Shares in Metcash (ASX:MTS) have traded off its recent lows for the year. This prompted us to review the Company’s recent results and fundamentals to assess the prospects for a further recovery in the share price.
About Metcash
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.
The Company operates via three divisions: Food, Hardware and Liquor. Hardware is now the largest contributor to group earnings and the key growth driver. This follows the acquisition of Total Tools in FY21, which merged the number one and two hardware industry wholesalers.
Within the Food division, MTS supports a network of ~1600 independently owned stores across Australia, mainly under supermarket banner IGA). The acquisition of Superior Foods Group in February 2024, adds diversification and growth to the Food division.
Key Fundamental Drivers
Can MTS Hold Food Market Share?
A trading update for the first seven weeks of the six months to 31 October 2024 (1H25) suggests that independents are gaining share. In particular, footfall data shows traffic re-accelerating from April and traffic growth for IGA above that of Woolworths, Coles and Aldi.
The forward sales and market share outlook are supported by several factors:
i. The Company has had some success in narrowing the price gap between its IGA stores and its competitors. This has been achieved via initiatives such as ‘Low Prices Every Day’; extending its Price Match program to all IGA-bannered stores; and growth in private label. As a result, IGA is no longer viewed as materially more expensive – which should support market share.
ii. The Company intends to take more equity positions in its retail stores. This involved MTS expanding its ‘JV partnership’ approach in Grocery to protect and scale the network.
iii. Continued store investment and further investment in digital capability and loyalty will allow IGA to better compete against its larger competitors.
iv. MTS aims to continue to drive efficiency in the business through its ‘Sorted’ platform which simplifies ordering for retailers. The platform also delivers benefits through value added services such as displaying best-selling products across the entire network.
Potential for Margin in Food Division to Expand
EBIT margin for the Food division improved marginally in FY24, to 2.2%. Cost savings and positive mix shift (away from low-margin tobacco sales) supported EBIT growth & margin expansion. At the FY24 results release, the Company noted that they will take margin expansion where appropriate without detracting from the prioritisation on volume. There is limited further upside to margin (at an EBIT level) over the next few years for the underlying business. This is due to increasing depreciation charges, as well as stock holding profits likely to be more difficult to maintain in a lower inflationary environment.
However, synergies from the acquisition of Superior Food Group are expected to result in a slight improvement in the overall EBIT margin for the Food division.
Hardware Division Well Leverage to Cyclical Recovery
The cooling Australian housing market impacted both revenue (-11%) and earnings (-3%) in FY24. Low double-digit sales growth for the Hardware division is expected in FY25. This is driven mainly by acquisitions, with underlying sales continue to slow. However, one risk to already-downgraded sales forecasts for the Hardware division is if spending continues to moderate sharply, as was evident in 4Q24.
The weaker revenue growth profile is expected to place further pressure on margins. Increased competition from Wesfarmers-owned TKD is likely to weigh on EBIT margin for FY25. However, there is potential upside to revenue growth should the recovery in housing start to turn positive.
Assessing the length and depth of the housing cycle is difficult to predict. However, MTS’ investments in new businesses, coupled with the Total Tools store rollout and tight cost control leave it well placed.
Balance Sheet Capacity Available
As at 30 April 2024, gearing (on a net debt to EBITDA basis) was 0.45x, well below its target range of 1.0-1.75x. Following recent acquisitions and higher capital expenditure requirements, gearing is expected to increase to the mid-to-upper end of target range. Notwithstanding, there is expected to be enough balance sheet capacity to fund ‘additional growth opportunities’. These are likely to include further acquisitions in the Hardware and/or food service space.
Fundamental View
MTS shares are trading on a 1-year forward P/E multiple of ~12x. This multiple is at the lower end of the trading range over the last two years (~12-17x). At current levels, we contend that valuation support starting to emerge. Potential positive catalysts for a re-rating include:
i. Potential for the Superior acquisition to lead to an uptick in EBIT margin for the Food division.
ii. Potential for the impact to Hardware earnings to be less than initially feared, should the recovery in housing & construction arrive earlier.
iii. Further acquisitions, supported by both balance sheet capacity and reducing CAPEX commitments in FY26.
Charting View
We last looked at the MTS chart on 7 May in The Dynamic Investor where we noted that it was hitting resistance and was at risk of heading back. We commented that “investors can afford to wait on the sidelines for now as a break under $3.80 would then have us targeting support back near $3.60 as a cheaper entry point.” With MTS now back into that support zone, these are the price levels for those looking to buy. However, investors need to be aware that there will still be strong resistance near $3.80 and then near $4.
Michael Gable is managing director of Fairmont Equities.
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