Metcash (ASX:MTS) is transitioning from a Food wholesaler facing structural headwinds to a Hardware retailer and wholesaler with a market leading trade offer. Based on the Company’s results for the six months to 31 October 2021 (1H22), the transition is happening faster than expected – as evidenced by the jump in the share price since the announcement of the 1H22 results. Hardware is now a larger earnings contributor than Food and the key driver of growth, with the Trade segment the key driver of strength for the Hardware division.
Whilst there is scope for further gains in the shares as the growth opportunity from Hardware materialises, is this likely to be mitigated by challenges in the Food division?
Metcash is Australia’s leading wholesale distribution and marketing company for the independent grocery channel. It has a diversified business across the food, grocery, hardware, and liquor sectors. The Company is the 4th largest player in the domestic supermarket segment, behind Woolworths and Coles (which together account for ~2/3rd of the overall market share) and Aldi.
Key Fundamental Drivers
Supermarket Share Gains Likely to be Retained
MTS is in a significantly better competitive position than 2-3 years ago. The Company has been able to maintain a premium in shelf prices, has a successful store refurbishment program (where IGA retailers are re-investing in their stores), and has markedly improved its market share. To date, much of this market share has been retained. More recently, market share has been supported by a period of extended lockdowns in 1H22.
Compared with the same period in 2H20 (i.e. two years ago), supermarket sales for the first five weeks of trading in 2H22 increased by 14.7%. This rate of growth is ahead of the rate of industry growth and reflects the sustainability of customer shopping habits even as lockdowns have lifted (i.e. work from home trends are favouring local shopping).
Competitive Position Unaffected by Food Inflation
As a wholesaler, MTS is a net beneficiary of inflation, given its high fixed cost base and the fact that the majority of wholesale contracts are on a % of sales value basis, rather than dollars per carton.
For 1H22, MTS reported wholesale food price deflation of 1.0% as the Company focuses on retaining price competitiveness. This result followed price inflation of 1.0% in FY21, although there was a moderation in the rate of food inflation in 2H21. MTS has provided guidance for a modest rate of inflation in 2H22.
MTS’ guidance contrasts with price deflation reported by the major supermarkets in their recent quarterly results (to 30 September 2021).
Given the likelihood that MTS’s food inflation is above that for its major competitors, a key question to consider is whether MTS loses market share in the event that consumers trade down towards the majors and/or discount grocers. To this end, MTS is expected to pass on price inflation that it receives to its retail partners in order to maintain its relative price position in comparison to the market. This is where IGA has typically enjoyed a pricing premium given its increased convenience offer in comparison to the major competitors.
Hardware Remains the Main Earnings Growth Driver
The Hardware division reported an outstanding result, with strong contribution from both the Total Tools acquisition and the pre-existing Independent Hardware Group (IHG) business. By way of background, Total Tools is a market leading trade tools specialist.
Revenue growth of ~18% to $1.5b, reflected strong performance in Trade and Total Tools. Profitability also improved meaningfully, with Hardware posting EBIT margins of 6.7%. This was 160 basis points higher than 1H21 and the highest in over seven years and driven by Total Tools.
The store roll-out and retailer conversion strategy within Total Tools is the key growth driver for MTS. MTS increased its ownership of Total Tools from 70% to 85% during the period. The Company had ownership interests in 13 joint venture stores at end 1H22 and plans to add 14 joint venture stores prior to the end of this calendar year. There were 94 stores in the network and MTS is targeting ~130 stores by 2025 and plans to open ~10 stores per annum. This expansion is likely to lead to a material step-up in network sales and divisional EBIT of $85m over the next five years.
MTS shares are currently trading on a 1-year forward P/E multiple of ~16.5x. This is at the upper end of its trading range over the last two years (~12x to16.5x). MTS has historically traded at a substantial discount to major supermarket peers Coles (ASX:COL) and Woolworths (ASX:WOW) given the wholesale exposure of MTS’ business.
However, with the transition of the earnings base towards the higher-margin Hardware business, there is potential for a re-rating in the shares. In particular, the composition of the Hardware division earnings to total group earnings is expected to increase to ~45% by FY24. This factor coupled with forward earnings growth for the Hardware division exceeding that for the Food division implies that the Hardware division should contribute a much larger portion of the overall valuation on a Sum-of the-Parts basis.
For valuation purposes, the EBIT multiple for Hardware (at ~15-17x) is significantly higher than the EBIT multiple applied to the Food division. It is also worth noting that the Liquor division (presently contributing ~20% of group EBIT) is also a higher-margin business relative to Food and would therefore also command a higher EBIT multiple than Food.
Aside from the above, there is balance sheet capacity to pursue further acquisitions in the highly fragmented trade/hardware sector. This provides further earnings growth upside.
We looked at the MTS chart at the start of December in The Dynamic Investor and commented that “it is getting ready to head higher again. For those looking for an entry point with MTS, if we can see it push up to $4.30, then that upside break would be a buying opportunity.” We got that upside break several days ago and MTS should continue to rally from here. The slight dip and retest of the breakout from the past day or so is another buying opportunity before the share price gets too far away from the breakout.
Michael Gable is managing director of Fairmont Equities.
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