3 Reasons Why J Sainsbury plc Is Making Me Nervous

Is J Sainsbury plc (LON:SBRY) sailing blindly into a storm? Roland Head takes a closer look.

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Shares in J Sainsbury (LSE: SBRY) (NASDAQOTH: JSAIY.US) have risen by nearly 10% so far in November, and were unmoved by last week’s interim results.

I have to admit I was a bit surprised: in these results, Sainsbury admitted that 25% of its stores were too large, wrote down its property portfolio by £628m, and slashed its dividend.

Perhaps the market view was that this bad news was already in the price: personally, I’m not sure. Having looked carefully at last week’s results, Sainsbury is making me nervous.

Here’s why.

1. Price cuts that will hurt

I believe one of the big problems for Sainsbury is that its profit margins are already lower than those of its peers — and it is only just starting to make serious price cuts.

In last week’s results, Sainsbury reported an underlying operating margin on retail sales of 3.1%. Wm. Morrison Supermarkets, in contrast, reported an underlying operating margin of 2.7%, after already making a substantial investment in price cuts this year.

What’s most worrying is that Morrison’s underlying operating margin has fallen by 1.9% since this time last year. If Sainsbury’s operating margin falls by a similar amount, it would be just 1.2%: borderline unprofitable.

2. Blind faith

As it happens, Sainsbury is only planning to invest £150m in price cuts over the next 12 months– half the £300m being spent by Morrisons on price cuts this year.

Sainsbury’s management believes it can get away with smaller cuts because the store caters to a more upmarket customer base than Morrisons or Tesco: personally, I think this approach smacks of overconfidence, and could backfire horribly.

3. When will profits stop falling?

Although Sainsbury does now have a turnaround plan, the firm still expects profits to keep falling for the foreseeable future, despite the impact of continued new store openings.

What’s more, as Sainsbury’s chief executive Mike Coupe admitted in a call with analysts last week, we don’t yet know how Tesco’s turnaround plan will impact the supermarket sector.

The latest consensus forecasts show Sainsbury’s earnings per share falling by 18% this year, and by 11% next year.

In my view these figures may still be too optimistic: despite Sainsbury’s shares offering a theoretical yield of around 4% and being priced at book value, I think the risk of further losses is greater than the potential near-term gains, and rate the shares as no more than a hold.

Should you invest, the value of your investment may rise or fall and your capital is at risk. Before investing, your individual circumstances should be assessed. Consider taking independent financial advice.

Roland Head owns shares in Wm. Morrison Supermarkets and Tesco. The Motley Fool UK owns shares in Tesco. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.

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