Investor optimism on Sainsbury's deal will be tested
Size matters - at least to investors in Britain’s supermarket operators, it seems. The immediate reaction to Sainsbury’s and Asda’s agreement to create a new retail sector leader initially sent shares in Sainsbury’s, UK No. 2 by market share, as much as 20% higher, whilst rivals’ stocks retreated. It was uncharacteristic price action for Sainsbury’s, which tends to underperform London-listed peers. Sainsbury’s market capitalisation remains four times smaller than that of the UK’s biggest retailer, Tesco, which was worth around £23.25bn at the end of last week. The huge gap is a reminder that Sainsbury’s has gone nowhere in a hurry for years. Up till late March, Sainsbury’s stock had lost almost 20% over two years compared to Tesco’s appreciation by the same amount. Sainsbury’s was holding on to a 15% rise on the day by Monday afternoon, leaving it some 10% higher on a two-year view, though Tesco still bested that with its 40% advance.
Sainsbury’s profits in shallow bounce
Sainsbury’s annual earnings released ahead-of-schedule on Monday also underlined disparate growth compared to close competitors. Sainsbury’s posted a modest 1.4% rise in underlying earnings to £589m, a late return to profitability since the grocery sector’s near melt-down between 2014-15. By contrast, Morrisons in March reported an 11% rise in full-year profits, continuing its sure-footed recovery of the last few years, whilst Tesco reported a much better than expected 28% jump in annual profits earlier this month. Sainsbury’s investors have become used to its more glacial pace. Before the weekend, they were expecting compounded three-year EPS growth of around 3%, according to Thomson Reuters data. That’s around the same as the actual rate of the last two years. At any time since mid-2016, Tesco earnings have been forecast to grow by at least 20% over three years.
The tolerance of the long-term Sainsbury’s shareholder
Tolerance is another quality required by long-term Sainsbury’s shareholders. The group’s capital expenditure, including refurbishments and new stores, was a little more than twice the size of its profits in the decade before it acquired Home Retail Group. This meant Sainsbury’s ratio of expenditure to profits was higher than rival Tesco’s, even before Sainsbury’s last splurged on a major acquisition. Such expenditure helped ensure a Sainsbury’s total return of only 2.4% over the last 5 years, despite the smaller group continuing to pay dividends during Tesco’s three-year hiatus. With Home Retail Group’s general merchandise unit Argos having since led Sainsbury’s back to an overall growth path, shareholders may hope that added scale and forecast net synergies of at least £500m per annum could lead to a faster rise in total return. At least after £750m in associated costs for the deal are out of the way.
Logic vs. reality
The logic of Sainsbury’s deal would be less arguable were it not for its spotty record of value creation, the 30% decline of Asda profits over three years, the brutal retail environment and obligatory regulatory scrutiny before 60% of the market devolves to two operators. It may not be clear for at least a year whether Asda and Sainsbury’s will be required to dispose of stores or other units to get the deal over the line. Given the pairs’ uncomfortable sector positioning, that’s ample time for investors’ ebullient reaction to moderate.