Metcash is still under pressure despite swallowing bitter pill

Without Ian Morrice’s decision to sell the company’s strongly performing auto unit, Metcash would have been very leveraged and vulnerable to further shrinkage in its earnings base.

Ian Morrice’s response to the structural shifts in the supermarket sector that had destabilised Metcash has finally stabilised the group’s supermarket sales base. There is, however, a significant cost involved and a continuing threat.

Last year Morrice sold one of Metcash’s better businesses, its automotive arm, to de-risk its balance sheet and help fund the multi-year investment in improving the competitiveness of its core food and grocery business.

The halving of the group’s interest costs helped it report a 2.7 per cent rise in underlying earnings and has enabled it to foreshadow the resumption of dividend payments in the second half of the 2016-17 financial year.

At an earnings before interest and tax (EBIT) level, Metcash’s earnings from its continuing businesses were down 7.4 per cent to $275.4 million, so the interest savings were very material to its bottom-line.

The very significant investment Morrice has made in improving the price competitiveness and the quality of the offer within the IGA supermarkets the group services does appear to have arrested the substantial sales declines the group has experienced in recent years, with supermarket sales up 0.5 per cent, or 0.9 per cent if the disruption caused by hail damage to its NSW distribution centre is taken into account.

The cost of protecting its sales base was, however, significant. Supermarket earnings before interest and tax were down $21m largely because of the investment in price. In effect, Metcash has re-based its supermarkets earnings at a lower level to reflect the intense price-based competition within the sector.

With its convenience stores’ earnings also falling, by $16m, the overall contribution from the food and grocery division (at an EBIT level) was down 17 per cent, from $216.8m to $179.9m. Four years ago, Metcash generated $388m of EBIT from its food and grocery businesses.

The source of the pressures on Metcash’s supermarket operations is well understood. The resurgence of Coles, the emergence of Aldi and the belated response from the once-dominant Woolworths has created intense price-led competition across the sector and Metcash’s independents have been hardest hit.

With Aldi expanding in Western Australia and South Australia as part of a new aggressive expansion drive and Coles and Woolworths slugging it out at the full-service end of the market, competition and price deflation has become an apparently permanent feature of the market.

There is also continuing speculation that Aldi’s fellow German discounter, Lidl, which along with Aldi has ravaged the UK supermarket sector, is looking to enter this market.

For Metcash, which has increased its cost base to help its independents improve their price competitiveness and upgrade the quality of their offer, that would be a particularly unpleasant development but at least its supermarkets are now in a better position to compete.

The group now has 150 “diamond” stores within its network, with Metcash saying the refurbished stores are producing increases of about 16 per cent in both warehouse and retail sales.

While Metcash is still in the renovation phase of its supermarkets strategy, it believes it has fixed the more obvious problems with the business and that the investments it has made in future growth are starting to pay off.

Given the fluidity of the competitive settings, there is no certainty that the investments will actually generate growth. Without them, and without the expensive decision to sacrifice margins and earnings to match competitors on price, of course, Metcash’s food and grocery operations would be in far deeper and potentially terminal trouble.

While its food businesses remain under pressure, Metcash’s liquor operations are performing solidly, with EBIT up 7.8 per cent to $62.1m on sales that rose 3.7 per cent.

Hardware, which Metcash is keen to expand with the potential acquisition of Woolworths’ Home Timber & Hardware business, improved its EBIT nine per cent to $32.8 million.

Woolworths’ disastrous foray, with its US partner Lowe’s, into hardware with the Masters brand could create an opportunity for Metcash to grab scale and synergies if it is able to acquire the Home Timber & Hardware business.

The sale of the automotive business to the Burson Group last year injected net cash of $242 million into Metcash’s balance sheet and, with other asset sales and reduced capital expenditures, reduced net debt from $668 million to $275.5 million.

That gives it the capacity to consider an acquisition that would help bulk up its non-supermarket earnings base. In the meantime, the stronger balance sheet is supporting the supermarket business through its multifaceted and expensive overhaul.

While selling a business that was performing strongly couldn’t have been an easy decision to make, without the sale Metcash would have been very leveraged and vulnerable to further shrinkage in the earnings base of its supermarket operations. This is especially true given the need to remain competitive against the major chains in a price environment that is becoming more, not less, competitive.