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Investing well costs less at Sainsbury

Sainsbury is well on the road to revival, but you wouldn't know it from its share price
May 17, 2012

When Sainsbury's chief executive, Justin King, became the boss in 2004, he arrived at a business in disarray. Profit margins had collapsed from a peak in the mid 1980s of 8 per cent to less than 4 per cent. Having been overtaken by Tesco a decade earlier, Sainsbury's share of the UK grocery market had fallen behind Asda's too, into a distant third place.

IC TIP: Buy at 313p
Tip style
Value
Risk rating
Medium
Timescale
Long Term
Bull points
  • Quality proposition translating into rising UK market share
  • New space coming into profit
  • Still under-represented in much of the UK
  • Attractive dividend yield
Bear points
  • Household spending under pressure
  • Threat from recovering Tesco

It is often said that arrogance and complacency were the reasons for Sainsbury's fall – not dissimilar to accusations recently levelled at Tesco. Immediately before Mr King's arrival, Sainsbury's top management is said to have rarely visited the stores, which had become shabby. Sainsbury's offering was also more expensive than its rivals', but no longer with the promise of quality that had once set the grocer apart. The problems were compounded by new distribution systems that didn't work, which meant that shelves were regularly short of essential items. Worse, the enormous cost of dysfunctional IT systems meant that staff levels and spending on training were cut, yet these, as Tesco has recently found to its cost, are the areas where customers noticed slipping standards the most.

It will come as no comfort to Tesco that it has taken Mr King nearly a decade to set Sainsbury straight. Supermarket groups are like supertankers: they take a long time to turn around, even if - which was the case at Sainsbury - many of the answers lay in a return to the well-understood principles of good retailing. In terms of Sainsbury's share price, that has resulted in a lost decade. The share price today has barely moved from where it was when Mr King's appointment was announced in late 2003.

Still, once more Sainsbury is outperforming its major rivals. A 2 per cent increase in like-for-like sales in 2011-12 was well ahead of Tesco and Morrison, and helped Sainsbury increase its UK market share to 16.6 per cent. That's its highest level for a decade, taking it to the cusp of reclaiming the number two spot. For a group that has had to battle the perception that it is more expensive than its rivals, that's no mean feat, especially given the pressure on household spending.

J SAINSBURY (SBRY)

ORD PRICE:313pMARKET VALUE:£5.90bn
TOUCH:312-313p12-MONTH HIGH:363pLOW: 258p
DIVIDEND YIELD:5.4%PE RATIO:11
NET ASSET VALUE:299pNET DEBT:35%

Year to mid-MarTurnover (£bn)Pre-tax profit (£m)Earnings per share (p)Dividend per share (p)
200918.946616.613.2
201020.073332.114.2
201121.182734.415.1
201222.379932.016.1
2013*23.377129.217.0
% change+4+6

Normal market size: 9,000

Matched bargain trading

Beta: 0.6

*Panmure Gordon forecasts (profits & earnings not comparable with historic figures)

 

As Mr King was keen to point out when Sainsbury announced its results for 2011-12 last week, promotional campaigns, such as 'Brand Match', mean that most customers no longer think it is more expensive, while investment in its own-label ranges mean that it has products to suit all budgets. Most important, Sainsbury has achieved this without compromising the core values that its customers hold dear - the quality and provenance of the food they eat.

The idea that its customers can, as its marketing slogan claims, "live well for less" has translated into a strong financial performance. Underlying operating profits climbed by a better than expected 6.9 per cent to £789m last year, while £100m of cost savings meant margins improved despite cost inflation, weak volumes and fierce competition on prices. It helps that Sainsbury has shaved £600m from its cost base over the past five years, resulting in operating margins improving from 3 per cent in 2007-08 to 3.5 per cent today.

Of course, as Mr King acknowledges, the coming year isn't likely to see the pressure on households ease. While supermarket sales have continued to rise, new space has driven the increase, with volumes in reverse. And the trading environment will remain fiercely competitive; a wounded Tesco, in particular, remains a rival to be feared. That's one reason why Sainsbury is cautious, suggesting that, in 2012-13, like-for-like sales will only rise by 2 per cent and operating margins will stay flat. Still, the chief executive is confident that this summer's calendar of special occasions, plus the usual Christmas splurge, provide "reasons to be cheerful in the year ahead". Sainsbury's new-found competitiveness means it's well placed to take advantage.

 

Calling an end to the space race

Tesco's trouncing of Sainsbury from the mid 1990s was partly the result of better retail execution, not least the development of its Clubcard loyalty programme. More important was the huge investment it made in selling space during the recession earlier in the decade. That meant that by 2004 Tesco had three times as many stores as Sainsbury and a third more selling space.

Perhaps conscious of the lessons from this period of expansion, no grocer has risked being left behind in the land grab of the past three years. Last year, Sainsbury increased its selling space by 6.5 per cent, or 1.4m square feet (sq ft), similar to the amount added by Asda but dwarfed by Tesco, which added 6.9m sq ft on top of 10.7m sq ft added in the previous two years.

 

New space hits maturity tipping point in 2014-15

As a result, City analysts fear there will be too much selling space, especially given the backdrop of declining sales volumes. However Tesco's profit warning earlier this year has seen it curtail its expansion plans, a move followed by its rivals. Sainsbury says that it will cut the rate of expansion to 5 per cent, or 1m square feet, in 2012-13. In turn, this means capital spending this year will fall by 20 per cent to under £800m and will be refocused on store refurbishment and investment in IT to support fast-growing web sales of both food and non-food.

Analysts welcome more focus on improving return on capital. Returns should also improve as recently opened stores mature. By 2014-15, the bulk of this immature space should be fully profitable and therefore begin adding to profit margins. But Sainsbury is also quick to point out that it hasn't turned its back on physical expansion. This year's planned 5 per cent increase in space is still the fourth-largest single-year expansion in its history. That seems like a sensible balance, because Sainsbury still has much to go after across the UK. Its market share is less than 10 per cent in 60 per cent of UK postcodes, and it remains underweight in convenience stores.