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Why I’d buy more of FTSE 100 dividend knockout J Sainsbury plc

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Supermarket group J Sainsbury (LSE: SBRY) divided opinion when it acquired Argos owner Home Retail Group last year.

Although the firm’s plan to cut costs and boost sales by shifting Argos units into its supermarkets made sense, the group’s goal of becoming a one-stop shop for almost everything wasn’t without risk. Diversification can often lead to falling profitability and a loss of focus.

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Too soon to say?

Today’s interim results suggest to me that the plan may be working, but that it’s too soon to be certain. Total sales rose by 17% to £16.3bn during the half year, thanks to the addition of Argos sales.

Like-for-like sales — a more meaningful measure — rose by 1.6% compared to the same period last year, excluding fuel. Drilling down in more detail, it seems that grocery sales slowed during the second quarter, rising by 1.4% versus 3% during the first quarter. However, clothing sales have performed well, gaining 6.8% during the half year.

Early indications are that moving Argos stores into supermarkets is working well. Sainsbury said that stores with an Argos branch tend to see an increase in total sales of 1-2%. And of course the group no longer has to pay the lease costs associated with the standalone Argos store.

Once Argos is in-store, it seems to become more popular with customers. During the first half, like-for-like sales rose by around 20% at the 15 Argos stores which have been in supermarkets for more than a year.

Profits are down

However, during the six months to 30 September, Sainsbury’s underlying pre-tax profit fell by 9% to £251m. This hit the group’s underlying operating margin, which fell from 2.5% to 1.9%. But this profit figure was in line with broker forecasts, and was the result of price cutting, wage increases and the consolidation of Argos’s H1 loss.

Although the group’s underlying earnings per share fell by a worrying 22% to 8.7p, this larger decline was due to the dilution caused by the issue of new shares to Home Retail shareholders.

It’s important to note that the Argos business has a seasonal bias — the group’s sales and profits are expected to be much higher in H2, which includes Christmas. Although today’s figures might seem poor, Sainsbury’s management says that their expectations for full-year profit are unchanged.

Strong cash generation

In my opinion, one of the highlights of today’s results was the cash flow statement. Underlying free cash flow rose to £494m during the first half, compared to £420m last year.

I estimate that Sainsbury’s shares now trade on an underlying price/free cash flow ratio of 8.1 for the last 12 months. That’s very cheap and suggests to me that benefits from cost cutting and tighter control of spending are now becoming apparent.

My view is at odds with many of my Foolish colleagues, but I believe the supermarket group’s transformation is going to plan. The shares currently trade on a forecast P/E of 12, with a prospective yield of 4.3%. With earnings per share forecast to rise by 10% next year, I plan to continue holding.

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Roland Head owns shares of J Sainsbury. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

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