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Can Metcash Limited ever challenge Coles and Woolworths again?

Metcash Limited shares have plunged to their lowest level in nearly 10 years. The company’s margins, profit and market share are falling, and now shareholders holding on to the promise of a decent dividend yield have been disappointed.

Profit will plunge by up to 15% this year, while the dividend payout will fall by over 25% as the payout ratio is reduced from 80% to 60% on lower profits.

What are Metcash doing to turn it around?

The biggest problem facing Metcash is increased competition from the four largest rivals to the 2,500 independent grocery stores it distributes to. Metcash, as the wholesaler, is just as exposed as its customers to aggressive discounting and marketing from much larger local rivals Woolworths Limited (ASX: WOW) and Coles, owned by Wesfarmers Ltd (ASX: WES), and now the two international entrants into the local market – Aldi and Costco.

These four competitors are concentrating heavily on increasing private label brands, as well as continuously reviewing supply chain efficiency to drive lower holding costs. To combat this, Metcash plans on spending $625 million over five years on creating a world-class supply chain, refurbishing and consolidating existing supermarkets,  and improving its fresh food offering in order to arrest the trend of falling sales and margins.

The initiative, which will be funded largely by reducing the dividend payout ratio, appears to be a make-or-break effort by the company to drive shareholder returns over the next 10 years.

But can they do it?

Metcash’s management have it all head of them. They have admitted that the strategy is high risk and that the quality of execution will ultimately have a large bearing on the success or otherwise of the project.

Investors also have to realise that Metcash’s competitors are not standing still. Woolworths and Coles are spending $2 billion on 180 new stores, while Aldi and Costco also have nationwide growth plans.

Some analysts also note that supplying independent supermarkets may make group-wide changes difficult to implement.

Foolish takeaway

I have long believed that Metcash had to make some drastic changes to remain relevant in an increasingly competitive retail environment. Independent stores are convenient, yes, but are also significantly more expensive than rivals. Improving the supply chain will aid to close the gap, however the magnitude of improvements will be important to ensure that independent grocers aren’t squeezed out of the market by competitors.

I remain sceptical, noting that these issues likely should have been addressed at least 18 months ago, however the plan in place seems reasonable and believable. I believe that in 10 years’ time, investors will look back on this program as either the start of something extremely special, or the start of the end for Metcash.

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

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