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J Sainsbury Plc Second Quarter Update – 04 October 2014

Since our last update, J Sainsbury Plc shares have suffered a similar fate to that of their rivals. With the growth of discount supermarkets unchecked, the “Big Four” in the UK have each lost market share.

With a volley of profit warnings emerging from Tesco during the last six months, shares for each of the UK’s leading supermarkets have weakened considerably, reflecting a high level of anxiety among investors over the earnings outlook for the middle tier.  

While our central view has been that Sainsbury’s brand quality provides it with a competitive buffer against the price leadership of the discounters, recent events have placed a question mark over this theory.

Most notably, management have opted to pursue a deeper price competition strategy than at the time of our previous update. This is in addition to the decision to invest heavily in a joint venture with Dansk Supermarkets that seeks to bring NETTO back to the UK.

The price competition strategy has contributed greatly to a 2.1% decline in like-for-like sales during the first half, prompting concerns that, in tandem with its competitors, the grocer’s earnings are likely to follow a similar path.

Consequently, investors have seen little incentive to lift the shares from their current multi-decade low, and we now suspect that the ensuing period of margin compression could be about to reach J Sainsbury’s door.

J Sainsbury Plc Monthly Chart

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The Road Ahead

The key issue affecting Sainsbury’s and its competitors remains the growth of discounters that have tempted shoppers away from the big four with the prospect of lower grocery bills. However, this is not the only factor affecting the sector.

Recent research suggests that total growth in the overall grocery market slowed to a record low of 0.3% during H1 2014. In addition to a lesser number of new spenders and reduced budgets among existing consumers, food price deflation has also been a key factor in the decline in sales values.

This reduction in food prices has been unprecedented in the UK grocery market’s modern history, with the impact being significant enough to make a meaningful contribution to the 2014 decline in overall UK inflation.  

“The latest grocery share figures from Kantar Worldpanel, published today for the 12 weeks ending 14 September 2014, show overall grocery market growth slowing to a new record low of 0.3% as price inflation falls to zero,” Kantar Worldpanel, September 2014

While the impact of the discounters and nil inflation for food prices are key issues, we maintain our assertion that the impact upon Sainsbury’s future earnings performance is unlikely to be of the same magnitude as with the likes of Tesco and WM Morrison. Our rationale for this remains very much the same as in our previous report.

This is that many shoppers are likely to choose J Sainsbury as their grocer for reasons other than their prices.

While the group has made competitive efforts to retain those customers who are more price sensitive, we believe that the quality perception of the grocer’s brand should continue to insulate it from customer defections of the scale that have been seen with Tesco and WM Morrison.

While the group is unlikely to remain as unscathed as we had previously suggested, we do believe that this should help to place a floor underneath future earnings deceleration.

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Balance Sheet, Dividend and Valuation Update

From a valuation perspective, earnings multiples across the supermarket sector have now compressed substantially to reflect the negative outlook for growth.

Both Tesco Plc and J Sainsbury Plc currently trade on multiples of 7.5X 2013/14 earnings, while WM Morrison rests considerably lower (2012/13 e), given the dire performance reported at the close of its recent financial year.

While we believe that the current valuation dynamic for the sector is unlikely to change over the near term, we do expect that any drop in earnings at J Sainsbury will be limited in comparison to its peers. This offers the prospect of support for the share price over the medium term; however, it will take time to become apparent (H1 2015 – full year results).

In relation to the balance sheet and financial condition of the business, we note that the group’s debt profile remains within reasonable levels (30-50% gearing) and that it has now taken action to prevent its defined benefit pension liabilities from rising further.

While overall net debt increased by £222 million during the previous financial year, much of this was attributable to the acquisition of sole ownership rights to Sainsbury Bank Plc. Over future periods, we would expect balance sheet expansion in this manner to be more limited.  

As such, we see no material risk to the business from its balance sheet, even in the face of an evolving monetary policy outlook. Although the balance sheet is largely secure, the dividend faces a much more uncertain outlook.

While we do not anticipate the group struggling to cover the pay-out, we do believe that with the business entering into a period that may require high levels of investment, it makes sense for management to conserve cash where possible.

Therefore, it is possible that the board could take the decision to cut the dividend over the coming quarters for no other reason than it is prudent to do so.

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Summary

In summary, we expect the earnings deceleration at J Sainsbury to be limited in comparison with that of its peers. The current share price of 227.0 pence implies a valuation that is in line with the sector average at 7.5X 2013/14 earnings.

In the absence of positive news flow, we would expect Sainsbury’s share price to average this level for the foreseeable future. In light of the board’s recent comments that second half performance would be in line with that of recent quarters, we would expect this share price dynamic to extend as far as the release of 2014/15 results in Q2 2015.

It is here that we expect J Sainsbury to set itself apart from the crowd with the differential in the pace of earnings deceleration becoming clear.

Having said this, such an outcome is not guaranteed to revive the share price as the risk that management will cut the dividend still exists. This could lead to further share price depreciation.

Nevertheless, we remain attracted to J Sainsbury Plc as a long term play. Key to this attraction is the way that it has preserved its brand image throughout recent and past scandals, as well as its leadership in combating the advent of discount supermarkets through innovative means, most notably its recent tie-up with Dansk Supermarkets (NETTO).

As a result, if management were to opt for a dividend cut in the near future, this would mark an inflection point for us in the case of Sainsbury. One which represents a further de-risking of the business and its balance sheet, that would likely lead to an upward revision to our outlook for the shares.

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