ASX shoots the lights out trades above 4 500

The ASX has lagged North American markets for a while now and while the Australian dollar is just one of the reasons to explain the lag, the big factor we feel has been in the composition of the Australian index, heavily weighted to resource stocks. So with the copper price now bouncing convincingly above US$3.50/lb – last at US$3.58/lb – there is cause for optimism. Today’s move above 4500 with an hour of trading left at the time of trading highlights the optimism. Rio Tinto’s comments yesterday forecasting Chinese GDP growth to exceed 8% sometime next year surprised many, including us. See our note titled “Rio Tinto’s early Christmas present”

Traders should keep an eye on the ASX200, there is a lot of scope for upside if Chinese numbers start to surprise on the upside and commodities creep higher into the New Year. Caution warranted as always.

A note on the supermarket chains – Metcash (MTS.AX) reports poor numbers

During the noughties decade (2000-2010) Australian grocery wholesale Metcash grew its business largely at the expense of a languishing Coles, but the past few years have seen many of those gains reverse. The once dominant IGA Distribution business, which generates the vast majority of Metcash’s business, is now struggling to cope with the price war between Woolworths and Coles.

The IGA Distribution business continues to see its margins slide, now down to 3.8%. Sales have hardly grown even when adding new stores and adjusting for the Franklins acquisition, so from this we assume comparable sales growth across the network is negative. It’s not that Metcash isn’t trying hard, it’s just that the group finds itself now in the very opposite industry structure it enjoyed during the naughties – intense competition.

The key risk for Metcash is the balance sheet position. When you buy Metcash shares in hope of a solid dividend, the complete picture should be put into consideration. Even after the most recent capital raising – which wasn’t too well received by the market at the time – gearing as measured by debt to equity sits at around 44%. This shouldn’t be a worry for a stable business that is growing its earnings but Metcash is no longer in that position. Guidance is for earnings growth to decline by 2 to 6% as opposed to a 1 to 3% decline previously outlined. Earnings, not only prices, are “down down” in the supermarket space.

Bottom line: With earnings declining, the balance sheet somewhat still stretched and no sign of the food war between Coles and Woolworths ending, Metcash will have to cut its dividend in order to sustain itself.  This means many investors that parked into Metcash as a defensive exposure will now have to look elsewhere until the extent of the earnings decline is better known. We think Metcash is a Sell at current levels and we wouldn’t be buying into perceived value unless management can generate a new niche segment, like it did a decade ago. The once champion of the independent space is now struggling to hold its ground, making it purely a contender in a very competitive space. Unfortunately, things are likely to get worse for Metcash before they get better.