The Metcash Limited (ASX: MTS) share price is bucking the downtrend with grocery distributor outperforming its larger rivals during lunch time trade.
The rally in Metcash puts the stock in third position on the S&P/ASX 200 (Index:^AXJO) (ASX:XJO) index leader board this afternoon as Pilbara Minerals Ltd (ASX: PLS) takes top spot and Clinuvel Pharmaceuticals Limited (ASX: CUV) in second.
Given the lack of news as most are still away on their summer break, it doesn’t take much news to move a stock. This might explain why Metcash is running ahead despite falls in the broader market.
Operating leverage cuts both ways
Morgan Stanley reiterated its “overweight” recommendation on the stock in its latest note and increased its price target by 5 cents to $2.95 a share.
The broker believes that worries about Metcash’s core grocery distribution business is overblown. Some investors believe Metcash is in a structural decline after it lost two key customers – 7-Eleven and Drakes.
These contracts represent around 10% of group earnings before interest and tax. But if these are a sign of things to come, Metcash could lose more customers.
That’s bad news for a high-fixed cost business as a modest drop in sales will make a disproportionately bigger dent to earnings.
Not all structural
But Metcash’s grocery challenge isn’t all structural, and that means there’s a chance for the business to stabilise or improve.
“We acknowledge the risk of continued share declines but believe the earnings base reflects also a number of cyclical issues which should turn in the medium term,” said Morgan Stanley.
One cyclical factor is deflation. Falling grocery prices have been a big challenge for our supermarkets over the past four years but there’re signs that inflation is returning (you can’t find $1 a litre milk anymore).
The other problem is the drought.
“We think the drought impact is as an underappreciated headwind MTS has faced in recent years,” said Morgan Stanley.
“Australia’s farm output has fallen 12.6% since Jun 2018, which undoubtedly reverberates through the local economies that MTS supplied retailers service.
Metcash is more exposed to regional communities than the its rivals and there are few signs that the drought is breaking in parts of New South Wales and Queensland. But when the rain does return, Metcash could prove to be a good way to gain exposure to that thematic.
Meanwhile, the turn in the housing market is also likely to give Metcash a boost through its hardware retailing division.
“MTS trades at a ~50% discount to the ASX Industrials ex-Financials, below its average 35% since 2010, despite having diversified its earnings base,” added Morgan Stanley.
“We think ~11.5xFY21e P/E and a ~50% discount to the ASX200 Industrials ex-Financials is too cheap.”
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Motley Fool contributor Brendon Lau has no position in any of the stocks mentioned. The Motley Fool Australia has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.