Please note all $ figures in $CAD, not $USD, unless otherwise stated.

Introduction

I’d be hard pressed to find a grocer I like more than Metro (TSX:TSX:MRU:CA). Historically, the company has been a compounder, delivering strong growth on both the top and bottom line. Since I last discussed the company back in December 2023, the company has been building out its network of distribution centers and has been generating cost efficiencies to drive margin expansion. In this article, I’ll provide an update to my original investment thesis, analyze the latest quarterly results, and explain why I’m a buyer of the company’s shares, even after the recent run up.

Background

Metro is one of Canada’s largest grocers with a network of 992 food stores. If you’re a Canadian like me and you’ve never heard of them, don’t fret. The company generally operates only in Eastern Canada, mostly in Ontario and Quebec, so it really doesn't have a west coast presence. Metro operates under the Metro, Metro Plus, Super C and Food Basics brands for its food offerings, but it also owns several drugstores. With its flagship Jean Coutu pharmacy chains, the company also owns drugstores through the Metro Pharmacy and Food Basics Pharmacy banners. As a $20 billion a year business, the company has a 10.8% market share in Canada, just behind Costco (COST) at 11%, Sobey’s/Safeway at 21%, and Loblaws (L:CA) at 29%.

As a low growth industry, Canadian grocers try to differentiate themselves through loyalty programs and by keeping costs low. Therefore, they’re generally able to grow in line with inflation plus a few percentage points through cost efficiencies and market share gains. There’s not too many capital allocation opportunities organically, so most pay out a dividend and buyback stock; there’s often not much opportunity to do M&A since the market is already very mature and there aren’t too many independent grocers. The last major deal that Metro did was its acquisition of Jean Coutu in 2018, the largest pharmacy brand in Quebec. Over the years, the company has done a good job in establishing the Coutu loyalty program and has integrated the deal successfully with cross selling opportunities.

Even though the grocery business is somewhat of a sleepy industry, Metro has been able to grow revenue and EBITDA at decent clips. Over the last ten years, the company has grown revenue at a CAGR of 6.2% with EBITDA growing at 8.4%. More recently, over the last five years, the company has grown its top and bottom line at CAGRs of 7.6% and 10.9%, respectively (source: S&P Capital IQ). With EBITDA growth outpacing revenue growth over both time periods, Metro has experienced margin expansion, as illustrated by the margin line in the chart below, up and to the right.

Comparing Metro to its peers’ share price performance, we can see that the company has held its own with share delivering a total return of 314% over the last decade. Against the TSX's return of 98%, Metro has outperformed by a wide margin.

Recent Results

Metro reported decent Q2’24 results, with revenue hitting $4.65 billion, up 2.2% on a year over year basis. Same store sales growth for the food segment was in line with expectations up 0.2% mostly by a weak preceding Christmas fell in the first quarter, whereas, last year it fell in the second quarter. On the earnings call, management noted that consumers continue to search for value, with some trade down to private label (growing at 2x national brands). Discount banners are continuing to outperform conventional, however the gap between the two growth rates seems stable. On tonnage, results were flat in the quarter (discount up slightly, conventional down slightly), transaction counts were up in all banners, and average baskets declined.

When we look at what drove the results, basket inflation came in at 3.0% (slightly above CPI) as promotion activity and penetration remains elevated. Going forward, it’s likely that basket inflation comes down closer to the 2.5% range, given CPI coming down in goods. In ecommerce, online food sales climbed 51% compared to last year, with strong growth due in part by third-party relationships for same-day delivery. On the discount banners in online sales, click and collect has become more popular. A 51% growth rate likely isn’t sustainable but it’s still early days for this segment. Eventually, I foresee growth moderating to more normal levels, particularly as Metro laps the start of the expanded third-party partnerships and the rollout of the click-and-collect to discount banners.

In pharmacy, growth in specialty drugs and pharmacist services saw growth with front-store being propelled by another active cough and cold season. Given these factors, same store sales growth was up by 5.8%, even though last year’s Q2’23 was quite strong too (same store sales growth of 12.2% last year). Overall, I wouldn’t count on Metro to deliver double-digit growth in same store sales, let alone high-single digit growth.

Why? Unless we can count on more and more worse seasons for allergies and coughs, I don’t think we should expect anything higher than inflation plus a few percentage points.

As for the outlook for Metro, the company targets 8-10% EPS CAGR over time, not necessarily in every year. It achieved an 11% CAGR over the past decade, 10% over the three years covering the pandemic, and 11% (on a same-week basis) in FY’23. FY’24 will be a transition year, considering the significant duplicate overhead, depreciation and interest costs, and ramp-up inefficiencies related to the company’s supply-chain modernization.

Management’s FY’24 guidance is for a 0-2% decline, followed by a 13% increase in FY’25 (source: S&P Capital IQ). Given management’s track record of delivering on its 8-10% long-term EPS CAGR, I don’t see any reason why it should not continue to deliver on this, although I see it likely reaching this over a 3-4-year time horizon.

From a balance sheet perspective, Metro had $2.78 billion in long-term debt for Total Debt to EBITDA of 1.6x (source: S&P Capital IQ). Compared to peers, this is a relatively low leverage ratio so I view this positively. The company's issuer profile is BBB by the rating agencies so Metro maintains an investment grade profile with a low cost of debt.

Valuation

On valuation, Metro is neither expensive nor cheap. Historically, the company has traded within a range of 8.0x and 13.8x EV/EBITDA (source: S&P Capital IQ). With the current 11.3x right at the long-term ten-year average multiple, the company’s shares are appropriately priced.

Analysts seem to think so too. Of the 9 analysts who cover the stock, there are 8 'hold' ratings on the stock and just 1 'buy' rating. The average target price is $76.89 with a high target of $82.00 and a low target of $69.00. From the current price to the average target price of $76.89 one year out, this implies about 0.7% downside, not including the 1.7% dividend. This seems to indicate that analysts don't see much upside from current levels.

Is there still value here? I think it depends on your time horizon. If you’re holding Metro for the next 5-10 years, I think you can make the argument that a 10% decline from here won’t be too meaningful to your long-term returns. But with shares at their historical average and analyst targets suggesting limited near term upside, it could be worth waiting for a pullback.

One of the arguments in favor of waiting is that the gap between Metro and its peers’ valuations have widened over the last couple of years. Today, Metro trades for 10.7x forward EV/EBITDA, which is above peers like Loblaw at 9.3x and Empire (EMP.A:CA) at 6.6x.

Apart from the general macroeconomic risks like a weakening consumer and the threat of higher interest rates curbing spending, Metro has its own challenges. Previously, Metro’s management team described 2024 as a ‘year of transition’ and noted that the company would face significant headwinds with higher capex investments to tighten the supply chain. While this could be offset through margin expansion later, it’s unclear when this could occur. For now, that capex is cash that’s not being returned to shareholders. As such, until these headwinds subside, I’d wait for a pullback below 10.1x EV/EBITDA, one standard deviation away from the historical ten-year average multiple. At current prices, I rate shares of Metro as a 'hold' and would have a preference for Empire, which I previously covered here.

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