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Is it time to sell Metcash?

Grocery and hardware wholesaler Metcash (ASX: MTS) has had a tough year, with sales hurt by stagnant consumer confidence and spending, and ongoing competition with its larger rivals Woolworth (ASX: WOW) and Wesfarmers-owned (ASX: WES) Coles.

The shares are currently trading around $3.30, having reached the lofty heights of $4.27 in March and a low of $3.05 in September. To further compound its woes, analysts at Morningstar have conducted a review of the business and competition and found that competition has increased further with small business owners struggling to keep up with the giants.

Metcash acts as a grocery wholesaler to the independent retail network of IGA stores, and also operates Campbells Wholesale and C-Store outlets, which service other small businesses such as the Lucky-7 chain. Morningstar believes that aggressive discounting at Woolworths and Coles is resulting in market share dwindling for smaller convenience stores, which usually have higher prices. The independent grocer chain will likely suffer reduced profit margins and lower stock turnover as a result.

The market is also complicated by the entry into many Australian markets of the Aldi and Costco brands. Aldi competes directly with IGA-type stores, as well as the giants due to its extremely low cost groceries. Costco competes with Metcash’s Campbells and C-store wholesale outlets by offering essentially the same service.

The increased competition is expected to result in Metcash having to accept lower prices for goods so that independent retailers can compete with the larger supermarkets, ultimately reducing Metcash profit margins. The analysis noted that while convenience of local independent retailers is currently offering some support, any deterioration in economic conditions will result in consumers sacrificing convenience for value.

Foolish takeaway

Metcash is inherently disadvantaged compared to the large retailers by the scale of the business. Metcash’s sales of $13 billion are dwarfed by the $44 billion and $36 billion turnover of Woolworths and Coles respectively. This allows the larger supermarkets to offer lower prices and squeeze the profit margins of smaller competitors such as Metcash. Thus far this year Metcash’s dividend of around 7% has supported the share price, however if profit continues to be squeezed it’s doubtful that the company will be able to maintain the payout. This will lead to share price falls.

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Motley Fool contributor Andrew Mudie does not own shares in any of the companies mentioned.

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