With new bid rumours swirling around Sainsbury's (SBRY) almost daily, what should investors in the UK's third-largest supermarket chain do? Is it time to take profits, or should you sit tight and hope for more? Regular readers will know that the basis of this column is a financial model that I've developed to guide my own investment decisions. Its basic thesis is that companies' share prices should be looked at in terms of their variation from a dynamic, relative mean, rather than an absolute one. My model has generated encouraging results for a number of companies, including Tesco, so I thought that it might produce similarly useful results if applied to Sainsbury's.
Sainsbury's shares: anything but cheap
The first thing to note is that shares in Sainsbury's are anything but cheap in absolute terms. The company made 10.4p in diluted underlying earnings last year; at its current price, that puts it on an historic multiple of almost 50 times. Even if Sainsbury's were to match Tesco's likely future earnings growth rate of around 12% over the long term, it would have to do so for more than 30 years (discounting at an admittedly high 11%) before moderating in order to justify such a high multiple.
That's rich; but on the other hand, Sainsbury's is expected to generate earnings growth of more than 30% over the next two years as it recovers from its 2005 profits slump. Moreover, its shares have recorded returns in the high-teens before from an expensive starting point.
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Sainsbury's shares: what price to buy in
My model concludes that, given current interest rates and earnings expectations, investors should buy Sainsbury shares up to 448p and should sell them at 582p. That may sound like a hold' recommendation on the face of it; however, there is another trading point, at 511p, which may be equated to a lighten' recommendation. So whatever holdings investors have in Sainsbury's, I would recommend that they halve them. That way, they will be underweight compared to their normal neutral' investing positions, but they will still be in a position to benefit in the event that a further bid between 550p and 600p (as mooted by various brokers) comes to fruition.
So what are the chances of such a bid materialising? I am sceptical. Much of the logic of any deal appears to be based around a sale and lease-back of Sainsbury's land bank valued at around £7bn as at the end of March 2006 and variously between £7.5bn and £8.5bn by banks.
However, assuming that whoever buys the land bank would want a 5% income return on their investment, this would equate to a rental bill for Sainsbury's in future of around £400m per year. When you consider that the supermarket only made £267m in underlying profits before tax in the year to 2006, you begin to see the difficulty.
To be fair, things are a little better if you use cash flows rather than earnings, and there is scope to pay off debt and reduce the finance costs of the business with the lump sum generated. Nevertheless, in a notoriously competitive industry, Sainsbury's would be cutting further into its profit margins.
It's all very efficient theoretically, but it's also just the moment at which a less efficient, higher-margin competitor is likely to launch a price war. This would be particularly bad news if Sainsbury's had been lulled into returning a rather too generous chunk of its capital to shareholders and had yet to start generating returns for itself from the remainder. On the other hand, it might just be possible to make a deal work if another retail party, such as the oft-touted Marks & Spencer, could be brought into the equation and additional synergies and economies of scale were brought to bear.
My overall conclusion, therefore, is that Sainsbury's is pretty expensive in both absolute and relative terms and is now trading above many brokers' fair-price estimates at least, that is, from before the current takeover frenzy began. On that basis, a judicious lightening of investors' holdings seems like a prudent move.
Tesco also a sell
So what about Sainsbury's arch rival, Tesco (TSCO). Like my colleague Paul Hill, I agree that Tesco too is looking a bit toppy. At its current price, my model shows that Tesco is a sell. If, when it releases full-year results later this month, it can convince analysts that underlying earnings for 2009 will be of the order of 28.5p per share (representing year-on-year growth of 16%), then the shares will no longer be a sell' but a hold' instead. Any less, however, and they will continue to be so. At the moment, the consensus estimate for underlying earnings from brokers who are publishing forecasts for 2009 is around 27p per share, or around 10% growth compared to 2008. That's below my watershed, so for the moment I'm happy to be out of Tesco as well.
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