Writedown worries for Metcash
While the profit warning was the trigger for a weakening in investor confidence, there are broader concerns about the direction of the company and its ability to maintain sales and market share in its core grocery and liquor businesses.
The decision by Metcash to explore a spin off listing on the Australian Stock Exchange of its automotive division has unsettled some shareholders who believe the justification for the move is a short term fix for the company’s balance sheet.
Concerns are also emerging about the Metcash business model, which relies on the capability of independent retailers to compete successfully against Coles, Woolworths, Aldi, Costco and, by current speculation, the impending launch of the German discount supermarket chain, Lidl.
Metcash has undertaken a comprehensive review of its operations over the past two years and has conceded last year that its independent supermarkets were losing market share as a result of store closures and the expansion of the major chains, including Aldi’s continued network growth and entry into the South Australian and Western Australian markets.
In December the company flagged that its full year earnings were expected to fall by at least 14 per cent after disappointing first half sales and profit results, an announcement that generated a backlash from investors.
The tolerance of investors has now been further tested by this week’s decision to take a $640 million writedown on the assets held on the balance sheet.
Metcash has been implementing a transformation program that has focused on improvements to supply chain, changes to marketing, product ranging and store formats, as well as a new pricing strategy to price match Coles and Woolworths.
The company is understood to have had some positive response to the transformation program, but its full implementation requires more capital investment, which appears to be one of the key reasons that a divestment of the automotive division is under consideration.
An exit from the automotive division by a public float or trade sale would generate funds to boost the balance sheet and provide the capital needed to advance the transformation plan.
Metcash believes it could realise up to $350 million from the sale of the division. With the sharemarket faltering towards the end of the current financial year and Metcash keen to bank proceeds from the divestment quickly, a trade sale looks more likely than a public float.
Burson Group and Repco (Genuine Parts Co) are the probable suitors for a trade sale, with both groups keen to expand. The divestment of the automotive division has drawn shareholder criticism based on the view that the July 2012 entry into the aftercare market with the acquisition of a majority interest in the franchised Autobarn chain and subsequent acquisitions would provide some revenue and income security against falling returns from the core grocery and liquor business.
Lack of scale in automotive
The Metcash move to appoint financial advisors, Citi, to examine options for divestment is related to the current financial problems and falling investor confidence. But it also takes into consideration the lack of scale in the automotive business, even after acquiring 10, servicing both the retail and trade markets.
Both Burson and the US-based owner of Repco have argued that the automotive parts and services markets are restructuring and consolidating and success will depend on scale.
Both Burson Group and Repco have indicated they are potentially interested in a trade purchase of the Metcash automotive division, which has annual sales of around $250 million from 219 parts and accessories stores, 140 service and parts outlets and a network of independent sellers. The key issue for Metcash is therefore return on investment or bang for buck.
Is it better to continue the diversification strategy into businesses beyond its core food and liquor business? Or would it make more sense to quit the automotive division, and potentially its Mitre 10 hardware division, and invest the capital back into the core business in which market share, margins and earnings are under sustained attack from strong and disciplined competitors?
The December profit downgrade reflected slower sales growth and the squeeze on margins and earnings associated with the price matching initiative. The full year result will now absorb the non-cash impairment of $640 million, although the net after tax trading profit forecast has been maintained at between $315 million and $330 million.
Announcing the writedowns to the Australian Stock Exchange, Metcash CEO, Ian Morrice, said the company has carried out a comprehensive review of the carrying value of its assets as part of the year-end process.
“This review took into account the increasingly competitive trading environment, particularly in relation to the food and grocery business,” Morrice said.
Morrice said Metcash would mark a $507 million provision in the 2015 financial year accounts in relation to intangible assets, including goodwill of $442 million and other intangible assets of $65 million, as well as a further charge of $133 million in relation to other assets and obligations, predominantly in the food and grocery business.
The writedown effectively shaves around one third off the value of Metcash assets, leaving the group with a book value on net assets of around $1.15 billion.
While the impairment is a non-cash provision and will not impact Metcash debt facilities, compliance with banking covenants or trading terms, it has certainly shaken investors, leaving shares on the Stock Exchange trading at more than 50 per cent below their price 12 months ago.
The Metcash board has already determined that the financial position of the company requires an 18 month halt to dividend payments for the full financial years of 2015 and 2016. Morrice claimed this week that Metcash is making progress with its strategic priorities and its transformation plan, but conceded the company was facing significant competitive challenges in its core business.
One of the indicators of the pressure on independent retailers in the increasingly competitive trading conditions has been industry rumours that a group of independent supermarket retailers are examining options for an alternative wholesale supplier, with Spar Australia apparently having been approached.
The Queensland-based, Spar Australia, is controlled by former Metcash executive, Lou Jardin, who has an interest in expanding wholesale supply in the supermarket and liquor sector beyond his Spar, 5 Star and Jardin’s Fresh Life store network.
The restlessness among independent retailers relates to Metcash prices and rebates as well as concerns about the direction of the company as it attempts to change from the traditional supply-led wholesale model to a consumer-led, retail-oriented operation and pressures on retailers to cut external suppliers and buy more products, including fresh produce, through Metcash.
Metcash will report its full year results on June 15 2015 and it is possible that the company will have an in principle trade sale agreement on the table for its automotive division next week.
Deal or no deal, there will be critics amongst retailers supplied by Metcash and shareholders about the decision to divest the relatively new business. But there will also be considerable interest in an update on the transformation plan and the direction and strategies that come out of the review of the overall business.
To restore investor confidence, Metcash needs to convince that it can arrest its declining market share in the food and liquor business that delivers the lion’s share of its revenues and earnings.
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