By Guy Carson, Clime Asset Management
Beginning with the takeover of Foodland in 2005, Metcash Limited (ASX:MTS) has continued to establish itself as the significant third player in the Australian grocery market with 19% market share (See Figure 1). Its 2009 results released last month further emphasised its significant position within the market and reaffirmed the impressive performance of management. The company reported results above their previous guidance and also above consensus analyst forecasts.
Coles (via Wesfarmers) rebuilding process, has enabled Woolworths (ASX: WOW) to push ahead as the clear number one and grow market share whilst increasing profitability.
Metcash have focused on backing independent players in niche areas that are not in direct competition with the big two. They see themselves as the champion of the independent retailer, servicing 2,500 independent retailers that operate under the brand IGA around Australia through nine strategically situated distribution centres. This strategy has enabled them to rise to prominence as the third player and has led to increased profitability for the company.
Metcash also have interests in liquor distribution and supplying convenience stores and petrol stations. Under the brand Australian Liquor Marketers, Metcash operate as a broad range liquor wholesaler that supply more than 13,000 licensed premises across Australia and New Zealand. Through its Campbells Wholesale brand, Metcash supply convenience stores and petrol stations nationwide with a broad range of groceries, liquor and confectionary.
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Competitive Advantage
During recent years we have seen Woolworths continue to dominate the Australian grocery market. Meanwhile, Coles have continually turned over their management team in the quest to take on Woolworths. After struggling for a number of years Coles as a standalone entity was taken over by Wesfarmers (WES:ASX) in 2008, in the short time since this transaction was completed there has been no public announcement indicating an improvement in Coles profitability.
Metcash has adopted a strategy of backing independent retailers with smaller catchments and provided them with services to enable them to retain customers within the local area. Typically these stores will not be located near a Coles or Woolworths store. Through the support they provide they enable the individual retailers to grow their businesses and as a result grow the brand. Also through this support, Metcash make it difficult for the bigger players to come in and price these independents out of business.
Historical Financials
Through the financials in Figure 2, we can see the quality job that management have done. Return on Equity (ROE) has grown consistently over the last five years. This has come through the rollout of more stores, sensible acquisitions including Foodland and cost savings.
The NTA is low (at $0.13 per share) due to high intangibles (at $1.54 per share) coming mainly from the Foodland acquisition in 2005, however given that profitability on the back of this acquisition we considered it to have been a value creating opportunity.
Recent Results and Moving Forward
The latest results continued the trend of increasingly profitability. Market share increased slightly from 18.8% to 19% and sales therefore increased at a rate greater than the overall market. On the back of this the ROE increased to 23.5%. Management continue to payout a high proportion of the earnings and as a result the stock is yielding 7.4% on a grossed up basis.
This latest result also highlights the defensive nature of the company and the grocery industry. Even when the economy is tough and recession appears eminent, consumers will continue to eat and drink and therefore supermarkets will continue to trade. Given this we view the stock as very low risk and believe there is very little chance of downside to the earnings and the dividend.
Current gearing levels are comfortable with net debt to equity at 38.9%. With the defensive nature of the earnings and the plan to roll out more stores, Metcash can easily take on more debt to fund growth plans.
Management have given guidance for 2010 earnings per share (EPS) to be 7-10% higher than 2009. On current closing equity this equates to a ROE of 25%, continuing the upwards trend we have seen over the last five years. We expect this to trend higher over the coming years as management continue to scale the business. Woolworths has consistently had an ROE in the high 30’s for the last five years. Thus, given the differences in business models and the realisation that Metcash will never get to the market position of Woolworths, we would expect that Metcash would be unlikely to achieve a similar level of profitability. We expect that 25% ROE would be sustainable and that there is upside to this figure in the next two to three years.
Conclusion
Metcash meets our criteria as a quality company. It has strong defensive characteristics and the management has done a great job in improving the profitability of the company over the last five years. This gives us confidence in the performance of the business going. However, in our view the market is currently pricing the stock fully.
