Wholesaler Metcash is at risk of losing supply contracts, analysts say

Wholesaler Metcash may be at risk of losing another three supply contracts with independent retailers and convenience stores, according to analysts, who have cut profit and share price targets after a trading update on Monday.

Citigroup analyst Bryan Raymond says Drakes Supermarkets, which has confirmed plans to build its own $80 million distribution centre in South Australia, may not be the only major customer to quit the Metcash network as independent retailers under pressure from Aldi, Woolworths and Coles attempt to reduce supply chain costs.

Mr Raymond said another three supply contracts were coming up for renegotiation in the next 12 months and could be lost altogether or lead to a significant deterioration in supply terms for Metcash.

He said the direct impact of losing the Drakes contract in South Australia, which is worth about $270 million in sales and $16 million in earnings (EBIT), was manageable for Metcash “as long as this is an isolated situation”.

“The risk is high, however, that the Drakes agreement could be the first of several major contracts that could be lost or renegotiated with a significant deterioration in terms,” he said.

“At this stage we do not envision any other supermarket contracts leaving Metcash in 2019. However, other multi-store operators are likely watching Drakes’ exit carefully and evaluating the economics of a similar strategy,” he said.

Multi-store independent retailers possibly big enough to support their own distribution centre include Ritchies, which has 76 stores in South Australia, Victoria and NSW and annual sales about $1 billion, and Romeo’s, which has about 38 stores in South Australia and NSW.

Mr Raymond said the loss of another two or three supply contracts could lead to a 20 per cent to 30 per cent derating of Metcash’s share price.

“In the event that these contracts are retained, we would expect further pressure on Metcash margins as the renegotiation would likely prove unfavourable to Metcash as they attempt to retain the business,” he said.

After falling 18 per cent on Monday, Metcash shares fell another 6 per cent on Tuesday to $2.84 before recovering to close at $3.01.

Morgan Stanley analyst Tom Kierath said the prospect of other independent supermarkets establishing their own distribution was low, given high fixed costs and low profit margins.

“We wouldn’t rule out the possibility of Drakes eventually moving back to Metcash distribution in future after negotiating terms,” Mr Kierath said, echoing the view that Drakes may be threatening to pull its contract to achieve better trading terms.

UBS analyst Ben Gilbert said more defections were unlikely in the short term, given the cost and risk associated with establishing a vertical supply model.

“However, if Drakes is successful, this could see others explore vertical integration over time,” Mr Gilbert said.

JPMorgan analyst Shaun Cousins said he was confident Metcash would retain customers, as being supplied by a Drakes warehouse could pose operational risk and it would lack scale. However, there were a few large Metcash customers who could go vertical or be meaningful customers to a new entrant.

Metcash is facing unrest from IGA retailers over several business initiatives including the online ordering platform, IndieDirect, and competition from digital disruptor iRexchange, which has signed up almost 500 independent retailers.

Drakes confirmed on Tuesday it would build an $80 million distribution centre in Adelaide’s outer northern suburbs and move to self-supply in June 2019, when its contract with Metcash expires.

Drakes general manager Bob Soang said it was an important plank in the group’s “vertical integration strategy within the supermarket sector”.

Asked if Drakes planned to supply other independent retailers, Mr Soang said: “Obviously we’re never going to say never, but it’s being built for us at the moment.”

The new 104,000-square-metre distribution centre will be able to handle about 23,000 individual product lines across grocery, dairy and frozen foods and will incorporate a $12 million investment in robotics and a high-tech warehouse picking and packing system.

Drakes operates 57 stores across South Australia and Queensland and has annual turnover of more than $1 billion.

Extracted from AFR

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