Why J Sainsbury plc could be worth 415p per share

Mike Coupe, Sainsbury’s CEO, is betting that an expansion into non-food and finance can improve returns. Is he right?

Disclosure: I own shares in J Sainsbury plc, Tesco & WM Morrison Supermarkets.

As the year end approaches, I’ve been on a bit of a buying spree. J Sainsbury plc (LON:SBRY) is the second new stock I’ve added to my value portfolio in the space of three months!

I’ve watched Sainsbury’s share price languish this year with mixed feelings. But having considered the recent results and the medium-term potential of the Home Retail acquisition, I’ve started to think that the market’s cautious view may be too pessimistic.

My decision to purchase had two elements:

• The shares offer good value and an attractive yield, based on current forecasts and historical performance;
• The market may be underestimating the potential benefits of integrating Argos and Argos Financial Services into Sainsbury’s wider business.

A simple value buy?

Sainsbury looks affordably priced on a number of measures, in my opinion.

• PE10 = 10
• Price/tangible book value = 0.95
• P/FCF (TTM) = 15.5
• Forecast P/E = 12.4
• Forecast dividend yield = 4.1%
• Earnings yield (Op. profit/EV): 10.3%

There’s nothing to dislike here. The earnings yield of 10.3% is above average and suggests to me that the  group is very attractively valued, relative to its profitability. By way of contrast, the equivalent figures for Morrison and Tesco are 5.6% and 3.5% respectively.

What these figures tell me is that the market is pricing in lots of profit growth at Morrison and Tesco, but none at Sainsbury. I don’t believe that’s a realistic view to take of the UK’s second-largest supermarket.

Is the balance sheet strong enough?

Excessive debt and lease obligations nearly forced Tesco into a rights issue at the start of the year. Is Sainsbury safe from such problems? Here are the key figures:

• Net debt: £1,341m
• Capitalised lease obligations: £5,988m
• Lease-adjusted net debt: £7,329m
• Estimated freehold property: £2,027m

These figures present two very different pictures. Measured by net debt alone, Sainsbury’s gearing is much lower than that of its peers. As a multiple of post-tax earnings, my favoured measure, net debt is around 2.98 times. That compares to more than 5 times for Morrison, and even more at Tesco.

Adding in capitalised lease obligations changes the picture. This figure represents future lease payments the company is obligated to make, regardless of whether it is utilising the properties concerned.

To help judge the impact of these commitments, Sainsbury also reports a lease-adjusted net debt figure. According to the firm’s reporting, the ratio of lease-adjusted net debt to EBITDAR* was 4.0 times at the end of September.

(*EBITDAR = Earnings before interest, tax, depreciation, amortisation and rent. The exclusion of rent is to avoid double counting; the rent is paid to reduce the lease obligations.)

The nearest parallel to this metric for most companies would be the net debt/EBITDA ratio, which is typically used for banking covenants. I wouldn’t normally invest in a company with a net debt/EBITDA ratio of more than about 2.5. So it might seem inconsistent for me to accept Sainsbury’s more elevated debt level.

I’ve decided to do so because I think there is a difference. During the ordinary course of business, Sainsbury’s lease payments are effectively a normal operational cost. If properly managed, they should not inhibit profitability or growth.

I don’t see this as an exact parallel with outright debt, which is the repayment of money previously spent.

Lease obligations only become a debt-like problem when the lessee no longer wants to use the leased building and cannot sell the lease. This is a risk factor that’s common to many big UK retailers, not least Tesco. It can be mitigated by higher levels of freehold ownership (as at Morrisons), but not entirely avoided.

Ultimately, it’s no secret that the big supermarkets do have too much floor space, and that it’s not always in the right place. In my view, this risk is already reflected in Sainsbury’s share price. However, the acquisition of Home Retail Group has the potential to resolve this problem.

Why the Home Retail deal could work

Sainsbury’s acquisition of Home Retail Group has had mixed press, and has not excited the market. But I can see why chief executive Mike Coupe felt that decisive action was necessary, and that Argos could be the answer.

Here’s a screenshot from Sainsbury’s 2016 annual report:

Source: J Sainsbury plc 2016 Annual Report (http://www.j-sainsbury.co.uk/media/3169495/sainsburys_ar_2016_2005.pdf)

The decline in sales per square foot and the fall in operating margin are a concern. An intense supermarket price war means that increasing prices — and margins — is not possible. Nor is reducing the size of stores, not least because of the lease obligations I’ve discussed above.

I believe the only satisfactory way to arrest the decline in trading intensity and operating margin is to increase sales per square foot. In parallel to this, it would be nice to see rising profits from activities which leverage the group’s large customer base and strong brand, but don’t use store space. These fall into two categories — banking, and online sales.

The acquisition of Home Retail Group (HRG) has the potential to solve all of these problems:

• Closing Argos stores as their leases expire and moving them into Sainsbury’s supermarkets should increase sales/sq ft and reduce property costs. Argos generated £4bn of sales last year at an operating margin of 2%.
• The acquisition of Argos Financial Services gives Sainsbury’s Bank a £625m loan book of apparently reasonable quality.
• The deal also included cash of £322m and various other assets. According to Sainsbury, the total consideration paid was only £18m more than the fair value of the assets. This amount has been charged to goodwill, but is negligible in the context of a £1.1bn deal. That suggests to me that Sainsbury paid a very reasonable price for HRG.

Sainsbury hopes to make cost savings of £160m as it combines the two groups’ property, logistics and central and support functions. I’d expect this to make a positive contribution to operating profit, which totalled £830m across the two groups last year.

Why I’ve bought

Sainsbury looks cheap relative to historic earnings, and reasonably priced based on current forecasts. The shares also offer an attractive 4% dividend yield.

Looking ahead, I would be surprised if Sainsbury’s cost-cutting integration programme doesn’t enable the group to squeeze some additional profit from Argos’s £4bn annual sales.

Supermarket non-food sales should benefit from greater purchasing scale and Argos’s logistics infrastructure. Sainsbury now also has a sophisticated and established national delivery network for non-food, with the ability to handle larger items.

Finally, banking has proved to be highly profitable for Sainsbury (and Tesco). The acquisition of the Argos loan book has led to a step change in the scale of Sainsbury’s banking operations, and positioned it well for next year’s planned move into mortgage lending.

Price target = 415p

I don’t think the current value of Sainsbury’s equity reflects the potential value of the combined Sainsbury-Home Retail Group business. So I’ve added the shares to my portfolio at about 250p.

I note that Morrison’s equity currently trades at about 1.4 times its book value. If Sainsbury can return to earnings growth over the next couple of years, I think a similar valuation should be possible. Based on the group’s current book value of 297p per share, that implies a price target of 415p.

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.