DJs and Metcash: Two dimensions to leverage

STEPHEN BARTHOLOMEUSZ
4 JUN, 2015
Business Spectator
We’ve just caught a glimpse of two major retailers trending in quite different directions.
South Africa’s Woolworths Holdings announced today that it is launching its David Jones department store in New Zealand, while Metcash announced a $640 million writedown and a suspension of dividend payments for the next 18 months.
The announcement that Woolworths Holdings would open a David Jones store in Wellington is, by itself inconsequential. It will take over the leasehold now occupied by the ailing 152-year-old Kilcaldie & Stains for an apparent initial outlay of less than $1m.
The significance lies more in the way the decision to introduce the David Jones brand and evolving model across the Tasman fits within the strategic logic that led the South Africans to pay $2.2 billion for David Jones and outlay another $213m to mop up the minorities (mainly Solomon Lew) in Country Road last year.
Essentially, its strategy revolves around operating leverage. David Jones, with the existing standalone Country Road, Trenery, Witchery and Mimco brands it already owned in Australia, provided Woolworths the ability to leverage both its business model, built around private label offerings, and its supply chain.
The capacity to push more volume, much of it private label, over an expanded retail network not only promised to generate conventional cost synergies but provided an opportunity to leverage Woolworths’ existing southern hemisphere supply chain and procurement platforms.
Now it will have a beachhead, admittedly a small one, in New Zealand – where it already has a presence through the Country Road, Witchery, Trenery and Mimco brands and therefore the ability to recreate the new model it is developing within David Jones in another jurisdiction.
The commonality with Metcash, such as it is, lies in the impact and potential of operating leverage.
The Woolworths SA strategy is make the leverage work for it by driving top-line growth. The Metcash strategy is to try to stop the leverage from destroying it and the 1400 or so independent supermarkets it supplies.
The leverage used to be an important driver of success for Metcash which, like Australia’s Woolworths, had become accustomed to high mid-single-digit increases in sales each year and double-digit growth in earnings.
Then Wesfarmers bought Coles and the supermarket world changed. The easy market share gains enjoyed by Woolworths and Metcash disappeared and instead Coles drove real price deflation and began regaining its lost market share. Aldi’s lower-profile but inexorable growth didn’t help.
Like Woolworths, Metcash’s sales momentum stalled and then actually reversed and suddenly the operational leverage had been turned against it and food and grocery earnings began falling.
Metcash’s Ian Morrice last year unveiled his ambitious response, a five-year and $675m plan to improve the competitiveness of his customers — the independent supermarket operators Metcash wholesales to — in order to ultimately turn around its own fortunes.
In the more comfortable past Metcash had been run to benefit Metcash, with the supermarkets supplied with the range of products that most benefitted Metcash, at costs that reflected Metcash’s earnings objectives.
Morrice, recognising that the supermarkets were on the frontline of the battle between Coles, Woolworths and Aldi, shifted the focus of his group to improving the competitiveness and appeal of his customers at the expense of Metcash’s bottom line. If the retailers can’t survive, of course, neither could Metcash.
It was obvious, when Metcash announced last month that it was investigating an initial public offering of its relatively high-performing automotive business, that the group was experiencing more financial pressure from the implementation of what is a five-year strategy than perhaps it had anticipated. The auto business should generate a substantial lump of cash.
That’s not unexpected. The disarray that has enveloped Woolworths and forced it into a deep review of its own strategies that will see something well north of $500m invested in lower prices illustrated the continuing pressures in food and grocery retailing.
Morrice’s plan to introduce more competitive pricing and improving both the product offer and store formats of the independents is being implemented against a target that is moving away from him, thanks to the competition between the three chains.
The impairment charge largely reflects damage to the core food and grocery business that the market already knew had been absorbed. The suspension of the dividend, however, points to a cash squeeze greater than the market had anticipated. Metcash had already reduced its payout ratio to help fund Morrice’s strategy.
With the highly-respected former Lion chief executive Rob Murray having joined the board and been anointed chairman-elect at the end of April this year, and former David Jones and Lend Lease chief financial officer Brad Soller also joining the company earlier this year, there are some new and inevitably sceptical eyes looking at Metcash’s position and prospects and Morrice’s strategy and its implementation.
It is conceivable that the prospective sale of the auto business, the action on the dividend and the impairment charges reflect the conservatism of the new additions to the company’s board and management.
The concern, however, is that the external environment is shifting against Metcash at a rate faster than its own ability or financial capacity to improve the competitiveness of the independents – that the rate of deleveraging of its business model has increased.
That means the June 15 announcement of Metcash’s full-year results will be pored over by analysts and shareholders — and Metcash’s own customers, the independents — even more closely.