Metcash upsets Woolies' big plans

PORTFOLIO POINT: Woolworths’ much-heralded move into hardware is thrown into disarray by Metcash buying a stake in Mitre 10.

Metcash’s $55 million stake in hardware wholesaler Mitre 10 has really thrown a spanner into Woolworths’ expansion plans. I don’t know whether Woolworths chief executive Michael Luscombe has a dartboard in his office, but if he does, there is a fair chance he would have a photo of Metcash chief executive Andrew Reitzer pinned to it.

Woolworths is committed to a huge capital expenditure program and Reitzer's moves have placed their chances of success in a considerable amount of jeopardy.

Word started leaking out earlier this year that Woolworths was looking to take on Wesfarmers in hardware. The Wesfarmers-owned Bunnings operation generates $6 billion a year in revenue and $600 million a year in profit.

Woolworths liked the sound of those numbers and came up with an ambitious plan: a joint venture with US home improvement giant Lowes, a bid for local distribution arm Danks and a plan to roll out 150 big-box hardware stores at a cost of several billion dollars.

Reitzer has just thrown the Woolies experiment into complete disarray with his measly $55 million investment; and by scooping up Mitre 10, Metcash has put the kybosh on any chance Woolies had to force further consolidation in the sector and get the scale it needed to be a competitive force.

This is all going to be highly amusing to Wesfarmers chief executive Richard Goyder. He’s been heavily criticised for paying over the odds for Coles and told at every opportunity that Woolworths would teach him a lesson. So he’ll be enjoying this sideshow immensely. Coles is still a country mile behind but from a sentiment point of view this is going to be a big win for Wesfarmers.

The Australian hardware sector is worth about $24 billion but it is still incredibly fragmented: you’ve got Bunnings, which is taking about 75% of the profits; then you’ve got Reece, which specialises in bathrooms and kitchens; Woolies has paid $88 million for Danks, which owns the Home Hardware and Thrifty Link chains; then you have the Crane Group, which owns the Tradelink chain.

Bunnings puts these three other companies in the shade: its gross profit margins are in the order of 10%; the best its competitors can do is 1–1.5%. Bunnings has the sector all sewn up.

The Mitre 10 deal makes perfect sense for Metcash because wholesale is its business. The owners of the Home Hardware and Thrifty Link chains are going to be thinking, 'Hang on a second, my wholesaler is about to become my competitor, why would I want to do business with him?’

So it’s a very clever play on Reitzer’s part. In the same way Metcash supplies IGA stores with groceries, it can now supply these little independent stores with hardware. The opportunities for growth in his grocery business were extremely limited and now he can play both ends against the middle.

Metcash has made no secret that it was looking to add to its existing suite of businesses, which in addition to IGA include liquor and food wholesalers.

What it’s come up with is certainly a much better strategy than going into the pharmacy business, which has just been a bloodbath as the three dominant forces slug it out while the government tears apart the industry brick-by-brick.

Hardware isn’t a guaranteed money spinner for anyone right now except Wesfarmers, so there’s still a question mark over whether Reitzer will get the fantastic returns he’s looking for, but it’s a very low-risk strategy in comparison to the kinds of money being thrown around by Woolworths.

In the meantime, it’s a big blow to Woolworths. This is a company that has traded at a premium to the rest of the sector for a very long time. Now, it is trading at a very significant discount to Wesfarmers on a price/earnings multiple basis. It’s a remarkable turnaround in a very short time and people are definitely concerned.

For Michael Luscombe, it will all be very unsettling. He’s been at the top of his game for a long time now and Reitzer’s move has upset the natural order of things as far as he is concerned. I don’t know how much longer he’s planning on sticking around as chief executive, but this is not going to play out for a number of years, which means when he goes out he may not go out on top.

Woolworths may still win this battle, but it might not be Luscombe who is leading the charge by then.

Ivor Ries is head of research at EL&C Baillieu Stockbroking. He may have interests in any of the stocks mentioned.