With the price of food and non-alcoholic drinks rising by a whopping 16.4% in the 12 months to October 2022, FTSE 100 supermarket chains are in a pickle.
Sainsbury’s (LSE:SBRY) and Tesco’s (LSE:TSCO) have tried a number of strategies to keep prices down. They’ve used shrinkflation, installed more self-service checkouts, and even taken the butter out of ready meals.
After all, the FTSE 100 giants are cautious not to drive more customers through the automatic doors of discount retailers like Aldi and Lidl.
Interestingly, Sainsbury’s is trouncing Tesco’s in one little-discussed metric of cost control.
The beef with volatility
Supply chain disruptions caused by Covid-19 lockdowns and the Russian invasion of Ukraine have shown how volatile food prices can be.
Supermarkets can guard themselves against price swings by entering into financial derivative contracts.
Based on data for the year ending 2022, I find Sainsbury’s management team out-manoeuvred rivals at Tesco’s with these contracts.
| 2021/22 | |
| Sainsbury’s | (£, million) |
| Net fair value gains on inventory cash flow hedges | 73 |
| Retail sales | 29,463 |
| Inventory hedge gains as % of revenue | 0.25% |
| Tesco’s | |
| Net fair value gains on inventory cash flow hedges | 33 |
| Retail sales | 54,768 |
| Inventory hedge gain as % of revenue | 0.06% |
To give a simple example, if a supermarket wanted to protect against a carrot crop failure – perhaps caused by a plague of rabbits – the mechanism would be as follows.
The supermarket would agree with a counterparty to buy carrots at 40p per kilogram over a 12-month period.
If the actual cost of carrots ended up being higher than the hedged price, the supermarket would record a net fair value gain. Conversely, the supermarket could experience a net fair value loss if the actual cost of carrots were lower than the hedged price.
In 2021/22, Sainsbury’s reported a £73m net fair value gain on inventory cash flow hedges, equal to 0.25% of retail sales.
Feast your wallets
Is Sainsbury’s a good fit for my portfolio? Not at its current price.
The supermarket chain reported a free cash flow of £503m in 2021/22 for its retail segment, a touch below its three-year average of £633m. The company forecast its retail cash flow would hover around £500m for the coming years.
In October 2022, Sainsbury’s shares were trading for around seven times the company’s retail free cash flow.
Having since rallied by 56%, that ratio looks far less oversold at 13 times retail free cash flow. (A standard rule of thumb is to avoid anything above 10.)
Despite Sainsbury’s deft use of financial derivatives to guard against price rises, I think Aldi and Lidl pose a serious threat to its market share.
Sainsbury’s first-mover advantage allowed it to put its stores in prime locations and build brand loyalty. However, my experience as a customer tells me Lidl and Aldi offer much better value for money.
Over the longer term, I see Aldi and Lidl bagging more market share – and as the cost-of-living crisis bites, that process might just speed up.
