Sainsbury s needs sales revival before inflation hits

It is time to cut Sainsbury’s some slack?

Shares of Britain’s second biggest supermarket chain failed to gain any ground in 2016, in fact they fell about 4%, a less than meagre performance that contrasted with some of the best gains by its rivals’ shares for years.

Investors were demonstrating persisting scepticism about Sainsbury’s, despite the group’s resilient underlying sales growth in the third quarter of 2016 and an industry beating outcome at Argos, which it acquired early last year.

True, Sainsbury’s has lagged the rebounding fortunes of Tesco and Morrisons, apparently distracted by the complexities of purchasing the catalogue store chain. The acquisition was in the works for months, but was not triggered until Home Retail Group (HRG) disposed of DIY retailer Homebase in April. The process coincided with a deepening fall of Sainsbury’s retail sales that lasted for most of the year. It was one of the group’s longest streaks of underlying sales falls this decade.

Inflation in moderation

Even after an almost unbroken 9-year run of quarterly sales rises dried up late in 2014, Sainsbury’s remained the only Big 4 grocer to keep growing for most of 2015. Its retail turnover slowed early in 2016, and was negative for the rest of the year.

It is against a backdrop of rekindled inflationary pressures that Sainsbury’s underlying volumes appear to be on the turn again. Kantar Worldpanel’s closely followed grocery data shows British food price inflation doubled in February, adding to evidence that Brexit-stricken sterling is pushing up shopping bills. Hardening prices probably helped Sainsbury’s post its first sales growth, according to Kantar’s data, for almost a year. Rising by a meagre 0.3%, they were slower than sales at almost every other large UK supermarket chain, but growing nevertheless.

Sainsbury’s December-February sales backed up an even thinner 0.1% like-for-like rise over Christmas, suggesting momentum really was returning. Crucially though, turnover at Argos outshone all comers, with a 4% jump, compared with just 1.5% expected. For the third quarter at least, Sainsbury’s high-stakes gambit paid off, though one Christmas doesn’t dispel risks from its increased exposure to the more volatile general retail pricing environment.

Those risks underline that delivery on the potential of Argos is now crucial to Sainsbury’s investment case. Argos could provide the edge that recharges growth at the group, whilst offering some protection against a rebounding supermarket sphere. It has not escaped investors’ attention that leaner and meaner Morrisons and Tesco have recently made headway in the battle against Aldi and Lidl. Tesco’s market share recently grew for the first time in five years and Morrisons last week posted its first profit rise in half a decade.

It was telling that on the day Morrisons reported that profit rise, its shares fell sharply. Natural ‘rotation’ played a part: the stock advanced 55% last year. But the tumble was mostly down to its warning about “the impact on imported food prices if sterling stays at lower levels”. Its caution is well-founded. Right now, mild price pressures are a welcome relief from the deflationary conditions of recent years, but retailers will eventually face the negative effects of inflation. The concern among investors is that Sainsbury’s weak competitive position could make it the most vulnerable of the Big 4, if price rises begin to weigh on consumer demand.

Dividends cost less at Sainsbury’s

Sainsbury’s investment case does have one major advantage right now—an undemanding valuation. The resurgence of Tesco and Morrisons shares leaves their forward price/earnings ratios looking ambitious, at 24.6 and 19.7 times forecast earnings respectively.

Sainsbury’s is rated around 13.3 times 2016 earnings forecast at £453m, according to Thomson Reuters. Whilst that figure is down about 4% on the year before, and would be the group’s third consecutive annual profit fall, it still represents a lower bar for expectations than for Morrisons and Tesco. And given that Sainsbury’s dividend yield is likely to remain higher than Morrisons in 2017 (Tesco doesn’t currently pay one) shares of the No.2 supermarket can arguably be seen as undervalued. The proviso is that Sainsbury’s and Argos sales must continue to revive, at least at the same rate as seen over the last few months.

The group will release a trading statement covering the fourth quarter of its 2016 financial year on Thursday 16th March at 7.00 am GMT.

The key risk is that sales will falter at the supermarket and at Argos. If that happens, Sainsbury’s slim share price gain of about 2% between mid-February and Tuesday’s close could be squelched. Investors may conclude that its main rivals are a better way to play a still hazardous supermarket sector after all.