SBRY Premium To Narrow In Short Term As Questions Re: Margins And Dividends Grow

The supermarket with moats is beginning to look like just another castle built on sand.

Year to end-Aug	PBT (£m)	EPS (p)	PER (x)	DPS (p)	Yield (%)
2014 (A)	898	32.80	9.6	17.30	5.5
2015 (E)	735	29.68	9.9	16.42	5.7
2016 (E)	715	29.19	10.1	16.35	5.6

Whilst SBRY is perceived to be the most attractive of the listed supermarkets, problems are building…

Take a quick glance at the recent share price performance of the UK's supermarket giants and you will know that the powers-that-be have been having a tough time of late. The bears argue that:

Ø These former FTSE darlings have had it too easy for too long;

Ø The day of reckoning looks to have come in the form of:

o Market-poaching European deep discounters;

o A weak grocery inflation environment, the weakest in almost eight years, according to Kantar;

Ø Market share competitors have evolved from vulnerable family independents to well-financed European discounters;

Ø Customers previously captive to the big four supermarkets are leaving in droves.

Initial responses

This perfect-storm story of structural change is well known by now and the old supermarket business model is fast becoming outdated. The big four have responded to this threat by:

Ø Retreating from the 'space race';

Ø Ramping up roll-out of convenience stores;

Ø Fast-tracking online businesses and improving multichannel experience; and…

Ø Making painful dividend cuts and/or cutting capex (with the exception of SBRY) and making management changes.

Where are we now?

Shares in Tesco (TSCO) and Morrisons (MRW) have been battered over the last year, falling 38.6% and 42% from their respective 52-week highs. There is precious little in the short to medium term that might improve sentiment.

Of the publicly listed UK supermarkets, Sainsbury (SBRY) appears to have resisted this slide in share price to some extent. The chart above shows TSCO (orange), MRW (green) and SBRY (blue) all tracing the same unhappy path until mid-March 2014. Here, the market appears to have concluded that Sainsbury has the best chance of steering its business unharmed through these turbulent times.

Sainsbury 'better' but everything's relative

Since mid-March Tesco's shares have declined by 27%, while shares in Morrisons are down 25%. Sainsbury's shareholders are sitting (comparatively) pretty with a more modest 11.7% slide. This period of outperformance may be attributed to the following factors:

Ø Perceived upmarket customer base, less driven by cost and therefore less likely to be tempted by the deep discounters;

Ø Perceived stronger brand and better management;

Ø Strong presence in southern England;

Ø Expansion of convenience stores and online business.

Ø Some innovation such as the joint venture with Danish discounter Netto (which will see the launch of 15 new Netto stores by end 2015)

We explain below why the SBRY share price premium to its peers overstates these best-in-class traits.

… Mr. Market makes too much of SBRY competitive advantages Market share falling…

We would classify SBRY's perceived strength in customer base not so much as a defensive moat but perhaps as a dangerous mirage. Even supposing SBRY hangs on to its 16.4% market share (which data suggests is on the slide), the price wars of competitors might force Sainsbury to squeeze its already low margins. If not that then the anaemic rate of food inflation almost certainly will.

The latest grocery shares figures from Kantar Worldpanel for the 12 weeks to 17 August show food price inflation has fallen for the eleventh period in a row and now sits at 0.2% -- its lowest since October 2006. Staple foods are bearing the brunt of the impact.

Whilst the table below shows that Sainsbury's market share has risen on a 12mth view, we would suggest that the group is beginning to feel the strain and its market share is no longer untouchable. Over the 12wk period to August 2014, its share fell for the first time in a number of years by 0.1% to 16.4% compared with the previous Kantar reporting period.

· Tab.1. Selected food retailer market shares:

Company	Market share 12w to Aug 2014 %	Market share 12w to Aug 2013 %
Tesco	28.8	30.2
Asda	17.2	17.1
Sainsbury's	16.4	16.5
Morrison's	11.0	11.3
Co-op	6.4	6.6
Waitrose	4.9	4.8
Aldi	4.8	3.7
Lidl	3.6	3.1
Iceland	2.0	2.0
Other multiples	2.8	2.6
Total multiples	97.9	97.9

Source: Kantar WorldPanel:

…and management changed

As for superior management, widely acclaimed CEO of 10 years, Justin King, left his post in July. Before Mike Coupe assumed that mantle, he made sweeping changes to the supermarket's higher management. This may lead to some disruption in these challenging times.

While the Netto joint venture is undoubtedly a good strategic move, it will enter the deep discounting market towards the end of next year as a distant third, behind Aldi and Lidl. This situation typifies the strategic lethargy of the big four in responding to evolving market conditions.

Feeling the squeeze

Some of these trends are beyond the capacity of good management or loyal and affluent shoppers to influence. We propose that the market has not adequately factored in the vulnerability of SBRY to strong, long-term macroeconomic and structural headwinds. If, as we believe, Sainsbury is set to struggle, we expect to see:

Ø Further market share losses to deep discounters and online specialists;

Ø Potential market share losses to price-cutting rivals;

Ø Continued retreat from expansion;

Ø Potential losses from property write-downs;

Ø Price cuts and squeezed margins;

Ø Lower forecasts and a rebasing of dividend, which is already proving hard to maintain.