Take Sainsbury’s off your shopping list

Should you buy shares in Sainsbury's? More people are shopping there and profits are going up.

But is it really a good business? It may be pleasing its customers, but it's spending a lot of money to do this. Take a closer look at its financial performance and there's really not a lot to shout about. I'll explain why.

A hit with customers

From the customer's point of view, Sainsbury's is doing a lot of things well. At 16.6%, its market share is at its highest for a decade.

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There are a few good reasons for this.

Sainsbury's food quality remains better than most mainstream supermarkets. On top of this, management seems to have finally realised that Sainsbury's had a reputation for being too expensive, and has done something about it.

It has promised to match the prices of branded goods at Tesco and Asda (unlike Waitrose's price promise, this includes goods on promotion), which has made it much more price competitive.

And unlike Tesco, Sainsbury's has not invested in big, unproductive hypermarkets. It is targeting its spending to reflect the changes in the way people shop for groceries and seems to be doing a good job of this.

Its convenience store business now has 440 stores and £1.3bn of sales. The online delivery business is the second largest in the UK (behind Tesco) with 165,000 orders a week and annual sales of £800m.

But returns are not improving

This is all fine and good, but the financial performance of the business has not followed suit.

Have a look at the chart below.

It shows Sainsbury's return on capital what it gets back in profits as a percentage of the money it invests in the business. Good businesses typically earn high returns. As you can see Sainsbury's returns are very modest at 10.1% before tax. More to the point, they aren't improving. Why is this?

Sainsbury's return on capital

The biggest reason is that, although Sainsbury's is increasing its sales, its profit margins are not improving. At 3.7% they are among the lowest in the industry, and some way below Tesco and Morrisons, which each earn over 5%.

It's almost as though Sainsbury's has effectively capped its margins in order to attract customers.

The other problem is that food retailing requires a lot of investment to grow and keep customers happy. Land and store fixtures and fittings are costly. This is one of the main reasons why UK food retailers consume so much cash flow and make very modest returns on investment. Sainsbury's low margins mean that it suffers here more than its rivals.

But, you might argue, Sainsbury's profits are up by 7.7% while Tesco's profits went down - so what's wrong with that?

There's nothing terribly wrong at all. But Sainsbury's investment increased by 7.9% and returns fell marginally. Put another way, what Sainsbury's is doing is equivalent to a saver putting more money in a bank account. As long as the interest rate doesn't go down too much, the amount of income you receive goes up. That's fine, but it's not the hallmark of a fabulous company.

Can returns improve? Well we're not holding our breath for profit margins to grow, as price competition amongst supermarkets remains intense. On the upside, a lot of Sainsbury's stores are quite young and have yet to achieve a mature level of sales. Add in the fact that it is scaling back its expansion plans a bit and these two things could be helpful.

Doesn't the stock market already know this?

The bulls would argue that it does. At 304p, Sainsbury's shares trade on 10.6 times 2013 forecast earnings and offer a yield of 5.4%. Add in the fact that its book value is forecast to be 314p per share, and surely the shares are cheap?

On top of that, Sainsbury's property assets have been recently given a market value of £11.2bn compared with a balance sheet value of £9.3bn. That's another 100p of extra value if you believe the figures.

However, this last point raises more questions than it answers.

For one, given that Sainsbury's shares trade below its net asset value, why doesn't the management do a massive sale and leaseback of its stores and give the cash back to shareholders?

The answer is: probably because having freehold ownership of your stores gives you a level of cost control that renting does not. You only have to look at retailers like Home Retail Group, which rents all its stores, to see what a downturn in sales does to the business.

The other issue that is barely mentioned these days is the 25.7% shareholding of the Qatar Investment Authority the same investors that tabled a bid of 600p per share in 2007. If the real asset value is much higher than the current share price, why haven't they put in another bid for the company?

Perhaps they have worked out that the value of assets are a function of the returns they can generate. Sainsbury's assets can only be used as supermarkets and the returns they are currently making suggest that the asset value on the balance sheet is about right.

So what should you do? You might not lose a lot of money owning Sainsbury's shares and the dividend is quite juicy. But the shares are not cheap and look unlikely to rise in value any time soon. For me, there's no compelling reason to own the company.

Occasionally, as Shinsei1967 rightly points out below, our analysts don't quite see eye to eye on individual stocks: David Stevenson has a more bullish take on Sainsbury's. For David's most recent view which he still backs '100%' - see here.