Interestingly, this historically low valuation has come during a period of rising profitability.
What have been the primary drivers of the current reduction in valuation and does this signal a buying opportunity for investors?
Sainsbury is a food retailer with over 1,200 locations primarily in the UK. The company operates supermarkets and convenience stores, while also generating revenues online and through their bank segment. As with most food retailers, the primary profitability drivers are influenced by competitive pressures and the ability to protect what are typically razor-thin margins across the industry.
Recent Struggles Are Industry-Wide:
UK supermarket chains have been battered of late. The main culprits are:
- The lack of UK households' purchasing power, with inflation consistently running ahead of wage growth.
- The rise of German food discount chains Aldi and Lidl.
- Fears that their struggling competitor Tesco (TSCDY) will force a price war with major impacts on Sainsbury’s margins.
With 28% of the total UK grocery market, Tesco has an ability to force change across its competitors. Tesco failed to adapt to the changes in the UK competitive landscape over recent years (namely increased local competition and pricing pressures from discounters). Traditionally a price leader, Tesco stores have lost their value appeal to most customers. Recent surveys have them charging an average 6% more than competitor Asda. After several profit warnings, a new CEO and an accounting scandal, Tesco is now on the path towards rapid cost cutting and price reductions across their store base.
Can Sainsbury Weather A Price War?
While Sainsbury has seen five years of continuous market share increases, profitability is currently the main concern for investors. While competitors have been forced to reduce prices at a rate faster than Tesco to compete, Sainsbury’s price levels have been relatively stable in comparison.
Additionally, Sainsbury has actually been able to pass along price increases for their private-label goods over the past 12 months.
Notably, Sainsbury's overall profitability, as measured by operating profit margins, has continued to rise to 4.2%, a level of profitability not seen since the year 2000. So despite the pressures from the discounters, Sainsbury is managing to squeeze out better profitability year by year, unlike the falling profit margins at Tesco, Morrison and even Wal-Mart (WMT; US owner of the Asda UK supermarket chain).
Sainsbury has been able to maintain their profitability levels even as competitors such as Tesco’s has fallen.
With a convergence in operating margins, Tesco’s shares have lost most of its historical P/S premium and both companies now trade within a similar valuation range.
The compression in valuation comes at a time when operating margins are still strengthening, pricing on products hasn’t collapsed, book value continues to grow steadily, and ROE continues to rise.
While shares have been hit on the fears of a price war, Sainsbury has shown an ability to navigate these pressures in the past. New chief executive Mike Coupe plans £500million of cost savings over the next three years and will cut annual capital spending to £500million-£550million from £925million. He will also scale back store openings and expansions, opening 500,000 sq ft of space next year instead of the intended 750,000 sq ft. While the industry may experience additional pressures moving forward, Sainsbury (at close to an all-time valuation low) seems like decent bet the weather the storm.
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