2023-07-07 21:24:15 ET
Summary
- Sainsbury's share price has risen by around 22% since my last review in December 2022, driven by a combination of earnings upgrades and multiple expansion.
- The company's strategy to reinvest cost savings in better value customer pricing has paid off.
- General merchandise sales will come under pressure over the coming months, but this downside risk is well understood by the market.
- Sainsbury's offers investors access to a high-quality business operating in a defensive sector at an undemanding valuation, the stock is a Buy.
Introduction
I last published on J Sainsbury PLC ( JSAIY ) in December 2022, with a Buy call based on a London Stock Exchange price of around £2.20 per share. Since then, the stock has performed very well and is currently trading at close to £2.70, having also gone ex-dividend £0.092. Given this very strong performance, I commence this latest review with an expectation that the value opportunity highlighted in my previous research may have already been delivered, implying potential for a downgrade. Note that the commentary below uses SBRY to refer to the group (this is the stock code for J Sainsbury PLC’s listing on the London Stock Exchange).
Consensus Estimates
SBRY’s share price is trading around 22% higher than the ~£2.20 level seen in late December 2022. Exhibit 1 looks at the change in analyst consensus numbers that SBRY publishes for UPBT (underlying profit before tax) between December 2022 and June 2023. We can see that consensus UPBT has increased by ~10-12% for FY24E and FY25E – this points to earnings upgrades explaining about 50% of the share price increase. Interestingly, the minimum analyst UPBT forecast has increased sharply (~30-40%) since December 2022; this can be taken to imply lower downside expectations and is consistent with an earnings multiple expansion. My conclusion therefore is that SBRY’s share price increase over the last six months or so has been driven in roughly equal parts by earnings upgrades and a multiple expansion.
Exhibit 1:
Source: Analyst’s calculations based on consensus estimates published by SBRY.
SBRY released FY23 results in late April and issued FY24E guidance for UPBT of £640m to £700m; FY24E guidance was left unchanged with SBRY’s 1Q24 trading update on 04 July 2023. The 14 June 2023 consensus UPBT estimate of £681m looks reasonable in light of SBRY's 1Q24 market release. The final point to make regarding the consensus forecasts is that growth for FY25E is pretty strong, at +7%.
Competitive Positioning - Continued Progress
In early April 2023, SBRY began offering lower prices on more than 300 items to members of its Nectar loyalty card scheme. This was a direct response to the popularity of Tesco’s Clubcard scheme. In June 2023 , SBRY extended Nectar price discounts to include fresh produce and ready meals; Nectar pricing now covers ~2,800 items. I think that this move will elevate the value that shoppers place upon the Nectar scheme materially and will also help to reinforce the view that SBRY is a supermarket that can offer both quality and value simultaneously.
As outlined in my previous Seeking Alpha SBRY notes, the group has been able to materially improve its price competitiveness versus peers by ‘reinvesting’ cost reductions in lower customer product pricing. Exhibit 2 tracks the average selling price of key products and clearly shows that SBRY’s price proposition has improved relative to both major supermarket peers and the discounters. Exhibit 3 presents the data in a slightly different way and highlights the cumulative price reduction relative to Aldi (a discounter) and Tesco (the UK's market share leader).
Exhibit 2:
Source: SBRY 1Q24 Trading Update Presentation, slide 6.
Exhibit 3:
Source: SBRY FY23 Presentation, slide 6.
An important quality that I look for when building an investment case is the ability of a company to generate sustainable earnings over the medium-term. SBRY had the option to use the cost-out savings to drive higher near-term profits, but instead the ‘Save to Invest’ strategy has been used to strengthen SBRY’s competitive standing. I think that SBRY is a considerably better business today than it was three or four years ago. A final point to make on this topic is that SBRY has been able to reduce costs without damaging its leading peer-relative customer satisfaction scores (refer Exhibit 4).
Exhibit 4:
Source: SBRY FY23 Presentation, slide 36.
Argos Transformation
SBRY has made excellent progress in improving its performance relative to major supermarket peers and defending against discounters Aldi and Lidl. Another area in which SBRY has executed very well, but which is often somewhat overlooked, is the transformation of Argos, the group’s general merchandise business. Exhibit 5 shows that Argos was given a boost by Covid, but with the pandemic impacts having now faded, operating profits for Argos remain significantly above pre-Covid levels. The improvement in operating profit has not been driven by an increase in sales; the key change has been on the expense side. Exhibit 6 highlights that a major plank of the Argos cost-reduction story has been the closure of stand-alone Argos stores and the opening of ‘in-supermarket’ Argos outlets and collection points, with more to come on both fronts in FY24E. Delivery of this outcome for Argos alongside the impressive performance for the core supermarket business reflects well on the SBRY leadership team.
Exhibit 5:
Source: SBRY FY23 Presentation, slide 8.
Exhibit 6:
Source: SBRY FY23 Presentation, Appendix 4.
Evidence of Profiteering Lacking – But Political Risk Remains
UK consumers struggling through a cost-of-living crisis. Banks and supermarkets are now attracting considerable negative attention, with allegations of profiteering and ‘greedflation’. Big supermarkets and banks are proving to be tempting and easy targets for politicians seeking voter popularity. Investors who follow banks are used to regular cycles of such ‘bank bashing’ but supermarket investors now need to also be mindful of the downside risk associated with political meddling regarding product pricing and acceptable rates of return on capital. I am highly doubtful that Sunak’s Conservative party will intervene directly in regard to supermarket pricing, but with a Labour government looking increasingly likely to be in power by early 2025, I’m watching this aspect of political risk in regard to SBRY closely.
Exhibit 7 sets out a summary of SBRY’s financial performance for the last three years. Note that 2019/20 was largely unaffected by Covid and can thus be thought of as a sensible base year from which to look forward. Retail sales (excluding fuel) for 2022/23 are up by 6.7% versus 2019/20. Within the total Retail bucket, Grocery sales for 2022/23 were 10.8% higher than for 2019/20. But these sales increases must be considered in light of an elevated inflation backdrop that has been in place for the last two years. Return on capital employed for 2022/23 was 7.6%, which is immaterially different from the 2019/20 return on capital employed of 7.4%. Exhibit 8 shows the movements in SBRYs’ Retail underlying operating margin between 2019/20 and 2022/23; the margin has fallen, despite SBRY taking significant costs out of the business. There was certainly no suggestion that SBRY was profiteering back in 2019/20, and I struggle to see how such an accusation makes sense today.
Exhibit 7:
Source: SBRY FY23 Profit Announcement, page 2.
Exhibit 8:
Source: SBRY FY23 Presentation, slide 18.
Summary & Rating
For a large supermarket group such as SBRY, I typically regard an EV/EBIT multiple in the range of 12.5x to 14.8x as representing around fair value. Based on a current share price (London Stock Exchange close 07 July 2023) of £2.705, my valuation analysis points to SBRY trading on a EV/EBIT multiple of ~10.9x (which compares with 9.9x at my last review in December 2022).
UK consumers have already been squeezed by rapidly increasing interest rates that have fed through into higher mortgage repayments and rental costs, and I expect this trend to continue. Evidence to date suggests that SBRY’s sales are holding up well despite this challenging backdrop, albeit with a boost from price inflation. Weakness in general merchandise over the coming months looks likely (general merchandise makes up ~20% of SBRY’s sales, ex fuel), and although this represents a near-term downside risk to earnings, my sense is that the market is already anticipating such an outcome. Political risk for UK supermarkets is a live issue, however I do not currently regard government intervention on supermarket pricing as probable.
SBRY’s competitive standing continues to improve thanks to the ‘Save to Invest’ strategy. The Argos transformation has been well executed, and the group has a solid balance sheet. For me, SBRY is a company that is deserving of a ‘high quality’ label. Although the share price has rallied by over 20% since my previous review, with my analysis pointing to SBRY currently on an undemanding EV/EBIT multiple of ~10.9x, I am comfortable to maintain a BUY rating on the stock. An expected dividend yield of ~5% pa will appeal to income-focused investors.
For further details see:
J Sainsbury: Trading Too Cheap Given Excellent Execution