Metro: Impressive Q1 But Management Strikes Cautious Tone

| About: Metro, Inc.A (MTRAF)

Summary

Another strong quarter with earnings up 24%.

Dividend increased again.

Inflation creating some short-term challenges.

Metro (OTCPK:MTRAF) reported Q1 2016 results on January 26th with sales increasing 4.3% and adjusted earnings increasing 24%. Same-store sales increased 2.8%, which was in-line with inflation. A combination of operating leverage, higher earnings from Couche-Tard (OTCPK:ANCUF) and share repurchases helped drive earnings growth. Management however expressed caution going forward after the recent spike in imported food prices.

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If you are interested in a more detailed report on Metro, check out my initial article.

Q1 Results

Looking further into Q1 results, Metro continued to benefit from modest inflation, operating leverage and the Couche-Tard investment.

Management indicated that both higher traffic and basket contributed to the increase in same-store sales. Gross margins increased slightly as a result of the ongoing benefits of last year's Premiere Moisson bakery acquisition and modest industry inflation. Metro tends to see operating leverage in modest inflationary environments while they can struggle in environments with low or high inflation.

Operating margins also increased as the benefits of higher sales scaled through the business. Grocery margins increased to 7.1% from 6.7% while SG&A as a percent of sales decreased to 12.3% from 12.6%. The Couche-Tard investments continued to pay off with earnings increasing 68% from $17.9 million to $30 million.

Going forward, the company expressed some caution on the conference call and the stock sold off nearly 4% on the day. The sharp decline in the Canadian dollar is creating some short-term challenges for the business. While modest inflation is good, high inflation is a bit harder to manage.

As a result, customers are increasingly choosing frozen fruits and vegetables as opposed to imported fresh produce. This substitution behavior is a sales headwind (and may result in same-store sales lagging inflation) while also potentially being a lower margin sale. Further, customers are increasingly switching more grocery trips to the Food Basics discount banner, which is a lower gross margin business.

However, there are some offsets. Despite being lower margin, discount banners are lower investment and can earn higher returns on capital. They also have lower labor costs. In addition, they have a larger private label mix, which earn a higher margin over branded products.

After Q2 2016 the effects of imported inflation should begin to subside as some locally grown and more affordable produce will begin to make its way into supermarkets.

Update on Couche-Tard

The stake in Couche-Tard is a meaningful part of Metro's market capitalization and is currently worth approximately $2 billion (pre-tax). The investment is contributing meaningfully to consolidated earnings growth driven by same-store sales growth, higher fuel margins and last year's acquisition of The Pantry.

In addition, Couche-Tard recently closed its previously announced acquisition of Topaz in Ireland, which should support further earnings growth this year. The company also announced it has filled the CFO role.

Loyalty

The loyalty program, which is similar to Kroger's (NYSE:KR), will increasingly become a tool management can use to customize promotions and influence shopping behavior. One reader left a great comment on my previous article and I wanted to further highlight the insight for SA readers:

A few years ago, Metro brought dunnhumby on board to manage their customer loyalty program (the very same company that has managed Kroger's loyalty program in the US allowing them to become much more successful over time). When this information is analyzed in smart ways, it can provide tremendous value to the retailer - and Metro so far is definitely using their analytics to the best advantage of the 3 biggest retailers in Canada (Loblaws & Empire). Since they started working with dunnhumby, I have seen many changes in the way Metro manages their business - they now understand better which items they need to be cost-competitive on vs. which items consumers are less sensitive to price on.

Outlook

Management remains confident they will continue to grow sales and earnings in 2016. While they don't provide guidance, inflation trends suggest sales growth will remain positive. However, short-term questions surround earnings growth, such as: 1) how much operative leverage will they achieve, 2) how much price will they absorb, and 3) the margin effects of customer substitution.

If operating leverage is lower than in recent quarters and management chooses to absorb some price, we could see flat or a slight decline in margins - something the market is not used to seeing lately. Store level execution, controlling labor costs, and an excellent promotional strategy likely become even more important this year.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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