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J Sainsbury (SBRY)

Created:

24 July 2008

Written by:

Nathalie Olof-Ors

BEAR POINTS:

• Especially vulnerable to a price war

• High fixed-cost base

• Cost of developing non-food operation

• Dividend could be under pressure

BULL POINTS:

• Still a takeover target

• Could do more property deals

City analysts have fired at will on J Sainsbury lately. The past two months have seen a profusion of 'sell' recommendations as the City has become increasingly worried that a full-blown price war among UK supermarkets is developing. As the priciest of the UK's Big Four food retailers, Sainsbury is overwhelmingly perceived as the most vulnerable. And its share price might have fallen even further were it not for the fact that the group could still be a takeover target.

Indeed, the share price gained almost 10 per cent last week on the news that Delta 2 had raised its stake in the company to 26 per cent, prompting hopes that the Qatari-backed investment fund might make a second offer after its failed bid last year. Yet many City analysts are sceptical that a bid around current price levels could be successful for one simple reason: the share price has halved since the Sainsbury family rejected Delta's 595p-a-share offer. So it stretches credibility to imagine they would accept a bid around today's depressed price.

And, given Sainsbury's prospects, it is hard to imagine its share price returning to those heady levels any time soon. Like its competitors, Sainsbury is in the unfamiliar position of being squeezed between suppliers who are desperate to pass on rising input costs and cash-strapped customers whose purse strings are tight.

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Sainsbury has taken this challenge seriously and is working hard to shrug off its pricey image, notably with the launch of its "Feed your family for a fiver" campaign. But this initiative might not halt the exodus of shoppers to discounters such as Aldi and Lidl. That will put pressure on profits and on Sainsbury's share rating - especially as the company does not have the scale of either Tesco or Asda, and has the highest cost base among the Big Four supermarkets operators.

Analysts estimate that Sainsbury's property rental costs, for example, absorb roughly 2 per cent of the company's sales. That compares with 1.1 per cent at Tesco and just 0.3 per cent at Wm Morrison. In practice, this means that any drop in sales will have a bigger impact on Sainsbury's profits than its competitors. In fact, some bearish analysts think Sainsbury may even be forced into making a profits warning soon.

Simultaneously - and worryingly - the company is injecting vast sums of cash into its non-food lines. Chief executive Justin King believes that non-food sales will be crucial for Sainsbury's long-term revival. But, in the short term, the capital spending this entails may put a strain on the company's finances. Some City analysts even think it will put a question mark over future dividends. So the fat dividend yield on the shares may be illusory. After all, at current levels Sainsbury's dividend costs about £180m, which is far above the levels of free cash flow that it has generated in both its past two financial years.

Partly, dividends have been funded by property disposals and Sainsbury has become adept at raising cash by putting mature properties into joint ventures with property investors. In the past 12 months it has done deals with Land Securities and British Land. There may be more to come, and Sainsbury still has a large reservoir of freehold properties. But the best have most likely already been put into joint ventures and the appetite for such securitised deals has waned.

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