from fiscal 2019. Food remains the group’s key segment, accounting for 55% of operating profits.

The liquor business grew the strongest, with sales up 5.6%, albeit weaker than our 6.7% estimate. EBIT margins of 1.9% were slightly below our 2.0% estimate, impacted by the premiumisation trend in liquor as well as the Container Deposit Scheme. The scheme has now been rolled out in New South Wales and Queensland, with the smaller state of Western Australia to follow in early 2020.