J Sainsbury PLC, along with the other major supermarkets, has been through the wars in recent years. Most people know the story by now, if only because of the more severe and highly publicised problems at Tesco.
J Sainsbury: It’s a supermarket
Here’s my extremely short version of the backstory for J Sainsbury.
The big four UK supermarkets (Tesco, WM Morrison, J Sainsbury and, to a lesser extent, ASDA) had it fairly easy. As long as they did a half decent job, millions of shoppers would continue to shop with them.
But then along came the Financial Crisis and the Great Recession, and shoppers had far fewer pennies to spare and more time on their hands to shop around.
The result was a change of shopping habits to more frequent and smaller shopping trips, at local stores that focus on price more than anything else.
That played right into the hands of discounters Aldi and Lidl, who fitted this new shopping behaviour like a glove.
The initial response from the big supermarkets was to ignore the discounters, but that was a massive mistake and the big four have been losing market share and struggling to adapt quickly enough ever since.
A highly successful company, until recently
Here are J Sainsbury’s results up to the 2015 financial year.
As the chart shows, things had been going very well. The company has a long and unbroken record of dividend payments and, in recent years, revenues, profits and dividends had all been going strongly.
Its statistics for the last 10 years look like this:
- Growth Rate (covering revenues, profits, dividends) of 6.4%, well ahead of the FTSE 100’s anaemic 0.8%
- Growth Quality (frequency of revenue/profit/dividend increases) of 75%, also ahead of the FTSE 100’s mediocre 50%
- Net ROCE (median over 10 years, net of interest and tax) of 5.4%, below the large company median of 10%
So J Sainsbury has grown fairly quickly and smoothly over the last decade, including the profit and dividend decline in the 2015 results.
However, its profitability as measured by Net ROCE (Return on Capital Employed) is weak.
Because I use post-interest and tax profits as the “return” part of ROCE, this low profitability figure could be because Sainsbury’s core business isn’t very profitable, or because the company has lots of debt (and hence large interest payments) or other non-operational expenses, or both.
In fact, Sainsbury’s profitability is so low that it effectively rules the company out as an investment for me. I currently use the following rule of thumb:
- Only invest in a company if its 10-year median Net ROCE is above 7%
J Sainsbury fails that test, so that’s the first reason I would be buying the company’s shares. But there are other reasons too.
Its financial obligations are too large for my liking
One of the reasons for Sainsbury’s weak profitability is its large debt obligations.
It has £2.8bn of total interest-bearing debts as at the 2015 annual results. That sounds like a lot and it is, especially as the company has “only” earned an average of £0.5bn in post-tax profits over the last 5 years.
Another large financial obligation is its defined benefit pension scheme. Because the company must ensure that its pension fund assets exceed the fund’s liabilities, it must pour cash into its pension fund if there is a deficit. And that’s exactly what it’s doing today.
The pension fund obligations stand at £7.7bn, while the pension deficit is £0.7bn. That deficit must be closed, and the company has agreed to pay £49m into the scheme each year until 2020, which currently amounts to almost 10% of the company’s post-tax profit.
And so for J Sainsbury we have:
- Debt Ratio (ratio of total borrowings to 5-year average post-tax profit) of 5.2
- Pension Ratio (ratio of pension obligations to 5-year average post-tax profit) of 14.4
- Combined Debt and Pension Ratio of 19.6
Unfortunately, those ratios break some of my other rules of thumb:
- Only invest in a defensive sector company if its Debt Ratio is below 5
- Only invest in a company if its Pension Ratio is below 10
- Only invest in a company if its Combined Debt and Pension Ratio is below 10
So along with “too low” profitability, J Sainsbury also has “too high” financial obligations for me. As a result, I won’t be buying the company’s shares anytime soon, no matter what the price.
The shares are attractively valued, if you ignore the other problems
Even though I wouldn’t consider buying the company’s shares at the moment, I’m crunching through the accounts anyway so I might as well take a look at what share price might be considered “fair value” given its financial history.
The caveat here is that this fair value would only apply if the company wasn’t breaking any of my rules of thumb, but it’s still an interesting value to calculate.
As J Sainsbury has a slightly above average record of growth, its shares, according to my valuation system, deserve a slightly above average rating.
With its shares currently at 261p the company’s valuation multiples look like this (compared to the FTSE 100 at 6,700):
- PE10 (price to 10-year average EPS) of 10.9, which is lower than (better than) the FTSE 100’s 14.0
- PD10 (price to 10-year average dividend per share) of 18.5, which is lower than (better than) the FTSE 100’s 32.9
- Dividend yield of 5.0%, higher and better than the FTSE 100’s 3.5%
So in terms of valuation, J Sainsbury is significantly more attractively valued than the FTSE 100. Its share price is cheaper than average, relative to past earnings and dividends, and the dividend income yield is above average.
And remember, the company also has a better track record of growth than average, so if anything it should be on higher valuation multiples than the index (ignoring its various problems, of course).
To calculate fair value for the company’s shares, I can adjust its share price until it has a middling rank on my stock screen.
At its current 261p, J Sainsbury has a rank of 47 out of 230 companies on the screen, so it is one of the most attractively valued (again, ignoring its problems).
For the shares to be “fairly valued”, they would have to increase to 450p, which is some 72% above their current share price.
At that level the shares would have a historic dividend yield of 2.9%, which I think would be reasonable as long as the company’s successful past could be replicated in future.
However, the company’s profitability is too low for me, and its financial obligations are too large, so I won’t be investing at the moment.
Disclosure: I own shares in Tesco and WM Morrison and they are both holdings in the UKVI Portfolio.
Note: Last time I looked at J Sainsbury’s shares I was much more upbeat. However, since then (May 2014) I have become more cautious about both profitability and financial obligations (partly as a result of the problems with Tesco and Morrisons), so under my now much stricter system, the company has gone from a buy to uninvestible.