What does the Metcash Limited downgrade mean for investors?

Management are fighting against much stronger competitors.

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After the market close on Thursday last week, Metcash Limited (ASX: MTS) announced that earnings per share would drop between 13% and 15% from last year鈥檚 30.9 cents. The company also announced that the dividend payout ratio would drop from nearly 90% last year to 60% or lower.

What does this mean for shareholders?

Well, immediately it means that your holding is now worth 10% less after a big fall on Friday took the share price to $2.85, close to the 12-month low of $2.76. Earnings per share should now be around 26 cents, and the dividend payout could drop to around 15 cents for the year ending 30 April 2014, implying a yield of 5.5% fully franked, based on Friday鈥檚 closing price.

Bigger problems ahead for Metcash

While the earnings news was less than well received by shareholders, Metcash has been facing wide-ranging structural issues for years. Until now, Metcash, and the network of IGA stores it distributes to have been able to command a reasonable share of the Australian grocery market by utilising small-format stores and aiming for convenience over price.

My main concern for Metcash from here onwards is the threat that the major supermarkets and overseas grocery chains pose on margins and volumes. Woolworths Limited (ASX: WOW) and Wesfarmers Ltd (ASX: WES) owned Coles are rolling out a combined 178 new mega-supermarkets in a $2 billion investment in the Australian economy. Similarly, Aldi is expanding, and Costco are slowly rolling out their warehouse-format stores all around Australia. These new stores will have an impact on Metcash sales, however the magnitude of the impact will be unknown for some time yet.

Could it have been an overreaction?

Before the announcement, the average earnings per share estimate among analysts was 29 cents per share (a 5% decline on 2013) and a dividend payout of 22 cents. The new outlook would imply a further 10% drop from that level, which is consistent with the share price drop on Friday.

Of bigger concern for me is the dividend payout. The payout ratio is being sacrificed to spend $450 million on initiatives to better compete with Coles and Woolworths. Up to now, the fully franked 6.5% dividend was one of the major factors holding the share price up. Without it, I fear that there may be further falls in the share price before any sustained improvement.

Foolish takeaway

The downgrade to Metcash鈥檚 full year guidance is worrying for investors. Larger retailers are eating into the margins of Metcash and its distribution network. A $450 million investment by the company will be used to address the loss of sales to larger competitors, however when competitors are spending over $2 billion on new stores to further erode Metcash鈥檚 margins and market share, management are going to have to pull some extraordinary moves to meaningfully grow earnings in the future.

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

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