Sainsbury’s is taking on discount supermarkets – should you buy in?

Netto supermarket © Getty Images
Sainsbury’s: if you can’t beat ‘em, join’em

The ‘big four’ supermarkets have had a rotten year.

All four have been seriously damaged by the up-and-coming ‘discounters’, Aldi and Lidl.

So I was intrigued to read that Sainsbury’s new boss has decided to adopt a “if you can’t beat ‘em, join’em” strategy. Sainsbury’s is taking a 50% stake in a new discount chain for the UK.

As I say, it’s an intriguing move, and I’ve been thinking a lot about its implications over the last couple of days. I’ve even considered buying some shares in Sainsbury’s, but in the end, I’ve decided to hold off. When I look at Sainsbury’s, there still plenty to worry about.

What exactly is Sainsbury’s doing?

Sainsbury’s (LSE: SBRY)  is forming a 50/50 UK joint venture with Danske Supermarked, Denmark’s biggest retailer. Danske owns the Netto discount brand, and the joint venture plans to open five Netto stores in the north of England by the end of this year. (Danske used to operate 200 Netto stores in the UK, but sold them to Asda in 2010.) Sainsbury’s and Danske are investing £12.5 million each in the venture.

The idea is that it should enable Sainsbury’s to get some exposure to the fast-growing discount sector without damaging the mildly upmarket Sainsbury’s brand.

What do I think?

I last wrote about Sainsbury’s in January and I was pretty bearish. I was concerned that like-for-like sales were only rising by a tiny amount, and for a supposedly successful chain, the 3.56%  operating margin was on the low side.

I also highlighted two serious problems for all ‘big four’ supermarket players. First, there’s the pressure from the discounters at the bottom end of the market and from Waitrose at the top end. And second, there are now too many large out-of-town stores that are no longer so popular with shoppers.

Sadly, when you look at Sainsbury’s recent full-year results, things haven’t improved much. Like-for-like sales have edged up by a paltry 0.2% while the operating margin has fallen to 3.33%. The company’s statement also made a big fuss about a 10.4% return on capital employed (ROCE) as though this was a great achievement. I guess it’s not too bad for a supermarket chain but it certainly doesn’t trigger any enthusiasm on my part.

As for the Netto deal, I admit that I was impressed when I first read about it. However, I do worry that it may be a distraction for management, and I was also put off by one comment  on the deal in the Telegraph.

David McCarthy at HSBC told The Telegraph: “We find the move by Sainsbury’s perplexing, and it will help further highlight how expensive the supermarkets are relative to the discounters.

“This was a problem in France for many years and it is only recently that the hypermarkets there have realised that the way to win is not by imitating the discounters with their own chains but by being more price competitive.”

In other words, Sainsbury’s needs to improve the offer in its core stores, not set up a separate discount chain. That’s the only way to fight off the threat from the discounters and ensure that like-for-like sales can start to pick up again.

The valuation looks tempting

I said at the beginning that I had been tempted to invest in Sainsbury’s. This was largely because it does look cheap on some metrics.

Since I wrote my last article on the supermarket chain in January, the share price has fallen by roughly 10% to 316p. Earnings per share last year were 32.8p, so Sainsbury’s is now on a price/earnings ratio (PE) of only 9.6. Most analysts expect profits to fall next year, but the P/E ratio will probably still be below 11.

What’s more, the dividend yield is a very healthy 5.5%. In a market where many shares are trading on very high ratings, those are tempting numbers.

Sainsbury’s is also making progress online, and 15% of its sales now originate on the web.

But, as I said, I’m holding off for now. These days, my only retail share is Next (LSE: NXT), and that’s not going to change just yet. (I think that Next is still worth buying now.)

With Sainsbury’s, I worry that there is more bad news to come for the supermarket sector, and more specifically, I think that Sainsbury’s has more work to do. It needs to focus on its core stores and try to push up its margins.

If the price falls further, I might be tempted to buy. But I’m not prepared to pay 316p when the chain still faces serious challenges.

• This article is taken from our free daily investment email, Money Morning. Sign up to Money Morning here.

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