Does J Sainsbury plc deserve such a big discount?

Disclosure: Roland owns shares of J Sainsbury plc.

I’ve been reviewing the stocks in my portfolio recently, with a view to culling low conviction positions and focusing more heavily on stocks where I feel there’s significant value on offer.

As part of this, I reviewed my holding of the UK’s number two supermarket, J Sainsbury plc (LON:SBRY). The firm’s recent FY results seemed broadly as expected to me and didn’t highlight any serious concerns.

The group’s main value ratios still look attractive to me:

• Trailing price/earnings = 14.5
• Price/book ratio = 0.9
• Trailing dividend yield = 3.65%
• PE10 = 11.1
• Price/sales ratio = 0.23

Why the big discount?

It’s this last ratio I want to focus on. Despite a fairly solid performance last year, Sainsbury’s price/sales ratio of 0.23 puts it at a significant discount to listed rivals Tesco (P/S = 0.27). and Morrison (P/S = 0.35).

One possible explanation for this is different debt levels. But if we swap price for enterprise value, the result is the same. In fact, Sainsbury’s discount is even greater:

• Sainsbury EV/sales = 0.27
• Tesco EV/sales = 0.36
• Morrison EV/sales = 0.43

The conventional explanation for this should be that Tesco and Morrison are significantly more profitable. Are they? Let’s compare each firm’s 2016/17 return on capital employed (ROCE):

• Tesco = 2.6%
• Sainsbury = 5.8%
• Morrison = 7.3%

So Morrison is currently more profitable than Sainsbury, while Tesco is less so. Leaving Tesco’s valuation aside, this might go some way to explain why Sainsbury’s has a lower price to sales ratio than Morrison.

However, I would argue that the scale of Sainsbury’s price/sales discount is too large for this to be the only explanation.

A different angle

One of my favourite valuation measures is earnings yield, calculated as EBIT or operating profit divided by enterprise value. This provides a profitability-weighted measure of valuation. Here’s how the three supermarkets compare in terms of earnings yield:

• Sainsbury: 9%
• Morrison: 6.7%
• Tesco: 3.4%

On this measure, Sainsbury is significantly cheaper than both of its rivals. The only logical explanation for this seems to be that the market is expecting Sainsbury’s profits to stagnate or fall, while those of Morrison and Tesco are expected to rise.

I’m not sure I share this view. I’d have thought that competition in this sector is tough enough to make such diverging performance unlikely unless managers at one company display rank incompetence . The only big risk that springs to mind is that Sainsbury’s expansion into non-food via its Argos business will be a disaster that distracts management from the core food business.

Sceptics may yet be proved right, but the signs so far are that the Home Retail acquisition is working to improve sales intensity in Sainsbury’s stores, and thus improve their profitability.

What if the discount closed?

If Sainsbury traded on the same price/sales ratio as Morrison, then that would imply a market cap of £9.2bn. That’s about 50% higher than the current figure of £6.1bn. In this best-case scenario, the shares could be worth about 420p.

On the other hand, Morrison’s price/sales ratio might fall, closing the discount in a different way. Sainsbury’s share price could languish at current levels.

A third option is that that two stocks will meet in the middle.

I’ve no idea what combination of shifts will take place, but I believe the valuation discount between Sainsbury and Morrison is likely to narrow at some point. In the meantime, I’m continuing to hold.

Disclaimer: This article is provided for information only and is not intended as investment advice. Do your own research or seek qualified professional advice before making any trading decisions.