Sainsbury’s: what’s the investment case?

Major questions are being asked about the future of Sainsbury’s after its merger with Asda was scuppered by regulators. We have a look at the outlook for Sainsbury’s and look at the investment case going forward.

Sainbury's Source: Bloomberg

When Sainsbury's announced it was going to merge with rival Asda it stressed the deal was vital if it was to remain competitive in the rapidly changing grocery market. Now, with that deal having been blocked by regulators, the pressure is on Sainsbury’s to prove that it has what it takes to go it alone and must convince shareholders the Asda deal was not pursued out of necessity but because it would have been complimentary.

One of the reasons why many believe Sainsbury’s needed to make what would have been a transformational merger is the supermarket’s performance relative to its peers. Although all of the Big 4 supermarkets have continued to lose market share to discounters Aldi and Lidl (as well as others such as the Co-Op), Sainsbury’s has been consistently losing the most since the end of 2017, according to data from Kantar Worldpanel. The latest 12-week data showed Sainsbury’s was the only major supermarket to see sales decline.

Asda, the UK’s third-largest supermarket, quickly started to look like the stronger business soon after the proposed merger was announced in April 2018, narrowing the gap in market share with second place Sainsbury’s by delivering stronger growth. Tesco has recovered strongly since the accounting scandal in 2014 and is now comfortably outperforming its peers while pursuing a new avenue of growth following its acquisition of wholesaler Booker. Morrisons, the fourth-largest supermarket, is seeing pressure on profitability but it is delivering leading like for-like (LfL) sales growth and offers a niche by manufacturing about one quarter of its own products, which it also wholesales to convenience stores and exports abroad.

Virtually all the major players have acted to address the structural changes occurring in the market. Tesco has built on its market-leading scale, Morrisons has built new wholesale and export avenues, M&S and Ocado have partnered up and Lidl and Aldi continue to steal market share by stacking-it-high and selling-it-cheap. Meanwhile, without Asda, Sainsbury’s is looking like the weak link of the pack.

Read more on how Sainsbury's shares rise as CEO comes under pressure after Asda merger is blocked

We have a look at what Sainsbury’s plans to do now its merger with Asda has been scuppered and consider whether the supermarket has what it takes to move forward without a partner.

Why did the Sainsbury’s-Asda deal fall through?

Sainsbury’s and Asda originally announced their proposed merger in April 2018. The deal was set to combine the second- and third-largest supermarket chains in the country to form a leading force that would have comfortably leapfrogged Tesco as the market leader. For Sainsbury’s, the deal was all about adding scale so it could better compete with Tesco, which has gained even further ground after acquiring Booker, and the discounters. For Walmart, the US conglomerate that owns Asda, it was a way of reducing exposure to the challenging European grocery market and an effective way of offloading Asda, which, although profitable for the business, makes up a relatively minor part of the wider company by accounting for just 6% of total sales. Walmart would have owned around a 42% stake in the enlarged entity if the deal had gone through.

Confidence was justifiably high when the pair unveiled their plan. Sainsbury’s and Asda had vowed the merger would have allowed them to cut costs and therefore prices for customers, promising to introduce £1 billion of price cuts over three years and to bring the cost of everyday goods down by as much as 10%. Sainsbury’s also felt the rise of Aldi and Lidl – which now boast about 15% of the UK grocery market – was providing enough new competition to give way for consolidation among the Big 4. Plus, the regulator in charge of analysing the merger, the Competition and Markets Authority (CMA), had been sending a signal that it was warmly embracing major M&A and consolidation in the UK after approving a slew of major deals over recent years, including the Tesco-Booker deal which acted as the trigger for Sainsbury’s to launch the bid for Asda in the first place.

But it became clear that the pair and the CMA had views that were poles apart. The regulator’s findings ultimately flew in the face of the claims made by the two supermarkets: saying the merger was more likely to lead to higher prices for customers rather than save them money.

More about Sainsbury's and Asda supermarket merger blocked by competition watchdog

The disparity in views primarily came down to how each party treated the threat of Aldi and Lidl. Whereas the analysis conducted by Sainsbury’s and Asda weighed more on the increased competition of the discounters the CMA’s paid less attention to that dynamic and focused more on the effect of the deal on how the traditional Big 4 compete with each other. Ultimately, while the supermarkets considered Aldi and Lidl as much as a threat as Tesco and Morrisons the CMA believes the limited ranges offered by the discounters means they are not viable alternatives for a customer’s full shop, even if they are stealing custom in certain areas and with particular products.

Sainsbury’s says business as usual in annual results

Sainsbury’s was the last of the three major publicly-listed supermarkets to release its annual results, and, coming just days after the merger was blocked, the company did not have much time to put on a brave face. The supermarket barely referred to the Asda deal and painted a picture of ‘business as usual’, introducing the foundations of a new strategy for it to go it alone.

Sainsbury’s sales rose 1% in the year to 9 March 2019, but LfL sales declined by 0.2% - a stark contrast compared to the 0.7% LfL growth reported by Tesco and Morrison’s particularly strong LfL lift of 4.8%.

Underlying pre-tax profit rose to £635 million from £589 million, but that excludes £396 million of exceptional costs booked in the year. That includes £118 million of pension contributions, £81 million on restructuring and refurbishing stores, £70 million on overhauling its banking platform, £46 million of fees related to the failed Asda merger and £40 million on integrating Argos. Once these were taken into account, reported pre-tax profit plunged over 40% to £239 million from £409 million the year before. Sainsbury’s tried to sweeten shareholders with a higher dividend payout of 11.0p, up from 10.5p the year before.

The company did take the opportunity to lay some ground work for its plan of how to move the company forward, vowing to accelerate investment and reduce debt. Sainsbury’s, still under pressure to cut costs even without the additional scale of Asda, has said it still intends to cut prices for consumers to help drive growth but that it will take longer than originally envisioned if the merger had been approved.

Sainsbury’s vs Tesco vs Morrisons: 2018/19 financial performance

It was a mixed year for the big three publicly-listed UK grocers in the last financial year. Tesco was the best performer in terms of growing revenue, profit and its dividend. Morrison’s LfL sales growth and dividend were welcomed by shareholders, although it has struggled with its bottom line like Sainsbury’s, albeit to a lesser extent. Sainsbury’s was the worst performing supermarket in several areas last year, only ranking top for debt reduction and gross margin improvement.

All results are taken from each supermarket’s most recently ended financial year (Sainsbury’s year end: 9 March, Tesco year end: 23 February, and Morrisons year end: 3 February, all 2019), with the best performer in terms of year on year (YoY) performance highlighted in blue and the worst performer in red:

(£, millions, unless stated) 2017/18 2018/19 % Growth
Revenue
Tesco 57,493 63,911 11.20%
Morrisons 17,262 17,735 2.70%
Sainsbury's 28,456 29,007 1.90%
Gross margin
Tesco 5.80% 6.50% -70bps
Morrisons 3.70% 3.40% -30bps
Sainsbury's 6.60% 6.80% +20bps
Operating profit
Tesco 1,839 2,153 17.10%
Morrisons 458 394 -14%
Sainsbury's 518 312 -39.80%
Underlying pre-tax profit
Tesco 1,145 1,716 49.90%
Morrisons 374 406 8.60%
Sainsbury's 589 635 7.80%
Reported pre-tax profit
Tesco 1,300 1,674 28.80%
Morrisons 380 320 -15.80%
Sainsbury's 409 239 -41.20%
Dividend
Tesco 3.0p 5.77p 92.30%
Morrisons 10.09p 12.6p 24.90%
Sainsbury's 9.7p 10.2p 5.20%
Net operating cashflow
Tesco 2,805 1,966 -29.90%
Morrisons 744 712 -4.30%
Sainsbury's 1365 618 -54.70%
Net cashflow
Tesco 212 -1,158 -
Morrisons 1 -63 -
Sainsbury's 651 -608 -
Net debt
Tesco -2,625 -2,863 +9.1%
Morrisons -973 -997 +2.5%
Sainsbury's -1,858 -1,636 -11.9%

Will Sainsbury’s CEO Mike Coupe leave the business?

Questions have been raised over Coupe’s future as Sainsbury’s boss after his grand plan failed and although there was speculation he was likely to leave before the end of 2019 the company made a point of supporting its chief executive officer (CEO) when it released its results. Sainsbury’s chairman Martin Scicluna as well as some major shareholders have backed Coupe, who said he remains 'committed to the business' and intends to stay for the long term.

What next for Sainsbury’s?

With Coupe to stay in the driving seat (for now) he needs to find a new strategy for Sainsbury’s and one that doesn’t involve major M&A. That will make it much more difficult to achieve the scale it has long desired and harder to continue cutting costs to remain competitive – especially without sacrificing earnings or its ability to pay dividends.

There is good reason to worry about how much deeper the cost cutting can go as a standalone business. Sainsbury’s delivered £220 million worth of savings in the recently ended financial year in addition to £160 million worth of synergies from Argos, but at the same time Sainsbury’s admitted that there were 'structural limits to how far we can adapt our costs without adversely impacting the customer experience' in papers filed with the CMA. It is also worth noting the effect of the drive to reduce costs for the business and prices for customers has on the supply chain, which ultimately must absorb any price drops that Sainsbury’s pushes for. For example, the supermarket said it drove a 6% rise in cheese sales by cutting the amount it pays suppliers (and therefore the price), which many believe have been unfairly squeezed by the buying power of the largest supermarkets over recent years.

With its core grocery business underperforming, Argos sales slowing down and its Tu clothing range just about managing to hold market share, Sainsbury’s has outlined five new priorities for the business to turn things around, but more details are likely to follow in subsequent updates later this year.

Sainsbury’s: improving 'quality, value and service' of core grocery business

Sainsbury’s has many sales strengths even if growth was uninspiring last year. While sales in its larger supermarkets nudged up by a paltry 1% its convenience stores outperformed the wider market with sales growth of 3.7% while online sales jumped 6.9%. The acquisition of Argos in 2016, diversifying the business beyond groceries and into general merchandise, has been regarded as a success after reporting higher growth in stores where an Argos has been added.

The supermarket is also strong when it comes to its own label premium produce, with volumes of its ‘Taste the Difference’ range up by 2.2% last year to outperform the wider market. Sainsbury’s has said 'quality is a key differentiator' and claims customers 'continue to switch to us from more premium competitors'. It also claims to be in a strong position when it comes to new trends, like in vegetarian and vegan products that now generate over £100 million worth of sales each year.

Many have said it is not product quality that is the issue, however, but the quality of service and supply. There have been reports of empty shelves shared on social media and grumblings about a drop in customer service following the huge staff overhaul conducted last year, when it stripped out middle management to make the business leaner.

Sainsbury’s plans to refresh 400 existing stores this year and continue adding concessions to draw in more of a crowd, whether that be an Argos store or an outlet of a partner. Sainsbury’s has already been adding the likes of Sushi Gourmet, Timpsons and Specsavers to its premises to make better use of excess space and give people more of a reason to visit the store. It also started to upgrade its beauty sections in a handful of stores last year with more to follow this year.

Growing Argos and Tu clothing

Sainsbury’s has been rapidly adding Argos stores inside its supermarkets in an effort to bolster sales. Today, there is just shy of 600 standalone Argos stores with a further 281 inside a Sainsbury’s supermarket. When the 300-plus collection points inside stores is taken into account, there are over 1200 physical Argos locations up and down the country.

The majority of Argos sales begin online and on mobile and most customers choose to pick up their goods, even if Argos has a terrific same day delivery service that covers about 90% of the country. This means Sainsbury’s can feed off the customers who come to pick up their goodies from Argos – why not pick up a pint of milk or whatnot while you’re there? The company says sales in a Sainsbury’s store are 43% higher three years after an Argos has been added than the first. It has tentatively started to roll out this model to its faster growing but more space limited convenience stores after introducing an Argos in one outlet in Ascot, Berkshire.

Sainsbury’s has its own range of general merchandise, but the offering is nowhere near as strong as Argos. While Argos sales rose 2.2% to outperform the wider market last year, overall general merchandise sales were flat YoY when Sainsbury’s own range was included – although it says that was still a strong result considering the wider market is in decline. Sainsbury’s has been gradually dropping its own general merchandising range, especially in low margin products like electricals, and leaving it to Argos. This will allow Sainsbury’s to shift investment and attention to the third spoke in the Sainsbury’s wheel, its Tu clothing range.

According to Sainsbury’s, Tu is the sixth largest clothing brand in the UK by volume. Sales fell in the recently ended financial year but at a slower rate than the wider market, and this was primarily because it cut back on sales events, with full price clothing sales rising 12%. It hopes that momentum can continue after adding the clothing range to the Argos website.

Sainsbury’s: sell more financial services to most loyal customers

Sainsbury’s sees a big opportunity in cross selling and spent considerable sums last year to be in a position to push more financial services on its customers. It transitioned Sainsbury’s Bank to a more flexible banking platform and in February 2018 bought out its loyalty Nectar programme.

There are over 18.5 million Sainsbury’s customers signed up to Nectar, just under three quarters of its customer base to suggest the supermarket’s customers are particularly loyal. Nectar is at the heart of its cross selling strategy, but it will have to improve usage – only 1.2 million customers, or less than 6.5% of all people signed up, use the app on a regular basis. That has risen 8% over the last year but Sainsbury’s will need to penetrate its customer base much further. The reason its Nectar loyalty scheme is so important is because it provides crucial data on consumers, giving it the ability to better meet their needs – such as recognising if they need financial services.

Sainsbury’s Bank is focused on providing more mortgages to people and flogging more ‘commission products’, which in layman’s terms means stuff like home, car, pet or life insurance. Over one fifth of all lending made last year was in the form of a mortgage, up from just 5% the year before, while insurance sales jumped by 25% and revenue from travel money operations edged 14% higher. The company has also started to leverage its bank by offering credit to Argos customers who can buy now and pay later: nearly one in five purchases on Argos utilise the financial service on offer.

Generate efficiencies by investing in digital operations

Some of the latest innovation that Sainsbury’s has shown off has rightly grabbed a lot of attention. The company recognises that running physical stores is getting more expensive at a time when more sales are shifting online, which means Sainsbury’s and others must think outside of the box. The fact over 60% of all Argos orders are made online but 85% pick their order up in store is one example of how it has tried to leverage both bricks and mortar and online.

The supermarket is slowly being recognised as one of the more technologically savvy players in the market after it started to roll out new concepts that aim to improve service while cutting the wage bill. It offers SmartShop – which allows customers to scan their shop to track spending – in over 100 supermarkets and has added a feature that allows them to pay in a handful of convenience stores. Taking that a step further, it has also introduced Pay&Browse in over 160 Argos stores that allows customers to pay through the app and bypass the till. Taking that another step further, Sainsbury’s recently became the first UK supermarket to trial a till free store in a Sainsbury’s Local in Holborn Circus. With no tills, Sainsbury’s is again making use of its Nectar app, which customers must use to scan and pay for their goods. This is only a three month trial and does present issues: people without the Nectar app are locked out (which places further emphasis on levels of engagement with the app) and the ease of use is diminished when purchasing certain products, like those that have a security tag. The concept has been welcomed but it is clear we are far from this becoming the everyday norm, however, Sainsbury’s has earned applause for its efforts. Considering labour costs are rising and pension contributions remain a concern for some, investors should take comfort that Sainsbury’s is trying to take real action: its trial store only had two members of staff, and one of them was there to take normal payments for those customers frustrated by the changes.

Sainsbury’s believes introducing technology and closer integration across the group can continue to deliver synergies and savings that it can use to be more competitive. For example, it says combining its own general merchandise division with that of Argos means it has one larger team that has more buying power over its suppliers. It will do the same by injecting expertise from Sainsbury’s Bank to grow the use of Argos Financial Services.

Strengthen the balance sheet and reduce net debt

Sainsbury’s was the only one of the three listed supermarkets to reduce debt in the last financial year, paying down £220 million of net debt, which was more than expected. It plans to reduce its net debt by 'at least' £600 million over the next three years from the current balance of £1.64 billion to closer to £1 billion.

Sainsbury’s beat its cash generation in the last financial year, which will give investors confidence it has the resources it needs, but the firm is not only trying to reduce debt but raise investment and maintain its dividend.

Sainsbury’s share price: how to trade

The Sainsbury’s share price shot up after it announced the proposed merger with Asda in early 2018. Shares had gained as much as 48% between late March and late August last year but began to suffer a severe slide as it gradually became clear that regulatory approval was not as much of a given as first thought.

In fact, since the merger was officially blocked the Sainsbury’s share price is now lower than it was before it made the bid for Asda and touching new all time lows. That deterioration has been exacerbated by some broker downgrades, including Bank of America Merrill Lynch which moved its rating from Buy to Hold and made a deep cut to its price target from 350p to just 250p (Sainsbury’s shares were trading at 212.2p as of the close of trade on 10 May 2019). The bank said focus has returned to the supermarket’s core grocery offering and says main drivers over the next 12 months will be its ability to improve its own label range of products as well as the buying terms with third party suppliers, and how well it manages to cut labour costs.

The bank added that, while Sainsbury’s currently trades at a discount to the wider sector, this is acceptable because it reflects the risks associated with its new strategy, which it did admit was 'encouraging'. Still, the death of the Asda merger means brokers are more bearish on Sainsbury’s than its peers.

Sainsbury’s vs Tesco vs Morrisons: how to trade

According to Reuters as of 10 May 2019:

Tesco Morrions Sainsbury's
Strong Buy (1) 7 3 5
Buy (2) 7 4 0
Hold (3) 3 7 8
Sell (4) 1 2 2
Strong Sell (5) 0 1 1
Mean rating (0-5) 1.89 2.65 2.62
Average recommendation BUY HOLD HOLD

What next for Asda after Sainsbury’s merger collapses?

As the publicly-listed one of the two, the pressure to revive fortunes has landed firmly at the feet of Sainsbury’s following the collapse of the merger but there is still a lot of interest surrounding Asda and what its owner Walmart will do now. Asda is an asset for Walmart by generating cash and profits as well as supplying some of the parent company’s senior management over the years, but it is clear Walmart would like to either exit the business or reduce its exposure one way or another.

The CMA’s decision to block the merger sends a firm warning to the industry that consolidation is not welcome, and that will make it hard for Walmart to find another buyer. No other supermarket will be able to touch Asda for the foreseeable future and the attractiveness to any other potential buyer is diminished because they simply wouldn’t be able to deliver the synergies and cost savings that someone like Sainsbury’s could. That is thought to have ruled out private equity making a bid, although firms like KKR have been linked.

Although it is likely that Walmart will continue to run Asda as it is there are some more adventurous scenarios being bandied about. Some have suggested the firm could look to spin Asda off into its own company and list it in London. Others think that while another supermarket can’t take the reins other retailers could look to buy Asda as a way of breaking into the grocery business, such as Amazon (which did so in the US by buying Whole Foods) or a retailer like B&M, which already sells some food items and a wide range of general merchandise.

What is the investment case for Sainsbury’s after Asda deal is blocked?

Although many have criticised Sainsbury’s for hugely misjudging its approach to the Asda deal the company had very good reason to believe in it. However, after putting all of its eggs into one basket – which has now been ripped away – Sainsbury’s must convince shareholders that Asda was always going to have been a complimentary addition to the business rather than a necessary one.

The supermarket has lagged behind its peers over the last year, which hasn’t helped. But the supermarket chain has demonstrated its strengths in several areas, particularly in digital innovation. However, while that may provide confidence about its longer-term prospects it will do little to allay the short term concerns of investors.

Sainsbury’s has said it intends to hold a capital markets day on 25 September 2019, to update shareholders further on how it will move forward. However, shareholders should be prepared to find out more when it releases its first quarter (Q1) trading results on 3 July.


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