New competitors pose threat to recovering Metcash
The share price for Metcash has gradually climbed in the past eight months as management has sought to rebuild confidence in the grocery wholesaler.
In the past week, a frenzy of buying and selling of Metcash scrip boosted the share price to a lofty $2.28 ahead of optimistic analyst forecasts of the 2015 full financial year result.
Metcash stock has been a gambling option for investors for much of the past 18 months, with up to 25 per cent of its share sold short six months ago after the share price dipped below $1 last September.
The gradual recovery in the share price follows a business model restructure, new management appointments, confident growth expectations for IGA’s biggest independents, Drakes and Ritchies, and the prospect of bolstering the Mitre 10 banner group by acquiring the Home Hardware business from Woolworths.
Some analysts have warmed to the grocery wholesaler, believing a refocus on its core food and liquor business and the implementation of a more aggressive business strategy investing in lower prices and store upgrades is gaining traction.
The analysts believe Aldi has not damaged the IGA independents as much as had been expected in South Australia and Western Australia.
In the 2016 full financial year results, Metcash reported that IGA supermarket like for like sales for the year were up 1.4 per cent, while convenience store sales increased by 0.4 per cent.
Total sales for the food and grocery channel in FY16 increased overall by a modest 0.5 per cent, but profits before interest and tax by 17 per cent to $179.9 million, compared to $216.8 million last year – a drop that reflected Metcash investment in pricing and other initiatives to rebuild sales momentum.
Investors who had shorted Metcash shares have sold down their shareholdings in recent weeks as the end of year reporting date got closer, pushing the share value back above $2, albeit less than half the value of the same shares in 2012 and early 2013.
The more optimistic view of investors and analysts for Metcash seems brave considering short- and long-term challenges facing the wholesaler as it tries to rebuild from a clear the decks 2015 financial year in which $640 million in writedowns left the company with a bottom line loss of $384.2 million.
In a report issued last week, Macquarie Securities was expecting around $180 million in net earnings for both the 2016 and 2017 financial years, certainly better than for the last financial year but a modest profit on annual sales of more than $13 billion.
The actual result reported by Metcash this week for the financial year ended April 30, 2016 was net earnings of $216.5 million on annual sales of $13.5 billion.
The underlying net earnings for Metcash allowing for extraordinary profit items was $178.3 million, largely attributable to lower finance costs.
Sales for FY2016 were 1.3 per cent above the previous year, but also reflected the divestment of Metcash’s automotive business group to the listed Burson automotive group.
Metcash has been forced to sacrifice profits in the same way Woolworths has to underpin its lower pricing strategy and will no doubt further erode its bottom line, at least in the short-term, if it has extend debt to acquire the Home Hardware business.
Although investors and analysts have taken comfort from the less than expected impact of Aldi on the IGA supermarkets, in part based on the view that the lower pricing strategy has shored up sales, it is early days on the Aldi invasion in terms of both store numbers and customer recruitment in both South Australia and West Australia.
Aldi and Costco will inevitably take sales from the IGA independents as they expand, and the counter attacks of both Coles and Woolworths to the international retailers will also impact on Metcash banner stores.
A greater threat to Metcash may however prove to be the entry of new competitors to the wholesale market.
A company headed by former Incitec Pivot vice president, Clive Yoxall, and former Australia Post executive, Terry Sinclair, is seeking $50 billion from investors for a new digital grocery supply business model called Irexchange (Independent Retailers Exchange).
Irexchange believes it can deliver groceries at a lower cost to independent supermarkets and convenience stores and has been courting suppliers and retailers as well as potential investors.
Irexchange is essentially an internet-based stock ordering system that would deliver stock into stores within 48 hours using the logistics firm, DHL.
In another more conventional play in prospect would see the national logistics firm, Linfox, and a consortium of grocery suppliers develop a rival wholesale distribution system to Metcash.
Linfox provides distribution services for a number of major grocery manufacturers such as Arnott’s, Kellogg’s, Unilever, Proctor & Gamble, Lion and Carlton & United Breweries, as well as the Coles and Woolworths supermarket chains.
Linfox provides an integrated logistics service that includes supply chain and warehouse management, IT support and transport and freight movement.
Irexchange has set its sights high, advising potential investors it believes it can generate earnings before interest tax and depreciation of $100 million within two years and $153 million within five years.
The upstart claims it can snare $4 billion in sales in its first year of operation and $8b within two years, which seems improbable even if irexchange can recruit disgruntled independent retailers from Metcash.
Linfox is more realistic and looms as a greater threat to Metcash as it aims initially at the convenience store sector, where it has already established credentials and would not generate a conflict situation with Coles and Woolworths.
There is every possibility that the new entrants could lure some customers away from Metcash, with 7-Eleven the most likely target in the convenience sector and FoodWorks and the Foodland group in South Australia in the supermarket sector.
After the exploitation scandal involving employees on student visas, 7-Eleven is under pressure to cut costs for its retailers, so a reliable alternative wholesale distribution system that would deliver supply chain savings could see the convenience store chain move from Metcash.
The recruitment of supermarkets is far more problematic for irexchange, notwithstanding a persistent lack of satisfaction with Metcash but, again, feasible for Linfox, which already has the scale that is crucial in the competitive grocery sector.
The FoodWorks banner owned by Australian United Retailers has around 400 stores and a further 250 smaller grocery outlets generating sales at retail level of around $2 billion.
FoodWorks has a strong heritage of independence running back to the Tuckerbag banner and has its own administration, marketing and retail services team.
FoodWorks’ relationship with Metcash is purely as a wholesale customer, a position that is largely shared with Foodland in South Australia, which runs its own banner but does trade with the Metcash-owned IGA brand under a licence agreement.
Metcash is certainly vulnerable to some defections from its food and liquor banners, but it has built a defence against new competitors in recent years by acquiring strategic shareholdings in its larger customer groups, including Ritchies and Drake Foodmarkets, which is an influential and dominant group within the Foodland banner.
7-Eleven and Foodworks are the businesses that would likely give Metcash the most cause for concern, and a new industry entrant the best prospect of a viable revenue base.
To succeed with its plans, irexchange would have to secure FoodWorks or Foodland from Metcash or, at the very least, Lou Jardin’s Spar Australia business in Queensland, to lure any but the bravest independent retailers.
The reason why a banner group is critical for irexchange is because independent retailers rely on Metcash for branding, marketing and promotions, training, IT support and other retail services, as well as for boxes of groceries.
Irexchange may well be able to theoretically take costs out of the supply chain, but they would need to deliver better than the 10 per cent projected price saving over Metcash, especially if the company would not be negotiating promotional activities for the retailers.
In any event, some of the expected cost savings may be lost on the distribution side of the business model, with DHL not likely to be able to achieve the same efficiencies on deliveries that Metcash can with its dedicated systems.
Metcash supplies around 10,000 independent retailers and businesses across the food, grocery, liquor and hardware industries and, while the irexchange threat is likely to be seen off relatively quickly, Linfox could be a more difficult proposition.
Irrespective of the level of the challenge from either, or both, new entrants, Metcash can ill afford the distraction of its management at a time when it needs to continue driving its transformation program to combat Aldi, Costco, Coles and Woolworths and to progress the Home Timber & Hardware opportunity.
Woolworths will review binding offers lodged for the Home Timber & Hardware and Masters Home Improvement assets at a board meeting on July 4.
Metcash is understood to have decided to go it alone with a definite offer for the profitable independent hardware stores business and the possibility of taking over some of the Masters Home Improvement sites.
Metcash has elected not to take on board a joint venture private equity partner to help fund its bid, leaving the listed wholesaler dependent on debt funding, a capital raising in volatile sharemarket conditions, or a terms purchase deal with Woolworths.
The wholesaler has approached the Australian Competition and Consumer Commission for confirmation of earlier informal indications that a merger of the Mitre 10 and Home Timber & Hardware banners would pass competition hurdles.
The ACCC has yet to give a tick of approval to the Metcash merger proposal, but would be expected to do so before the July 4 Woolworths board meeting, which may well have other sale options, including private equity firms that might then themselves start stalking Mitre 10.
Even if Woolworths and the ACCC favour Metcash, the wholesaler faces a difficult integration of the two businesses and persuading independent hardware storeowners to not defect from either of the two banners to join some of their number who have already signed up with alternative groups.
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