Guess which is the best performing grocery-related stock this year? Here's a hint – it isn't Woolworths Limited (ASX: WOW) even though it has been on a comeback trail as it successfully claws back market share from arch rival Coles, which is owned by Wesfarmers Ltd (ASX: WES).
The answer is Metcash Limited (ASX: MTS), the ugly duckling of the industry with its lack of scale and competitive advantages to withstand the onslaught of low-cost offshore rivals like Aldi and very possibly Amazon.
But the stock has made a strong turnaround with Metcash's share price up nearly 21% since the start of the 2017 calendar year when dominant rival Woolworths is up 11.4%, and Wesfarmers is a mere 3.7% in the black.
In contrast, the S&P/ASX 200 (Index:^AXJO) (ASX:XJO) has gained 5.5% this year.
There could be more near-term upside for Metcash. Morgan Stanley believes its first half result, which will be released on Monday, will give a glimpse into how Metcash is evolving into a diversified cashed-up business.
This will then prompt investors to focus on what management will do with the expected surplus capital – which is always a nice problem to have.
This isn't to say that Metcash has found a solution for its struggling grocery distribution business that still contributes the bulk of its earnings. Metcash supplies groceries to its chain of small supermarkets.
However, earnings might be stabilising in this division. Morgan Stanley notes that dry grocery deflation has eased, the major supermarkets and Aldi have slowed new store rollouts and the rate of closures of independent supermarkets has moderated in recent months.
Meanwhile, the broker believes investors are underestimating Metcash's hardware division. The company has several growth levers it can pull to drive this division forward over the coming years and Metcash's half year results are likely to put a spotlight on what these growth levers are.
"We forecast Metcash's FY18 net debt at $36 million, which represents a c$950m improvement since FY12," said the broker. "Metcash now looks undergeared, especially as the dividend payout ratio sits at 60%."
Morgan Stanley estimates that a $200 million share buyback will lift earnings per share (EPS) by around 7% in FY19 and leave net debt to earnings before interest, tax, depreciation and amortisation (EBITDA) at a comfortable 0.2 times.
The broker has an "overweight" recommendation on the stock with a price target of $3 a share. Metcash is trading 0.2% higher at $2.76 in late morning trade.
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