Franklins boost for Metcash

Profit upgrades are few and far between these days, but Metcash managed one last Wednesday. At its half-yearly results announcement (to 31 October 2011), management stated that the company’s 2012 earnings per share would grow by low to mid-single digits (up from a forecast of low single digit growth).

In plain English—a language beyond most corporate executives—earnings are forecast to grow somewhere between 1% and 6%. It’s better than flat, but not by much. For the half-year, revenues grew 2% to $6.1bn but profit fell 14% to $94m. Excluding a restructuring charge related to the acquisition of Franklins, underlying earnings rose 1% to $117m (with similar growth in earnings per share to 15.2 cents).

As expected, operating cash flow surged, reversing a weak number in the second half of 2011 (due to an inventory build-up for Easter trading). A fully franked interim dividend of 11.5 cents was declared (ex date 9 Dec), up from 11 cents last year.

It was a tough period for Metcash’s largest division, IGA Distribution. Food price deflation, a more value-conscious consumer and the marketing war between the two supermarket giants conspired to produce a flat result. Under those circumstances, this was a creditable performance.

An increase in the intensity of the marketing war, perhaps with a price war thrown in, or a decision by either Coles or Woolworths to move into smaller format grocery stores, remains a risk for IGA Distribution. Interestingly, the new head of supermarkets at Woolworths, Tjeerd Jegen, recently expressed surprise at the strong market position of the local independent grocery sector. But chief executive Grant O’Brien has been quick to scotch any suggestion of entering this market. Perhaps he thinks Woolies has enough on its plate without taking on IGA.

The results from Metcash’s much smaller divisions were mixed. Australian Liquor Marketers, under pressure from the supermarkets’ relentless expansion, produced a surprisingly strong 32% lift in profit. With profit down 35%, the reinvention of Campbells Wholesale appears to be struggling.

Mighty helpful

Over at Mitre 10, where the company enjoyed a 28% increase in earnings in the first half, the turnaround is gaining traction. The company stated that since its acquisition, better management and improved buying had attracted 20 independent hardware stores to the brand. Metcash chief executive Andrew Reitzer explained Mitre 10 was on schedule to generate $1bn in wholesale sales and a 3% operating margin, although it will face challenges as Bunnings and Masters lock horns.

A pertinent question remains: If the first half result was flat, how will Metcash produce profit growth during 2012?

The answer lies in the tug-of-war that Metcash has had with the ACCC over the acquisition of Franklins. Metcash officially acquired Franklins on 30 September. On 30 November, the ACCC lost its appeal to injunct Metcash from acquiring it (after the fact).

While the ACCC can still appeal to the High Court—its determination to unwind the acquisition has been nothing short of dogged, and anchored in economic theory rather than real life according to the judge presiding over the case—in the meantime, Metcash is getting on with the job of fixing Franklins.

At the results presentation, management admitted the battle had damaged the prize. Franklins’ sales have dropped 11% since the deal was first announced last year, so Reitzer backed away from his previous claim that the deal would add 1.5-2 cents to earnings per share. Still, the acquisition should end up being pretty profitable once the stores are on-sold to independent owners.

Profit boost

While Franklins’ retail business (the stores Metcash will on-sell) is currently losing money, profits from the wholesale business (which it will retain) will boost underlying profit in the second half. On top of that, the company’s new distribution centre is expected to begin producing significant productivity benefits. Both of these positive effects were behind the guidance upgrade, and benefits should persist into the 2013 financial year and beyond.

The Franklins acquisition has resulted in Metcash’s net debt-to-equity ratio hitting 57%, up from 47% in April (see Chart 1). As the stores are on-sold, debt levels should decline slightly, although they’re likely to remain a little less conservative than they should be. While Metcash is a defensive business, its market niche could be threatened if Woolies or Coles launched a concerted attack. High debt levels would make it more vulnerable.

In short, the original rationale for the recommendation made on 1 Mar 10 in Metcash: Top quality, budget price (Long Term Buy - $4.12) remains on track. Metcash has finally acquired Franklins and, while it is suffering from a difficult market environment and intense competition, the business is sufficiently resilient to withstand the onslaught.

The stock is up slightly since 26 Aug 11 (Long Term Buy – $4.04) although we’re hopeful of another opportunity to upgrade a notch (as we managed during a troubled August). On a forecast yield of 6.6% and a PER of 12.5, Metcash remains a solid LONG TERM BUY.

The model Growth and Income portfolios own shares in Metcash.