Why I've changed my view on Sainsbury and sold my shares

Mike Coupe, Sainsbury’s chief executive (image: J Sainsbury)

My position in J Sainsbury (LON:SBRY) had  not been working out as well as I’d hoped. So after a year, I decided to revisit my reasons for buying to see if they still stacked up. I often find this can be a worthwhile exercise.

Discount to peers

The main thrust of my investment case was that Sainsbury’s stock was trading at an unwarranted discount to its two main listed rivals, Tesco and Morrison.

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).

I also noted that based on 2016/17 figures, Sainsbury’s earnings yield (EBIT/EV) was much higher:

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

So my argument was that this discount should gradually close and that Sainsbury might increase in value. A particular attraction was the group’s earnings yield of 9%, which is reasonably high.

What actually happened?

Revisiting these metrics showed me that the gap has closed, but not in the way that I’d hoped. While Sainsbury’s share price has gone nowhere much, weak earnings performance means that its valuation relative to earnings has increased:

Here’s how the earnings yields (EBIT/EV) compare now on a TTM basis, ahead of each firm’s FY18 results:

• Tesco: 6.4%
• Morrisons: 7.5%
• Sainsbury: 7.4%

Sainsbury still trades at a price/sales discount relative to the others, but it’s not as large as it was. It seems clear to me that in terms of profitability, all three supermarkets are more closely matched than they were.

Is it worth holding?

In terms of profitability, none of these three supermarkets seems especially expensive. However, it’s worth understanding why Sainsbury’s earnings yield has fallen from 10.3% at the time of my original purchase to 7.4% today.

Unfortunately it’s because the group’s profitability has fallen, rather than because the shares have risen.  The group’s full-year operating margin fell from 3% in FY16 to 2.4% in FY17. And the TTM operating margin for 17/18 is 1.7%.

The reason for this, from what I can tell, is that Argos is diluting the group’s margins (as some commentators suggested at the time of the Home Retail acquisition).

It was apparent before the acquisition that Argos had a lower operating margin than the supermarket business, but I had hoped that higher sales density achieved by moving Argos branches into under-utilised supermarkets would offset this. As yet it’s not clear whether this will be the case.

Obviously the integration of the two businesses will need a year or two to bed in and deliver synergies. But how great will these be?

According to 1H18 results, Sainsbury’s board is targeting £142m of EBIT synergies by the end of 2018/19. But to achieve this, the group will incur £130m of integration costs and £140m of integration capex — that’s a total of £270m of cash expenditure.

Broadly speaking, I don’t expect the benefits of this integration spending to appear fully until 2019/20. And even then the reality may still be that Argos is simply a lower margin business.

I might have been tempted to give the board the benefit of the doubt here, but Sainsbury’s management has opted to report all retail sales as one segment (as of 1H18 results). So there will be no segmental breakdown of profit from Argos and Groceries.

This means that it will be very hard to see how the different parts of the business are affecting the group’s overall profit margins. On balance, my view is that the current valuation is probably about right. I’m no longer convinced by the case for a re-rating, so I decided to sell.

Including dividends, I scraped a 2% profit after one year. Not great, but certainly not a disaster.

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.