Difficult capex choices for Sainsbury’s

J Sainsbury’s (SBRY) is currently undertaking its latest round of self-help measures so that the grocer can hopefully make up some lost ground against its fierce rival Tesco (TSCO) and counter the unique challenge posed by the discounters Aldi and Lidl. While Sainsbury has not given back too many of the exceptional grocery volumes it saw during the pandemic – sales are essentially flat compared with last year – management still needs to pull off a delicate balancing act between deleveraging debt, capital investment and shareholder payouts and it seems that the only way it can manage this is by continuing to sweat the company’s fixed assets.

Sainsbury’s is currently carrying net debt, including finance lease obligations, of around £6.8bn. To keep within its target range of cash profits to net debt of 2.4 to 3 times, the company must generate annual free cash flow of £500mn from its retail business to help pay down debt, as well as maintaining the dividend which cost £238mn this time. In these results, the retail business generated £503mn of free cash flow, despite the reversal of positive working capital inflows as projects delayed by the pandemic came back on-stream.  

On the face of it that all sounds like good news. But this could be one of those rare occasions where maintaining immediate free cash flow comes at the cost of investment in Sainsbury’s long-term growth. For example, the results highlighted the perennial issue that the company’s capital expenditure is not keeping pace adequately with the level of depreciation. The group depreciation charge stayed steady at £1.2bn, while cash capital expenditure was £645mn, with a forecast for this year of between £700mn and £750mn.

While some of this will relate to impaired intangibles and right of use assets when compared with Tesco’s figures for 2021 of £1.7bn depreciation and £1.5bn of capex, a large and persistent gap in Sainsbury’s overall capacity to renew the business beyond the basics of remedying daily wear and tear is obvious. That reflects a conscious choice on the part of the board, but it does beg the question as to how long this situation can continue.

It is fair to say that the M&A speculation that briefly buoyed sector has now given way to optimism over the benefits from price inflation that Sainsbury’s could accrue. We are more cautious on this point as supermarkets are also particularly vulnerable to rising labour and input costs. Sainsbury’s is currently trading at a forward PE ratio for 2023 of 14 times Berenberg’s forecasts, which looks classically priced for extended range trading. Hold.

Last IC view: Hold, 285p, 07 Jul 2021