A turnaround will be a tough task for Metcash

STEPHEN BARTHOLOMEUSZ
INDUSTRIES RETAIL
Business Spectator

Metcash’s response to the intensifying structural pressures in the supermarket sector began with a major strategic review nearly a year and a half ago. The success of the multi-faceted strategy remains uncertain.
While today’s interim earnings announcement was somewhat better than the market had anticipated, underlying earnings were still down 6.1 per cent — 12.7 per cent at an earnings before interest and tax level — as the performance of the group’s food and grocery business continues to weigh on the group’s profitability.
That business, which is on the frontline of the supermarket wars that have so destabilised the once-dominant Woolworths, saw sales stabilise (the underlying trend improved from minus 3.7 per cent to minus 0.4 per cent). But that improvement came at a cost to margins and earnings.
Metcash’s food and grocery earnings before interest and tax fell 22.9 per cent to $91.9 million, or roughly half the level of earnings the business generated four years ago.
The strategy Ian Morrice unveiled in March last year, a strategy that was itself nine months in the making, involves a heavy investment in price to match the group’s competitors, improvement in its home brands, enhancements to its store network, an upgraded ‘fresh’ offer and a host of more detailed initiatives.
That’s not dissimilar to the broad bones of the strategy that Woolworths has embraced as its sales have flatlined in the face of the intense competition from Coles and Aldi. The open question is whether price-matching by sacrificing earnings will have a material impact beyond slowing the rate of declining competitiveness.
The challenge for Metcash and Woolworths is that the competition isn’t standing still.
In his KGB Interview, Coles’ John Durkan made it clear that he plans to keep lowering prices while still investing in his stores and in service. He has the benefit of the operational leverage Coles has created through the continued surge in its sales, whereas Metcash and Woolworths are fighting the effects of declining leverage.
Durkan’s comments also explain, perhaps, why Metcash has probably been most impacted by the rise and rise of Aldi at the discount end of the supermarket segment.
As he said, in the UK where Aldi and Lidl have wreaked havoc among the established supermarket operators, the two German discounters moved into an industry that had no real independent presence at a time when the full-service operators were adding capacity and costs and lifting prices.
The Australian market has a big independent sector, much of it serviced by Metcash. That segment of the market has been hardest hit by the expanding presence and visibility of Aldi and its deep discounting strategy.
Woolworths may have been more affected by Coles’ continued lowering of prices, which is a proprietary strategy that was at the heart of its turnaround plan rather than a direct response to Aldi than by Aldi directly. But there is no doubt that the twin impacts of Coles and Aldi on supermarket price deflation generally have damaged both Woolworths and Metcash.
Metcash had no option but to sacrifice some of its own profitability to try to improve the competitiveness of the independents it wholesales to. It also sacrificed one of its best businesses to give it the balance sheet to support the re-making of its food and grocery ‘pillar’ by selling its automotive division to Burson Group for $275m earlier this year.
That sale and the repayment of $US200m of borrowings has given Metcash breathing space on its debt maturities and, perhaps, some insurance against an inability to stabilise the earnings of its food and grocery business.
The group’s liquor division lifted sales 3.5 per cent and EBIT four per cent, to $25.9m, in the half. Its hardware division had relatively flat sales but generated a 22 per cent increase in EBIT to $11.6m.
There has been a lot of speculation that, if Woolworths were to decide to liquidate its Masters home improvement joint venture with Lowe’s of the US (where Woolworths is incurring losses of $200m a year and rising) Metcash might be able to pick up some of the non-Masters elements of the Woolworths hardware strategy and, in effect, create a new central pillar to offset the decline of food and grocery.
Morrice appears to retain confidence in his ability to turn the food and grocery business around despite the intensely competitive conditions and continued price deflation. He continues to chisel away at Metcash’s own costs while investing strongly (accepting lower wholesale margins and therefore earnings) in his customers’ competitiveness.
The fate of much of the independent supermarket sector is riding on his efforts.
With Woolworths now throwing hundreds of millions of dollars at prices — it has already ploughed $300m into lower prices this year — and also prioritising competitiveness and sales over immediate earnings, the competitive landscape within which Metcash is trying to achieve its turnaround, however, is getting even tougher and more disrupted, not easier or more stable.