Metcash (ASX:MTS) has benefited from COVID-19-driven changes to consumer behaviour. Here we assess the extent to which these benefits, coupled, with other internal measures, support a further re-rating in the shares.
Key Fundamental Considerations
Can Strong Supermarkets Sales be Maintained?
Metcash has three operating divisions: Food (which comprises 50% of group earnings), Hardware (~30% of group earnings) and Liquor (~20% of group earnings). MTS’ Supermarkets business is the main driver of financial performance for the division Food division. 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. For the six months to 31 October 2020 (1H21), Supermarket sales growth has benefited from continued momentum of the ‘shop local’ trend and growth in transaction and basket sizes. Also, EBIT margin for Supermarkets has improved on the back of positive operating leverage from higher volumes.
We outline a number of factors underpinning our view that sales performance is likely to remain strong over the medium term:
1. Market Positioning Has Improved
MTS is in a significantly better competitive position than 2-3 years ago, as evidenced by:
i. A premium in shelf prices (discussed in further detail below).
ii. Store refurbishments, where ~40% of IGA-branded stores have now been refurbished under the Diamond Store Accelerator (DSA) program. The Company has flagged that it currently has a strong pipeline of DSA’s, with COVID-19 a catalyst for retailers to accelerate store openings and refurbishments, which appear likely to continue due to strong trading results and tax incentives.
iii. Notwithstanding that competition from the major supermarkets has been intense, MTS’s business lines are largely insulated against COVID-19. In particular, the Company has a diverse network of smaller format stores, which reduces concentration risk.
iv. Product lines have been re-positioned (as part of the DSA program) towards growing sales of higher-margin fresh food by adding packaged meat, cheese counters and ready-made meals.
v. There is also positive sentiment from suppliers toward MTS, who are pleased that the Company is investing back into stores and that compliance has improved. There is a desire among suppliers for MTS to succeed, as they do not want too high a concentration with Coles and Woolworths.
2. Online Offering is Improving
The key changes to consumer buying behaviour post COVID-19 that MTS is expected to benefit from is the accelerated shift to online purchasing of groceries, as well as increased consumption of food at home.
With the Company confident that a good portion of the consumer behaviour changes can stick, MTS has increased its investment on its online capability, which in addition to the DSA program and improvements in price & range, is another lever by which to retain customers.
3. MTS’ Food Inflation is Tracking Ahead of Larger Competitors
Trends in food inflation, to which the Food division is highly leveraged, continue to improve. After significant deflation in recent years (deflation averaged -2% over FY16-19), food inflation turned positive in 2H20 (+1.5%), which improved to +2.1% and is higher than the rate of food inflation reported by MTS’ major competitors Coles (+0.8%) Woolworths (-0.2%) as per recent 1Q21 results.
While COVID-19 has resulted in higher prices for groceries, the key factors underpinning the current inflation in food prices have been cost price increases, a more rational pricing environment in grocery retail following the Coles demerger as well as the success of the Company’s strategy to improve both price and range. More recently, there has been data suggesting that shelf prices for the most popular SKUs at IGA online are ~6% higher than Coles & Woolworths. While the pricing premium for IGA online is significantly lower in comparison to historical trends, the premium is nonetheless justified given IGA’s increased convenience offer in comparison to the major competitors.
Overall, we consider that these factors are expected to continue to underpin expectations for food inflation to remain at these levels going forward.
Hardware Business Has Potential to Grow Via Acquisitions
Organic sales growth for the Hardware division has been impressive, as a result of elevated home improvement activity consumers spending more time at home. In addition, recent growth initiatives across Trade, DIY and digital capability, as well as improvements in price & range have supported both sales growth and margin expansion.
Importantly, there is an opportunity for the Company to grow the Hardware business by pursuing further bolt-on acquisitions. The Hardware market is highly fragmented (especially in trade), which means that there are more potential targets and hence more attractive economics for MTS (assuming attractive transaction multiples). Further, Hardware has been more of a focus in Merger & Acquisition history for MTS (e.g., Home Timber & Hardware, Total Tools, and independent hardware retailers).
Net Cash Balance Sheet
Aside from using its net cash position to pursue further Merger & Acquisition opportunities, MTS can return capital to shareholders. In particular, MTS has a substantial franking credit balance that would enable tax effective returns of capital either via a higher dividend payout or an off-market share buyback.
Earnings growth is expected to remain strong in all divisions in the short term as MTS benefit from COVID-19-driven demand. Importantly, the Company is well positioned to benefit from COVID-19-driven changes into the longer-term. This is underpinned by: i) The Supermarkets business adding/refurbishing stores which should help sustain its stronger market position and ii) The Hardware division continuing to consolidate its leading position in the fragmented trade hardware sector.
At current levels, the shares are trading on a 1-year forward P/E multiple of ~14x, having re-rated from ~12.5x prior to COVID-19. The re-rating is justified in light of the improved fundamentals, as well as the potential for capital returns. However, at current levels, with the P/E multiple at the upper end of its recent trading range, we consider that current levels are unlikely to present an attractive opportunity.
For the last two years, there appeared to be resistance near $3.20, but MTS finally managed to gap above that in November. However, there will also be resistance near the 2018 at around $3.70. If $3.20 is going to offer support, then MTS shares are trading in the middle between support and resistance, which doesn’t provide a good risk/reward ratio. Those looking to purchase MTS should wait to see if it can come back towards $3.20 and then bounce higher from there.
Michael Gable is managing director of Fairmont Equities.
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