Metcash's acquisition - and financing - of Australian trade tool franchise Total Tools Holdings (TTH) received significant attention at the company's Investor Day briefing for analysts, which has held on 16 March 2021. Despite this time and attention, however, Metcash did not really succeed, in HNN's opinion, in being very clear about what is going on.
That's not too surprising, as in recent years much of Metcash's presentation style has moved more towards what could be termed the "ornate" rather than the strictly factual. Some of that move has been driven by Mark Laidlaw, the former CEO of Metcash's hardware operations (including IHG, the Independent Hardware Group). Mr Laidlaw, has agreed to interrupt his retirement to return to Metcash in the role of the chairman of Total Tools - though for how long is not known.
Beyond the method of delivery, there are really two sources of a lack of clarity in the presentation of the Total Tools acquisition. One relates to the actual numbers that are being presented, and the other to the way in which this acquisition meshes with the overall strategy undertaken at Metcash.
Before we get to that, however, we might focus on one slightly surprising statement that Mr Laidlaw made, which could have real consequences for independent hardware retailers. In answer to a question from analyst Simon Mawhinney of Allan Gray Australia about the planned expansion of TTH, and where the marketshare to support expansion would come from, Mr Laidlaw had this to say:
Phase two of this is the network opportunities sharing with Annette's [Welsh, CEO of IHG] business. So there'll be some regional towns, for example, that couldn't justify a Sydney Tools going there. Okay, population is too small, but there could be a Mitre 10 or a Home Timber and Hardware store. They could have a Total Tool store built next to it in some of those regional towns.
OK. Wait a minute. So in "phase 2", which comes after the TTH network had been built out to 200 stores or so, a Mitre 10 or HTH retailer in a small town could wake up one day to find that a TTH store was going to be built next door? With discounted prices on power tools, power tool accessories and hand tools?
If it's a corporate/joint venture store, it wouldn't matter, because it is all Metcash revenue. But if it's not? What happens then? This could end up being even a little worse than it seems at first. One response might be, for example, for the owner to sell that store - but it would have probably already lost some of its value. And, of course, IHG would have the right to buy the store with a matching offer, giving it a winning matched set in a small town.
HNN is very sure that this is in the category of "unintended consequences" - IHG really is not so devious. But you have to admit, that's a heck of an unintended consequence. And it goes to something deeper in all of this, which is that HNN just cannot help sensing that, for a $57 million investment, plus a further $95 million in CapEx to fuel growth from FY2022 to FY2044, there seem to be a lot of details that haven't really been thought out.
To look at the numbers to begin with, the presentation slides from the Investor Day identify what Metcash terms "Network revenue June 2020" for TTH as being $658 million. According to the Australian Stock Exchange (ASX) announcement for 27 July 2020:
The retail store network generated sales of ~$555m for the 12 months ended 31 December 2019.
So, the assumption would be that the $658 million number refers for sales from 1 July 2019 to 30 June 2020. That would indicate that the first calendar half of 2020 outperformed the first calendar half of 2019 by $103 million.
Those numbers are not without meaning, as they reflect the overall market impact of TTH. But that revenue is not something that TTH - and now Metcash - fully participate in. As HNN mentioned in its initial coverage of the acquisition, Dun & Bradstreet estimated revenues for FY2019/20 as being around $98 million. Further:
Metcash has announced that in its two months of ownership prior to its first-half results, TTH declared $18.6 million in total revenue, and $4.8 million in total EBIT. Those numbers annualise out to $111.6 million and $28.8 million.
Metcash mentions in its ASX announcement of 1 September 2020, commenting on the completion of the acquisition:
The terms of the agreement, including the purchase price of ~$57m for the 70% stake, are consistent with those disclosed in Metcash's prior ASX announcements. The purchase price was determined based on a normalised annual EBITDA of $12.6m. Total Tools has however benefited from a change in consumer behaviour related to COVID-19 and is expected to report a significantly higher EBITDA for the year ended 30 June 2020.
If we presume that TTH can retain something close to its current numbers, and bearing in mind that Metcash only has a 70% ownership stake, that means the company will benefit to an amount around $20 million in earnings a year. This is far from being insignificant, but it is something of a step down from what the figure of $658 million in apparent revenues indicates.
Metcash hasn't made any misstatements, but providing more targeted revenue numbers and estimated EBIT would have better contextualised the acquisition.
Inside the acquisition
While better numbers might be helpful, the real problem in understanding this acquisition is that it requires an in-depth view of what is going on inside Metcash, how that interlocks with the external, macro environment in retail, and, finally, how all that plays out when it comes to the current state of the hardware retail industry itself.
HNN would suggest that what we're really seeing in the TTH acquisition is the final playing out of some less-than-successful strategies that have been at work over the past six to seven years in Metcash.
On a very high macro level, Metcash has tended to invest in short to medium term projects, and possibly has neglected a number of more long-term objectives. This is particularly the case as regards digital technologies. The CEO of Metcash, Jeff Adams, did call this out during the Investor Day. He indicated that the company would be making major investments through to FY2024 in replacing its internal systems, getting rid of what Mr Adams referred to as instances of "triple-handling" in some processes.
It is, however, a little bit less clear how Metcash's digital investment will play out when it comes to actual retail processes. Again, it is just very difficult to know when Metcash refers to some of its current digital assets as being "industry leading" whether that is simply a promotional attitude, or if the company actually believes this. As compared to, say, Amazon.com all of the Metcash digital assets seem evidently primitive. In hardware, they certainly don't have the functionality of the Bunnings website - though it, too, lags somewhat in international terms.
One clear indication that digital retail may not be everything it is made out to be is that the only performance indicators given are percentage increases over the previous corresponding period. And in the digital world, seeing numbers like a "150% increase" don't tend to indicate very high growth, but rather a very low starting base.
What still remains lacking at Metcash is the ability to conceive of digital as not just a secondary, cost cutting, market expanding business objective, but rather a primary objective, and one that is aimed at producing actual growth. We've seen, for example the parent company of big-box hardware retailer Bunnings, Wesfarmers, make a very large investment into data analytics. In a recent speech to a technology conference, the governor of the Reserve Bank of Australia (RBA), Philip Lowe, had this to say about the importance of data analytics to future growth in Australian businesses:
Looking across the economy, there are investment needs and opportunities in many areas. The one I would like to focus on today is investment in IT, digitisation and data science. Investment in these areas is critical to lifting our nation's productive capacity.
In many ways data is the new oil of the 21st century. Investing in data and our digital capability are critical to our future prosperity. These investments allow better decision making and a faster response to the changes in our economy and society. These investments are also crucial to organisations delivering the more personalised goods and services that many people are seeking.
There are opportunities for digital innovation in every sector of our economy. Almost every organisation needs a strong digital capability to perform well, to innovate and lift their productivity. Technology and data analysis also hold the keys to solving many of the great challenges of our times, including controlling the pandemic, dealing with climate change and responding to increasing cyber threats.
If a company has all but excluded itself from the primary driver of growth in the 21st Century, technology, it then has to look elsewhere for growth. The difficulty with this is that even those other growth opportunities are going to find themselves still altered by technology.
In 2018, HNN took a look at data analytics in the hardware/home improvement retail industry:
Wesfarmers takes new path to growth - HI News, page 34
For example, the difficulties that have beset Metcash's food business have been well-documented. It has lost some major wholesale partners such as 7-Eleven and Drakes, which pulled their contracts. Then there are the independent supermarket owners who built a smaller, competing supply cooperative. As described by Inside Retail:
Led by former Coca-Cola Amatil managing director Warwick White, through his independent grocery firm Stone Advisory, and with Ritchies Supa IGA boss Fred Harrison on the board, Co-Operative Supermarkets Australia [CSA] is expected to use its industry experience and contacts to collectively bargain with suppliers.
Independent supermarket co-op could spell trouble for Metcash - Inside Retail
On its website, CSA states what was the inspiration for the move:
Following a trip by some leading retailers to Europe to see REWE and Leclerc, there was a new belief that grocery independent co-ops can beat the chains. The trip cemented the view that independents needed to control their own destiny.
Such a move would have been much less likely just ten years ago, but digital technology has made it possible for smaller cooperatives to manage order processing, fulfillment and delivery efficiently without the need for larger scale.
The same forces that have been at work on the food business have appeared, more indirectly, in Metcash's hardware business. While Metcash has been broadly successful in agglomerating Mitre 10 with the retail assets of Danks, Home Timber & Hardware [HTH] as well as Thrifty-Link, it's an open secret that IHG has not succeeded to the degree it expected it would. While the company lost very few stores through the acquisition (far fewer than buying groups expected), IHG also did not gain as many additional independent stores as it had expected it would.
In large part that was because buying groups such as Hardware & Building Traders (HBT), led by Greg Benstead as CEO, innovated and made better use of digital technology along with other techniques to deliver solid results to its members. For example, IHG's Mitre 10 had long seen its printed mail catalogue as being a major part of successful marketing. HBT in 2020 introduced a system where individual members could digitally compose their own catalogue for their own areas, taking advantage of any HBT/supplier deals they chose. The catalogues could then be distributed in printed form, or accessed online.
In 2019 IHG made some belated efforts to approach buying groups with the suggestion that they could do better if they all joined forces. It was, however, a case for far too little far too late, and as far as HNN is aware no buying groups expressed interest in any kind of further integration with IHG.
What has been seen this year, as IHG has moved to close down its two minor brands, True Value and Thrifty-Link, and to increase the emphasis on its Mitre 10 brand over the HTH brand, is that Metcash no longer sees IHG as a real source of future growth through expansion. HNN would suggest the company will continue to be interested in getting larger stores from groups such as National Building Supplies (Natbuild) to join, but less avidly pursue smaller stores.
Given these contractions to growth, Metcash has been forced to explore new ways to achieve future growth. Like many companies that find themselves in such a position, one of the key changes it has made is to alter the risk profile of its investments.
Not that long ago, hardware at Metcash consisted almost entirely of its wholesale business, with only a small amount of full retail ownership - and much of that was purely defensive, preventing Bunnings from expanding by buying out Mitre 10 hardware stores. That began to change four to five years ago, and that change has accelerated to the extent that, according to data released at the Investor Day, where in 2018 some 40% of revenue came from joint stores, that has grown to 45% in 2021. While IHG was at pains to play down its future acquisition strategy, it's HNN's belief that JVs will come to make up over 50% of revenue for IHG by 2024.
Of course, this looks pretty smart. Selling only wholesale goods means that IHG misses out on the biggest slice of profit, which comes in the store to customer transaction. Why not buy into that, especially when it means taking over a store that not only has a good track record, but about which, as the main supplier, your company knows a great deal?
Unfortunately, as everyone knows, there is no such thing as free money. When a company moves from a wholesale to a retail operation, the risk profile undergoes a radical change. One advantage of the wholesale sales model is that, if the economy, or a sector of the economy undergoes a period of extended negative growth, the wholesaler is unlikely to be severely affected. Wholesale assets, and their attendant fixed costs, can usually be reallocated to different sectors, and the relatively less-skilled workforce can be laid off and later rehired without too much difficulty.
That's not the case with retail. In a down cycle, retail fixed operating costs can be deadly, and staff cannot simply be let go and rehired later. So when companies move from wholesale to retail they assume a great deal more operating risk. This is not always fully acknowledged.
There is one more factor to take into consideration about the TTH acquisition, and that is the effect of the COVID-19 pandemic. While there was a real effort made by Metcash to suggest that the pandemic will somehow result in fundamental structural change to its markets, that does not seem to really be the majority view. While current conditions might just stretch to November 2021, there is little doubt that once COVID-19 vaccinations are in place, Australians will return to their habits of eating out as much as they did in 2019, and grocery sales will slump. In terms of hardware, there may be a marginal increase in sales, but that will depend in large part on what the housing market does, which is far from certain.
This means that come the second half of FY2022, companies like Metcash will be running direct comparisons back to FY2019, and perhaps even then contemplating sliding results.
It is the culmination of all these factors - poor technology adoption in the past, sliding growth in the food business, a failure to fully capitalise on investments in the hardware sector, and the hangover from COVID-19 - that has made the investment in TTH "make sense" for Metcash. It makes sense, because the company is likely faced with just two choices: don't take the chance, and then pay the price for low growth, or take the chance and just possibly do better.
If Metcash is lucky, it might benefit from a new source of growth. Even if it isn't lucky, and TTH proves to provide more neutral than high growth, Metcash might buy itself "cover" for as much as the next two years, by which time, hopefully, some of its digital transformation benefits will kick in.
The core reality of that investment is perhaps best revealed by this question asked at the Investor Day by investment analyst Andrew McLennan of Goldman Sachs.
It looks though that this is going to be very much a space race. You've flagged how many stores you're looking to roll out, but you've got a competitor starting from way back, but having a huge amount of capital, obviously you've got different skillsets in terms of trade versus DIY, etc. Just wondering how confident you can be that allocating this capital and accelerating the growth profile can continue to enable you guys to run ahead of the Bunnings funded competitor.
This is, of course, the background to this acquisition: TTH is widely regarded as having backed out of a potential ASX listing and put the company on the market out of concern when Wesfarmers/Bunnings entered the trade tool specialist market with the purchase of Adelaide Tools.
Mr Laidlaw's response to the question partially affirms this supposition.
So you're absolutely right. I mean, what the franchisees of Total Tools were saying [was], "We've got a great business here. We've got great franchisees. We've got a good plan, but do we have the capital to compete with Bunnings?" That's a fact. So we bring that, but I'm very confident with the expertise that Paul [Dumbrell, CEO of TTH] has in his team that we will stay ahead of that competition. Adelaide Tools, just five stores. I'm not sure if the owner's staying around. So Bunnings have to acquire that expertise from somewhere. We've got it out there in 88 stores.
This does identify the extent of risk that Metcash is facing. Bunnings has plans to build out its network of tool retailers to around 30 stores over the next two to three years. However, perhaps characterising it as a general "space race" - the retailer with the most stores wins - is not quite accurate. It is a space race, maybe, for Metcash, but it really isn't for Bunnings.
One of the factors that was not mentioned at the Investor Day, and that perhaps has not been quite figured into the TTH acquisition, is the extent of the relationship Bunnings has with Techtronic Industries (TTI), the company behind the Milwaukee, AEG and Ryobi power tool brands. The volume of goods made by TTI sold through Bunnings would be substantial (Bunnings has exclusive rights in Australia for both Ryobi and AEG), and one would imagine that this, along with a very long and good relationship between the two major companies, could guarantee good supply agreements.
Every indication that is currently coming from Bunnings is that the company plans to take things slow, and make sure the retail offer is an appealing one. The real question for TTH, in this circumstance, isn't the competitive moves Bunnings may make, but how long it will take the bigger company to develop a performant, verifiable model. At that point, and only at that point, is Bunnings likely to increase its investment and start building out the store network.
What Mr Laidlaw's answer really does show is something of an ongoing problem that has persisted at Metcash, which is really not understanding Bunnings. That was evident in his opening remarks to the Investor Day presentation:
Annette [Welsh] and I have been fortunate enough to travel the world, looking at home improvement businesses, hardware businesses, looking for best practice and gone to many good places. And it's amazing when you come back to it, if you categorised the Big Box DIY best performers in the world, you look at B&Q, you look at Home Depot. Bunnings is the best in the world, in our opinion, at Big Box DIY. Very, very good. They've absolutely captured that weekend warrior. You only have to drive past car parks on the weekend to see how successful that is at capturing the heart and soul of the DIY customer. They're not so good at trade, but we'll talk about that as well.
We also looked at a lot of good individual businesses around the world. There were some great businesses in the US, entrepreneurial. There's a business called Orchard. Unfortunately, the big guys always then go and buy them out and you lose the entrepreneurialism. But the best at actually trade and DIY, not so humble, is absolutely Mitre 10 New Zealand, who are outstanding at it, and Mitre 10 Australia is becoming very, very good at it, and leading the way in many areas. Having those trade drive-throughs for the trader to get in and out, get on with it, is outstanding.
With all due respect to both Mr Laidlaw and Ms Welsh, Metcash is an Australian company with a market capitalisation of around $3.5 billion. At its peak, revenues from its hardware segment have been around $2.4 billion, and the majority of those revenues come from its wholesale operations, not retail.
Home Depot has a market cap of USD329 billion, and revenues of USD132 billion in FY2020. B&Q is owned by Kingfisher in the UK. Kingfisher has a market cap of GBP6.7 billion, and had FY2020/21 revenues of GBP12.34 billion.
Bunnings is owned by Wesfarmers, which has a market cap of $60 billion. It had sales of $31 billion for FY2019/20, of which $15 billion came from Bunnings. If we accept that 17% of that revenue was due to trade sales, that means Bunnings earned $2.6 billion in trade - about double the trade portion of the wholesale/retail revenue of IHG.
Of course, everyone in hardware has an opinion about every other retailer in hardware - and is entitled to that. It's difficult to see, however, what role such opinions really should play in evaluating CapEx investments of over $100 million in a franchise operation. Far better to plan based on a clear vision of a competitor, rather than working off of potentially erroneous assumptions.
What effect will Metcash's investment in TTH have on the overall tool market in hardware retail? Most hardware retailers are going to be less concerned about how many Milwaukee drills TTH sells, and more concerned about the market in power tool accessories, such as bits, cutting disks and replacement batteries. As the franchise expands, will it see tradies go to TTH for their actual tools, but return to hardware stores for those accessories? What happens when both TTH and Bunnings are expanding their operations?
There is really no way to tell, and it's likely to be a store-by-store, customer-by-customer situation. Perhaps the real impact of the TTH investment is not so much directly about TTH itself as it is the signal that Metcash plans to deal with its hardware business in a different way. The industry will likely only understand the consequences of that once 2021 is over.
In general terms, however, what we are seeing play out at Metcash is similar to what we see at many other listed and unlisted Australian companies. Many of these companies have reported reasonable performance over the past five years, but this has been due, at least in part, to not realising how much they should have been investing in technology. As the 2020s roll by, we'll see more of these getting into trouble as their sources of growth dry up. Like Metcash, they will invest in riskier projects, in the hope of shoring up their share price and future outlook.
Some will eventually make the transition to technology, but more will likely fail, or find themselves in receivership, being scavenged for whatever assets they have left that will be of value. HNN would suggest that will happen more quickly than most would suspect, as soon as 2025. Let's hope Metcash - and IHG - evades that fate, but to do so it will need more significant action than has been envisioned so far.