EUR 850.00 For Business Accounts Only

Morningstar | Metro Continues to Lack a Competitive Moat as Industry Headwinds Remain; Shares Overvalued

We plan to lift our Metro CAD 37 valuation around CAD 1 to account for the time value of money and a slightly more constructive out-year outlook for the company's pharmacy brand Jean Coutu (19% of total sales) that continues to see prescription growth of just over 2%, above the 1% long-term sales growth we currently estimate for the business. Our more constructive long-term stance on Jean Coutu is mitigated by the slightly stronger generic headwinds during the first half of fiscal 2019 (ending September), which should now ease as industry pricing cuts anniversary April 1. Meanwhile, Metro's grocery results (81% of total sales) benefited from easier year-ago comparisons and the timing benefit of pushing through pricing to offset near-term higher inflation, in line with our forecast of 2.5% and 2% 2019 and long-term same-store sales growth for the business, respectively. Finally, we continue to see competitive pressures from Walmart, Costco, and others offsetting near-term synergies from the integration of Jean Coutu, leading to relatively stable gross margins of around 19.6% on average over the next five years. We see shares of no-moat Metro as overvalued.

Jean Coutu (acquired May 2018) annualized sales reached CAD 2.75 billion in the quarter, trailing our CAD 3 billion 2019 estimate, which we plan to reduce lower toward CAD 2.9 billion, as industry generic pricing pressure continued to weigh on results. This was evident in the company's anemic pharmacy same-store sales growth of 1.1%, held back by a prescription drug price decline of 0.1%. That said, prescription growth of 2.2% remains solid (Jean Coutu reported prescription lift of 2.2% and 2.5% the past two quarters), and although pressure to further reduce generic pricing could occur, we now believe our sales forecast of around 1% on average over the next five years is too conservative and plan to lift it toward 1.5% to account for stronger volume growth.

Metro's food same-store sales growth of 4.3% accelerated from the 3.2% lift seen last quarter. But this was due to easier year-ago comparisons, as the metric lifted only 3.3% on a two-year stacked basis versus the 6.6% reported last quarter. Further, Metro's food basket inflation of 2.5% in the quarter was an acceleration from the 1.8% lift last quarter, which also provided a tailwind to same-store sales growth. Although Metro's food same-store sales spread above inflation improved in the quarter (1.8% this quarter versus 1.4% last quarter), we don't think this signals an improved ability to sustainably push through pricing, but rather is tied to timing, as we expect competition to remain intense.

We expect Jean Coutu synergies to be offset by continued competitive challenges over the next few years, resulting in stable gross margins of 19.6% through 2023. Jean Coutu synergies reached CAD 13.6 million in the quarter and CAD 24.3 million through the first 24 weeks of the year, tracking in line with the company's target of CAD 75 million at the end of three years (mid 2021). The pace of synergies should now slow down with most of procurement having been completed and the integration of retail and distribution systems ahead (most of this benefit is set to be realized in the second half of fiscal 2020). Despite Jean Coutu synergies, gross margin was 20.1% in the quarter, down 10 basis points versus last year, as transportation and wage pressures persist. As a result, we don't expect to change our 2019 gross margin estimate that calls for a 10-basis-point decline to 19.6%.