Metcash reported a largely flat sales and EBIT result in 1H25. The stable result masks significant movement under the surface, with a good Food segment result, but weaker organic earnings in Liquor and Hardware. The path of Hardware EBIT margins will be the central debate on Metcash over the next 12 months. We estimate Hardware corporate store earnings fell 45% in 1H25, driven by a decline in sales. If Hardware is truly cyclical, then a meaningful recovery is likely. We take a more cautious stance.

Metcash provided a trading update indicating 1H25e underlying NPAT will be between $132-$135 million. The key driver has been the decline in sales and negative operating leverage in Metcash’s IHG hardware stores. Tough conditions are likely to prevail in 2H25e as well, albeit we are at a low point in the building cycle, providing scope for margin recovery at some point.

The ACCC’s interim report into Australian supermarkets has not produced any alarming concerns for Coles and Woolworths yet. However, it is too early to draw conclusions either way. The interim report is a very preliminary summary of the issues the ACCC will explore.  The ACCC is yet to process much of its data and there will be further submissions and interrogation over the next two months. We expect the risk to Coles and Woolworths is largely around their ability to expand gross margins to offset cost pressures. Beyond that, we expect the ACCC to conclude that the supermarkets do hold market power but are still largely competitive.

Metcash reported FY24 EBIT down 1% and, adjusted for acquisitions, it was a similar result in both the first and second-half. The company is actively managing costs to offset weak sales trends and this thematic is likely to be a feature again in FY25e. Metcash’s performance relative to market growth remains impressive and is the primary reason for our positive stance on the stock.

Australian supermarket volumes are likely to drop by 2% in FY24e on a per capita basis, which is a continuation of declines seen since March 2022. While higher food prices may explain some of the softness in volumes, other factors are at play including channel leakage, lack of store refurbishments and less new product innovation. We forecast 3.0% comparable sales growth for the supermarket sector in FY25e, but a downside case of 2.3% is possible if volumes continue to decline. A low rate of comp sales growth would be very challenging given comp cost growth is unlikely to fade. Weaker comp sales will put downward pressure on Coles and Woolworths profit margins.

The Senate Inquiry into Supermarket Prices has escalated into a debate about the merits of return on equity (ROE) as a measure of profitability. We certainly prefer ROE and other returns measures over percentage profit margins. However, in the case of Woolworths, the ROE of 27% (pre sig items) is influenced by historical cost accounting, buybacks and demergers. Care needs to be taken in looking at a single year.

Metcash’s investor day made it clear that it is looking to accelerate growth. This growth will increasingly come from store openings and Metcash will need to spend more capex to facilitate the growth. The company is in a stronger position to grow given the profitability across the network and capability of management.

Metcash’s acquisition of Superior Foods and two mid-sized hardware businesses is sensible and, in our view, best described as fairly priced. The upside in value for Metcash shareholders will come from realisation of synergies by FY26e, with potential value creation as Metcash builds scale in the foodservice and frame & truss sectors.

The Australian supermarket sector is under scrutiny given higher grocery prices. This report is written to give perspective about prices, profit margins and potential risk areas as the Senate inquiry is held over the next four months. Price increases in supermarkets largely reflect higher costs. However, retail prices have risen faster than the producer prices in fresh produce and red meat. Like almost all Australian businesses, supermarkets have faced higher costs and their profit margins are only slightly higher than pre COVID-19 levels.

Many Australian consumer companies are likely to report weak 1H24e results. However, they are likely to be better than consensus estimates with slightly better sales trends and higher gross margins in some cases. While earnings should be fine this half, share prices have run in anticipation of results and the trading updates and outlook commentary are likely to flag higher operating cost growth as a headwind.