Sainsbury Continues To Provide Mixed Signals To Investors (OTCMKTS:JSAIY)

Financial performance resilient

J Sainsbury plc (OTCQX:JSAIY, OTCQX:JSNSF) delivered sales growth in 2021 of 3.4%, including fuel, while sales contracted by 2.6% excluding fuel. The small drop in sales was easily overshadowed by the doubling of Underlying Operating Profit to reach GBP 730 million. This huge jump in profitability channeled through other profitability measures; EPS more than doubled to 25.4p, leaving today’s P/E multiple at 8.2 times, and Return on Capital Employed increased by 2.8% to reach 8.4%. The full-year dividend of GBP 13.1p means today’s dividend yield of 6.2% is one of the highest among UK large cap companies. To make things more enticing, the company’s management decided to increase the minimum percentage of dividend distribution from 52% of net income to 60%. This should ensure that today’s dividend pay-outs will be at least sustained, and most likely increased, in the foreseeable future.

General merchandise sales dropped by 12%, clothing increased by the same percentage, while grocery stagnated with a slight drop of 0.2%, following lockdowns-induced growth of 7.8% in 2020. Online food sales decreased by 4.7% versus an increase of 120% in the COVID year. Free cash flow generation remained very strong, an average of GBP 633 million over the past three years, GBP 500 million in the past year, 1.7% of sales. Operating cashflow to sales was 2.4%.

Leverage remains high at 3.1 times net debt to EBITDA, although this has come down nicely from 3.6 times in the previous year. Further reduction in debt comes among the top priorities in Sainsbury’s strategy, which gives comfort to shareholders and creditors alike.

Overall, the gains made during the 2020-2021 burst of growth, induced by COVID and inflation, seem to hold.

Sainsbury has been gaining market share, but Tesco continues to outperform

Sainsbury achieved robust performance in 2021 – not only on a standalone basis but also in comparison to peers. Volumes growth of 4.2% was well-ahead of its three large peers – Tesco, Asda and Morrisons – and inline with the wider market volume growth of 4.3%.

But Sainsbury still lags the performance of market leader Tesco PLC (OTCQX:TSCDF, OTCQX:TSCDY). Tesco achieved sales growth of 3% versus Sainsbury’s negative 2.6%, and recorded adjusted operating profit margin of 4.6% versus Sainsbury’s 3.4%. Also, Tesco generated free cash flow of 4% of sales versus 2.6% for Sainsbury.

Sainsbury’s catch-up game with Tesco continued in Q1. In its trading statement published on 5th of July 2022 for the 16 weeks ending 25 June, Sainsbury reported a drop in grocery of 2.4% from the same period last year. This is acceptable and expected, coming off from the highs of last year, and affected by the inflationary hits to consumers. Total like-to-like retail sales dropped by 4%. Drops were heavy though in general merchandise and clothing, ranging between 10-14%.

Given that we are at the beginning of what is expected to be a rough ride for the UK economy, it is unlikely that we have seen the bottom. And when Tesco published their Q1 results recently for the quarter ending 28 May 2022, the market leader outperformed once again. Tesco managed to pull off total sales growth of 2%, including 1.5% like-to-like sales, while like-to-like sales in the main UK market dropped by 1.5%. Tesco was keen to highlighted that three-year like-to-like sales growth has been a respectable 10%. CEO Ken Murphy made an important note that Tesco was witnessing “early indications of changing customer behavior as a result of the inflationary environment.”

Risks are mainly macro

The early warning shots from Tesco were confirmed in the market retail statistics published on the 24th of June that showed retail sales in Britain have dropped by half a percentage point between April and May. Surprisingly, this drop was mainly driven by a relatively large 1.6% drop in food sales. The date also showed that volumes did drop while values were higher – confirming the direction that consumers are reducing their purchases because if the inflation bite that is making lower volumes of goods more expensive. This adds unexpected complications to Sainsbury, which noted in the last annual report that “Whilst food inflation is unlikely to lead to lower sales given large elements are an essential purchase, it may cause increased competitive pressure and so lower margins generated on those sales”. Now, Sainsbury’s management have to contend with the double-edged sword of lower food sales combined with the increased competitive pressures.

Separately, research company GFK has assessed that consumer confidence in the UK is at the lowest level since records began in 1974. All the roads lead to the direction of market and sales contraction in the foreseeable future. In such environment, competition between retailers on price will be as fierce as ever. Sainsbury already announced that, over a two-year period, it will absorb a total of GBP 500 million in price increases for its goods – meaning it will not pass on the full increase in the cost of its products. And Sainsbury’s non-discretionary non-food sales, mainly clothing and home products, are likely to receive even a bigger hit, given the low morale of customers.

Another structural limitation for Sainsbury is that by focusing only on the UK, Sainsbury operates in a mature and highly competitive market. Previous attempts to expand internationally had come to naught, and this an experience shared by many peers, not least larger UK rival Tesco and Walmart. Retailers realized that international expansion distracts resources from the local market, is associated with a bundle of other risks, and achieves little to not synergies or economies of scale, given the localized supply chain and investments of retailers. This lack of diversification leaves Sainsbury with limits options for growing the business. Sainsbury’s attempt to buy growth through the acquisition of general merchandise retailer, Argos, has looked as a desperate attempt from the outset to make rash bets. In a world of Amazon domination, Argos was not set to flourish.

Is Sainsbury still a worthy investment?

Whilst noting the considerable risks to outlook, and the out performance of Tesco, I believe there are merits to invest in Sainsbury for the following reasons. First, Sainsbury is trading at the lowest share price, and lowest valuation multiples, in years. The shares are off almost 40% from their peak last year, when M&A activity in the sector was heightened. The shares are trading at a third of their value of 10 years ago. P/E is a pale 7 times and market cap to operating cashflow is 6.6 times, versus Tesco’s P/E of 13 times but at a lower market cap to operating cashflow of 5 times. Tesco has been doing a better job generating cash from its business; Tesco’s operating cash to sales is 6% versus only 2.6% for Sainsbury.

Sainsbury’s market cap has been below its Book Value for years, which is pumped up by its sprawling real estate portfolio. The current market cap of GBP 4.8 billion is close to 57% of the Book Value of GBP 8.4 billion. Warren Buffet has noted that in his earlier investment days he would look at this parameter closely to find undervalued assets. True, he later switched to focusing more on growth businesses rather than what could be value traps or distressed assets. But Sainsbury is not a distressed asset, thus this measure does add to the argument that the company is undervalued – both on profitability and cashflow parameters, and on asset value basis.

Sainsbury’s management have also been doing considerable efforts to cut costs, and to rehabilitate the Argos business. A combination of closures of under-performing stores and increasing efficiencies is set to reduce costs by hundreds of millions of pounds, supporting profitability.

But what would induce investors today to take the plunge and put their money in Sainsbury shares is its mouth-watering dividend yield. The 6.4% yield today is one of the highest in the FTSE 100. Yields in this range usually mean investors are betting the good times will not last for long. But dividends are now covered four times by net income and almost five times by operating cash flow. Expected drops in sales, profitability and cash flows this year should be tempered by the defensive nature of Sainsbury’s mostly non-discretionary portfolio of products. And Sainsbury’s new dividend policy of increasing the proportion of net income to be distributed as dividends would support the current yield further.

Another upside potential for Sainsbury, although remote, is M&A. Late last year the sector emerged to life with two big M&A deals; the acquisitions of Morrison’s and Asda by private equity-led groups for GBP 7 billion a piece. Sainsbury’s share price was boosted along, as both Morrison’s and Asda are smaller businesses. But soon after the share price was deflated, as investors realized an acquisition of Sainsbury was remote. This is due to that 15% of Sainsbury is owned by Qatar Investment Authority (QIA) and Vesa Equity Investment which owns 10%, which complicates an outright bid by other investors. QIA made a bid 10 years ago to take over Sainsbury for 600 pence a share, and an earlier bid was made by private equity group CVC. Given that 10 years later, Sainsbury is trading at third of that offer, it was fortunate for QIA that the takeover bid was not supported by Sainsbury’s board and the Sainsbury family, which owned 18% of shares at the time.

Whether QIA could consider another takeover attempt is a big question mark, but maybe QIA would not object to other acquirors propose a juicy bid in these depressed market conditions. The board and management of Sainsbury would definitely not want to repeat the past mistakes of rejecting attractive offers – shareholders will not accept it this time around.

The combination of low market valuation, high (and relatively secure) dividend yield, defensive nature of the business, and a possible, although remote, chance of being acquired – all represent tempting features for investing in Sainsbury today. But investors have to keep in mind the darkening outlook for the UK economy, and the potential hit that Sainsbury can face, especially in its non-food merchandise.