SIF Folio: Is Sainsbury's a Super Stock in the making?

I recently heard a discussion on a radio phone-in show about the idea that windfall taxes should be levied on companies whose profits have been increased by the coronavirus pandemic. 

Inevitably, supermarkets were put forward as one potential target. The argument was that record sales during the lockdown period would be likely to result in record profits. Against this backdrop, supermarkets are benefiting from the 12-month business rates holiday that’s been granted to all retail, leisure and hospitality firms.

Perhaps conveniently, all three of the big supermarkets have said that the extra costs incurred handling the pandemic will roughly match the savings on business rates. So bumper profits seem unlikely, although I still expect a robust performance. 

The politics of this situation are not for me to discuss. My interest today is J Sainsbury (LON:SBRY), a business that’s significantly underperformed its two listed rivals over the last five years.

Rather to my surprise, Sainsbury’s almost qualifies for my SIF stock screen at the moment. The only area where the orange-topped retailer falls short is with its earnings yield of 6.5%, which is  below my 8% minimum. 

This has prompted me to take a closer look, especially as the retailer’s StockRank of 85 suggests that the Stockopedia algorithms have a positive view of this stock. Indeed, these ratings indicate that the stock is no longer seen as a value trap, as it was in February.

With a new chief executive due to start work on 1 June, is this finally the right time to buy Sainsbury’s shares?

Deep value

Sainsbury’s ValueRank of 73 suggests that the stock scores well on measures of value. At face value this is certainly true.

Asset value: At the time of writing, Sainsbury’s shares are trading at 187p - a discount of almost 50% to their book value of 350p per share. If we strip out intangibles and focus on tangible net asset value, the stock still looks cheap when compared to its NTAV of 305p per share.

However, this situation isn’t new. The retailer’s share price has tracked consistently below its net asset value for a number of years, as these two graphics illustrate:

Leverage: One reason for the stock’s discount to NAV may be that Sainsbury’s freehold property ownership is relatively low, while its leverage is fairly high.

At the time of the failed Asda merger in 2018, about 50% of Sainsbury’s store estate was owned freehold. In contrast, 87% of Morrison’s store portfolio was freehold at the end of last year.

Excluding IFRS16 lease liabilities, Sainsbury and Morrison both have net debt of around £1.1bn. But while Morrison’s lease liabilities are only £1.3bn, Sainsbury’s add up to £5.8bn. Given that both firms have similar market share, you can probably guess which company I’d rather own.

Cash flow: Sainsbury’s remains a cash generative business, or at least it was last year. According to Stocko stats, the shares trade on just 5.7x trailing free cash flow.

The shares EV/EBITDA ratio of 5.3x doesn’t look expensive either. However, much of this cash is needed for deleveraging. And if the company traded at a more normal multiple of book value, the P/FCF ratio would also be much higher. I’m not convinced this is a true cash cow.

Dividend yield: Although the stock’s trailing dividend yield of 5.9% is attractive, long-term shareholders will still remember how Sainsbury’s cut its dividend in 2015, 2016 and 2017. 

No final dividend has yet been declared for 2019/20. Although management says this decision has been deferred, I suspect that the payout will be passed. 

Deep value or value trap? When a solvent and profitable FTSE 100 company is trading at a discount to its tangible net asset value, something doesn’t add up.

Sainsbury’s shares could be a bargain, but suspect they are probably fairly valued. In my opinion, the closest analogy here is with the big FTSE 100 banks. The shares are cheap because the business does not generate a satisfactory return on equity.

Quality: low returns

Sainsbury’s QualityRank of 46 suggests a less-than-exciting story. Unfortunately the firm’s profitability metrics support this view. Returns have been underwhelming in recent years, even by supermarket standards:

I don’t know what figure Sainsbury’s would use for its cost of capital. But I don’t think the group’s returns in recent years would cover this cost. Last year’s return on capital employed of 4% was well below the c.7% figure achieved by both Tesco and Morrisons, according to Stockopedia’s data. 

In my view, this difference is mostly due to the other firms’ exposure to the wholesale market, which has provided stronger margins and growth. Tesco also enjoys superior economies of scale, while Morrison’s vertically-integrated food production business helps to support its margins.

Sainsbury’s has none of these advantages. In 2016, the group pinned its growth hopes on non-food sales with the acquisition of Argos. Although I was initially positive on this deal, a weakness quickly became apparent: Argos operates in intensely competitive markets and has even lower profit margins than supermarkets. 

We can’t be sure if this is still true today, as the group stopped breaking out margins on non-food sales soon after acquiring Argos. But I believe the Argos acquisition has diluted Sainsbury’s profit margins. Non-food sales have also suffered in lockdown. Increasingly, the acquisition of Argos looks like a strategic mistake to me.

Momentum: misleading?

In its recent results, Sainsbury’s sounded a cautious note about the year ahead. Management believes that weaker economic conditions could result in slowing non-food sales and an increase in customer bad debts.

However, these concerns do not yet seem to be reflected in broker forecasts or the stock’s MomentumRank score of 86. To understand why, we need to look at the factors behind this score.

Price momentum: The stock’s perennial low valuation means that the shares are only around 20% off their 52-week high. 

Relative strength is also positive, because supermarket shares have outperformed the FTSE 100 this year (for obvious reasons).

As a result, Sainsbury shares appear to have strong price momentum, even though they’ve fallen by 14% so far this year. 

Earnings estimates: Broker forecasts have actually edged higher in recent weeks, giving the stock’s momentum score a further boost:

My view: Personally, I’m not convinced by this rosy momentum outlook. I think the broker consensus trend graph tells a more compelling story:

If the market hadn’t crashed, I suspect Sainsbury’s stock would have underperformed the wider market and would have a much weaker momentum score.

My view

I think that Sainsbury’s shares are cheap for a good reason. 

Unlike his peers at Tesco and Morrisons, Sainsbury’s CEO Mike Coupe hasn’t been able to improve the profitability of this business. His only serious effort was an attempted merger with Asda, which was blocked by the competition regulator.

Mr Coupe’s successor Simon Roberts is a sector specialist who started work at M&S aged 16. He has served as Sainsbury’s Retail and Operations Director since 2017, prior to which he was President of Boots UK.

In my view, buying Sainsbury’s stock is effectively a bet that Mr Roberts’ can deleverage the group and boost returns in a way that Mr Coupe has failed to do

I’m not convinced that this is a great basis for an investment. I won’t be rushing to buy these shares.