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J Sainsbury Plc – 24 June 2014

 

Company Overview

Founded in 1869, J Sainsbury Plc is a UK grocery retailer that operates more than 1,200 stores and employs 161,000 people in Britain. The group is divided between three divisions: Grocery Retailing (Sainsbury’s), Financial Services (Sainsbury’s Bank) and Property Investment (joint venture with British Land).

The group holds a 16.8% share of the UK grocery market and is often perceived by consumers to be an upmarket brand with a bias toward quality as opposed to value or price-driven retailing. The group also boasts of being the largest Fair Trade retailer in the world, the sixth largest retailer of children’s wear in the UK by volume as well as the seventh largest purveyor of home ware and small ticket household goods.

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UK Grocery Market Overview

The UK grocery market is subject to fierce competition and is currently dominated by the “Big Four” supermarket chains, Tesco, J Sainsbury, Asda, and WM Morrison. These firms occupy what is frequently referred to as the middle segment of the market, while continental discounters hold the lower tier and the home grown, more quality-focused Waitrose and Marks & Spencer cater for the more affluent customers at the higher end of the income spectrum.

Index  FTSE 100 Ticker SBRY.L Latest Close 314.90
52 Week High 428.00 52 Week Low 301.50 P/E 9.8
Dividend Yield % 5.5 Dividend Cover 1.86 CEO: Justin King / Mike Coupe
CFO: John Rogers

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Sainsbury’s Trading Update and Overview

Full year results for 2013/2014 showed top line sales (ex fuel) increasing by 2.7% over the period while underlying earnings per share grew by 6.1%. Although growth at J Sainsbury was slower than in previous years, it has remained above the industry average.

Nevertheless, J Sainsbury’s share price has continued its late 2013 decline throughout much of the current year, reaching its lowest level since 2012 in March (300.00 pence). The group’s interim management statement in June did little to arrest this decline, despite expansion efforts adding a minor increase to the top line during the 12 weeks to 7 June.

During the period, total sales (ex fuel) increased by 1% while like for like sales fell by 1.1%, indicating that the group’s efforts to insulate themselves from lower food prices, increased competition and ongoing reductions in consumer grocery spending have continued to pay off.

The difference between top line sales and the like for like (LFL) is that the LFL measurement strips out most forms of expansion whether geographic, by acquisition or organic growth into new lines of business. The metric is popular as it provides an insight into how the business will have performed if its operational size and capability from the comparable reporting period had remained constant.

As a result, a sustained reduction in LFL sales can help to predict the beginning of a longer-term slowdown or contraction in earnings. However, it tends to overlook or ignore the potential impact that aggressive expansion or diversification into new lines of business can have on performance and future prospects.

While the shares did stage a brief rally following the announcement, they later fell back on news that Kantar Worldpanel had observed a decline in Sainsbury’s market share. After increasing its estimate from 17% to 17.1% during Q1, the following three months are reported to have seen the chain’s capture of the market reduce to 16.5%, which represents the sharpest quarterly decline for almost a decade.

All in all, the group continues to face competitive pressures in its core markets, which have led to a reduction in footfall, while the downward trajectory of food price inflation has magnified the impact of this upon top line figures. At present, there is nothing on the immediate horizon to indicate a change in this trend. However, we are not discouraged; on the contrary, we remain attracted to J Sainsbury and continue to believe that the business and brand have bright futures ahead of them.

J Sainsbury 8 Hourly Chart

JSAINSBURY2014SHAREPRICEVIEW

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J Sainsbury Announces Joint Venture with Dansk Supermarked; Enters the UK Discount Arena

After becoming the first UK supermarket to trial the mobile scan and go payment system in its stores, the group is now set to be the first of the British heavyweights to enter into the discount arena.

This follows the open to Q3 2014 when Sainsbury’s management unveiled a joint venture agreement with Dansk Supermarked, which will see the Nordic brand Netto re-enter the UK for the first time since the onset of the financial crisis.

With the UK discount sector forecast, by the Institute for Grocery Distribution, to grow by 96% from £10 billion to almost £20 billion by 2018,  it becomes easy to see the attraction to both J Sainsbury and Dansk Supermarked.

What channels make up the UK Grocery Market

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So far, sentiment toward the tie up within the analyst community appears to be mixed. Some have expressed their support for the move, while others have been quite vocal in their opposition of it.

Some of those who have come down on the “against” side of the fence have described the venture as, among other things, an admission by Sainsbury’s that the “Big Four” cannot fend off their discount competitors and still cling to their historical models.

Those in favour of the move seem to hold a similar view to that of Mike Coup, the incoming CEO at Sainsbury, in that they believe any opportunity for exposure to a fast growing sector or market is going to be positive for the group over the longer term.

Last week when covering Tesco Plc, we expressed our expectation that many of the “middle tier” supermarkets, or the “Big Four” would be likely to stray toward the discount pricing model over time as part of efforts to relieve ongoing pressure upon sales volumes and market share.

Under this scenario, J Sainsbury was the exception to the rule. Our belief regarding the group has been that the consumer perception of its brand remains above that of its competitors. This is particularly the case following the horsemeat scandal of 2013, which embroiled the entire industry barring a select few, one of these being Sainsbury’s.

In short, we see Sainsbury’s as having a differentiated offer when compared with its peers. This is one that seeks to provide value through fair, but not cheap, pricing and a relentless focus upon quality.

We are attracted to the concept of a joint venture proposition between Sainsbury’s and Dansk. This is because under the proposed plans, J Sainsbury will enter the discount market through an ownership stake in the venture with Dansk, an experienced operator in the field of discount retailing.

Through such an approach, J Sainsbury will avoid compromising the slightly upmarket, quality image  conveyed by the brand, and will not be forced into adopting the discount-pricing model across its core operations. The two operators will share an equal burden of costs, risks and rewards, while management at J Sainsbury remain free to focus on core operations.

“It’s a case of as well as, not instead of. The bulk of supermarket shopping is still in big supermarkets” – Mike Coupe, Incoming CEO at J Sainsbury Plc

Ultimately, we feel that the venture is likely to prove positive for earnings over the broader term. We also anticipate that the brand’s goodwill among consumers will be sufficient to see the parent group through the worst of any near-term bad weather in the mid-section of the UK grocery market.

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J Sainsbury Plc: Strategy Going Forward

The strategic priorities of management at J Sainsbury revolve around five key pillars. These are:

  1. Great Food
  2. Compelling General Merchandise and Clothing
  3. Complimentary Channels and Services
  4. New Businesses
  5. Space and Property Value

The group’s avid focus on “great food” and strong reputation for quality sees 20% of all fruit & veg spending in the UK go to J Sainsbury. Consequently, management have made a conscious effort over the last decade to provide a sustainable future for UK farmers and to this end, have invested £40 million in development projects since the year 2006. This continues to underpin the group’s resilience to price competition among competitors.

In addition to the significant presence in grocery retailing, J Sainsbury has also built a substantial non-food offering throughout its larger stores and is now the UK’s sixth largest retailer of children’s wear by volume. It also ranks as the seventh largest retailer of general home ware such as kitchen utensils and small household items.

Growth under both of these product lines outstripped that of general grocery merchandise in the 2012-2013 year, while annual sales by value surpassed the £1 billion barrier for the first time.  This continues to provide J Sainsbury with a cushion against any further reduction in consumer spending upon grocery items in the core business.

Despite this success, management estimate that two thirds of the UK population are still not within a 15-minute drive from one of the group’s larger outlets incorporating a non-food offering. Consequently, management see the adaptation of existing stores to incorporate a non-food offering as key to strategy objective two, as well as strategy objective number five.

Multichannel service delivery and expansion into new businesses also remains a key driver of revenue and earnings resilience.

In the 2013-2014 year, online retail orders reached the significant £1 billion barrier for the first time. This was while the group’s Click & Collect service also gained momentum in popularity among shoppers.

Looking further out, new or emerging businesses such as Sainsbury’s Bank and the group’s health and pharmaceuticals operations offer the potential to add greater diversification to income, while underpinning core earnings throughout periods of increased competition in the groceries arena.

Strategy

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Balance Sheet, Dividend, Valuation

The year ending in March 2014 saw J Sainsbury add £222 million in debt to its balance sheet, which was largely attributable to an increasing pension deficit. As a result of the movement in net debt, the group’s gearing ratio increased by a fraction from 37% to 39.7%. Excluding the effect of the pension deficit, gearing actually reduced to 33.7%. Although an increase in balance sheet liabilities is not always a comforting event, the aforementioned ratios are within the range of what is commonly deemed as acceptable.

On a different side of the same coin, gearing was not the only balance sheet item that experienced an increase throughout the recent financial year. The Sainsbury property portfolio also underwent a valuation increase of £500 million to £12 billion in March 2014, which helps to take the sting out of a rising debt profile, given the security provided by a strong tangible asset base.

In relation to the dividend, management raised the total shareholder pay-out during the year by 3.6% to 17.3 pence, which was covered 1.86 X over by diluted underlying earnings. When announcing the dividend, management declared that the board remained focused on growing the shareholder pay-out while steadily increasing the dividend cover to 2 X earnings over time.

From a valuation perspective, J Sainsbury currently trades on a multiple of 9.8 X 2013 earnings. This matches that of Tesco and is at a mid-way point between the valuation achieved by WM Morrison, the more beleaguered of the “Big Four”, and the more upmarket Marks and Spencer. The table below offers a comparative view of earnings multiples across Britain’s listed supermarkets space.

Tesco Plc
J Sainsbury Plc
WM Morrison Supermarkets Plc
Marks and Spencer Plc        
9.1 X
9.7 X
7.2 X
13.3X

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Our view on the above is that the market valuations, on a price to earnings basis, overlook a number of material differences between Sainsbury’s and Tesco. The most notable of these is the difference between consumer perceptions of both brands, which is reflected in the behaviour of earnings at both companies over recent reporting periods.

During the 2013-2014 year, underlying diluted earnings at Tesco declined by just over 7%, which reflects poorly against the positive 6.3% growth under the same metric at J Sainsbury. Our own separate outlook for Tesco sees downside risks to earnings at the group, while J Sainsbury maintains a competitive cushion against the worst of such risks or pressures as a result of its clear and differentiated image.

Although competitive pressures brought on by the discounters may eventually feed through to the bottom line at J Sainsbury, we do not anticipate the impact of such an event being on the same scale as with Tesco or WM Morrison.

Consequently, our official line on the valuation is that it does not accurately reflect the strengths and benefits of the J Sainsbury business and brand.

While declining valuations are the norm within an industry where earnings growth is slowing, much of our discontent with the market multiple for J Sainsbury is as a result of its proximity to the level of lower tier, or second rate operators.

With competitive pressures as well as company level dynamics factored in for each, we feel a more appropriate valuation in the case of J Sainsbury would be in the region of 11/11.5 X earnings.

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Summary

To summarise, earnings growth has slowed at J Sainsbury over recent quarters, although it still remains positive. The retailer is exposed to risks arising from competitive pressures; however, these are reduced when compared with its peers. This is because of the differentiated brand offering, its successful efforts at diversification and a proactive counter attack against the discounters through its tie up with Dansk.

Looking ahead, we see limited downside to earnings and market share at J Sainsbury. We also believe that the present valuation materially overlooks various strengths and benefits of the business when compared with its nearest competitor, Tesco Plc. Our official line on this is that a more appropriate valuation would be in the region of 11/1.5 X earnings, which implies a fair valuation that is somewhere between 350.00 and 370.00 pence.

In terms of trading guidance, despite our positive outlook for J Sainsbury we see the shares remaining under pressure at or around the current levels over the near term, although we believe that a sustained break below 300.00 pence is unlikely in any event.

Looking further out, we believe that J Sainsbury’s earnings numbers throughout the current year will set it apart from the crowd. Under this scenario, we expect a sustainable return to a 350.00 – 370.00 pence trading range over the medium term.  

J Sainsbury Plc Hourly Chart

JSAINSBURYSHORTCHART

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