Metcash plays the long game with its retail transformation

Nearly five years ago, the Australian Competition and Consumer Commission’s inquiry into the grocery sector pointed the finger at Metcash’s dominance of independent grocery wholesaling for the inability of independent supermarkets to compete on price with Woolworths and Coles. That tension between its self-interest and that of the independent supermarkets it services probably explains why Metcash’s relatively new chief executive plans a massive transformation over the next five years.

Ian Morrice, who became Metcash’s chief executive officer last June, today unveiled plans to spend up to $675 million over the next five years, reducing its dividend payout ratio to help fund it, in an attempt to improve the competitiveness of the independents the wholesaler services.

The necessity for a change to the Metcash model was made very clear in Morrice’s presentation of his strategic review. It was underscored by yesterday’s change to earnings guidance for this year, with earnings per share now expected to fall between 13 per cent and 15 per cent.

There was a slide in the presentation that illustrates why Morrice has decided Metcash needs to be transformed. Between the 2008 and 2011 financial years, Metcash’s food and grocery division’s sales grew at a compound annual growth rate of 6.8 per cent. Between the 2011 and 2013, financial years' sales shrunk at a compound annual rate of 0.5 per cent.

That resulted in a significant loss of what Morrice described as ‘’operating leverage’’. The underlying earnings of the business had grown at a compound annual rate of 10.2 per cent between 2008 and 2011 but fell at a rate of 3.9 per cent in the 2011-13 period.

Apart from its focus on its own returns, there is a more fundamental reason why Metcash and its independents have struggled in the past few years.

Ian McLeod became Coles’ chief executive in mid-2008 after Wesfarmers bought the business, along with its sibling brands. Once he and his team got their feet under their desks, there was a marked and accelerating improvement in Coles’ performance, its sales and its market share.

Metcash (and Woolworths) had, until the Coles resurgence, profited from Coles’ dramatic decline in competiveness. The turnaround at Coles may have impacted Woolworths’ growth rate but it bit even harder into Metcash’s performance, as well as the performance of the independent supermarkets and convenience stores it supports.

Morrice’s strategy reflects a stronger recognition of Metcash’s reliance on the competitiveness of its independents. It is founded on retailing fundamentals, whereas Metcash’s previous response to the competitive pressures in the sector was to cut costs and diversify away from it.

Previously, Metcash’s focus was on what was best for Metcash. Therefore it supplied ranges that best suited its own financial outcomes rather than what the independents could best sell. But from now on, Morrice says Metcash will buy and range for shopper needs -- not its own -- and tailor its range to the requirements of the local retailers. The new strategy will be sales and consumer-driven rather than supply-driven.

Morrice plans to develop a better and tiered range of house brands – the major chains have had considerable success with their own brands – and promises more competitive pricing to deliver about $100 million of consumer benefit.

There will be an extra focus on the independents’ fresh produce offerings, on their store formats and on deploying Metcash consultants to improve their execution. More than 400 supermarkets will be refurbished over the next three or four years.

Morrice does face moving targets. Coles is now moving into a more expansionary phase, growing its network rather than concentrating mainly on improving its existing portfolio of stores, while Woolworths under Grant O’Brien has regained its own competitive edge. Aldi is accelerating its store expansion strategy and Costco is also moving into a more aggressive mode.

Morrice’s starting premise is that there are points of competitive differentiation for independents because they aren’t the chains and they are local and convenient. If they are competitive on price and format and carry ranges tailored to their catchment areas, there is growth potential for both the independents -- and Metcash itself.

While Metcash and its shareholders will experience some short-term pain as prices are reduced, inventory is cleared and capital is poured into the transformation program, the alternative is more of the experience of the past three years and a continuing and probably accelerating decline in the performance of both the independents and Metcash.