Metcash pays the price in the supermarket duel

Metcash's fortunes have taken a hit as the battle between Coles and Woolworths intensifies. It needs sales growth to boost its bottom line, but it won't be easy in a deteriorating retail environment.

It is far too early to tell whether Ian Morrice’s five-year and $675 million plan to arrest the decline in Metcash’s core food and grocery division’s fortunes is gaining any traction. Today’s results, however, do confirm the need for a major restructuring of that business.

For the year to end-April, the food and grocery division suffered a 0.5 per cent decline in sales and a 19.5 per cent slump in earnings before interest, tax and amortisation, from $378m to $304.3m. That was the main factor in a decline in the group’s overall earnings of 17.9 per cent to $169.2m.

When Morrice unveiled the results of a strategic review in March, he made the point that after sales rose at an impressive compound annual growth rate of 6.8 per cent between 2008 and 2011, they had actually shrunk by a compound annual rate of 0.5 per cent between 2011 and 2013. They are still shrinking.

The explanation for that reversal of fortunes is obvious.

Metcash’s successes, and then its failures, are directly related to the successes and failures of the two big supermarket chains. For years it profited from the ineptitude of Coles. Then Wesfarmers acquired that business, installed Ian McLeod and his team, stabilised its performance and then injected considerable positive momentum into it.

After initially preferring to protect its margins and profitability, Woolworths was eventually forced to respond and the two big chains have been going head to head in a price-driven contest that has resulted in consistent grocery price deflation.

Metcash and the independents it services have been caught in the middle of that contest, as well as from the pressure exerted Aldi and, to a degree, Costco.

That’s been a painful experience. The combination of sliding sales, price deflation and the aggressive shopper docket fuel discounting has had an exaggerated impact on Metcash’s bottom line or, in Morrice’s terms, has turned its "operational leverage" against it.

There’s no quick and easy response to the situation in which Metcash finds itself, other than to deliver a better suite of products to its independents at more competitive prices.

Morrice has understood that to survive Metcash has to focus initially on improving the competitiveness and profitability of its independents rather than its own. Hence the decision to reduce Metcash’s dividend payout ratio and to invest heavily in the food and grocery business.

He may yet confront another set of challenges. His predecessor, the long-serving Andrew Reitzer, responded to the emerging pressures in food and groceries by diversifying into the hardware and automotive sectors. That has been a successful strategy, with those segments contributing a 23.6 per cent increase in combined sales and a 48 per cent increase in earnings between them.

Metcash has, however, another pillar. Its liquor business lifted sales 8.3 per cent and EBITA 14.2 per cent.

Liquor, dominated by Woolworths’ Dan Murphy's business, is another segment of retailing where Coles has badly lagged its major competitor and where its business has been a serial under-performer.

Ominously for Metcash, however, Ian McLeod’s successor at Coles, John Durkan, has identified liquor as a key area that he will focus on with some urgency. The segment is almost inevitably going to become far more competitive and therefore there is some potential for two of the three Metcash pillars to come under real pressure.

While the Woolworths/Lowe’s hardware joint venture is building scale, hardware and auto are highly-fragmented sectors and there is a strong element of convenience to Metcash’s Mitre 10 network that also provides some insulation from the competition at the big-box end of the sector between the Bunnings and Masters chains.

The food and grocery transformation program is underway. Morrice says the initial results are pleasing, although the heavy investment phase is only just beginning and the wider environment for retailers appears to be deteriorating.

Metcash needs sales growth in its core business to get its operational leverage to work for it, not -- as has been the case in the past few years -- against it.