When I think of UK supermarket operator J Sainsbury (LSE: SBRY) (NASDAQOTH: JSAIY.US), two factors jump out at me as the firm’s greatest weaknesses and top the list of what makes the company less attractive as an investment proposition.
1) Intense competition
If you were starting a business from scratch, you might be tempted to do so in the food sector as, generally, food is the very definition of a consumable product, which means people buy it, they use it up, and they buy it again over and over. Repeat-purchase qualities promise consistent cash flow, which is an attractive proposition for any entrepreneurial ambitions.
However, because of the obvious benefits of operating in the food sector, the food-retailing space is extremely crowded. Think of the choice we have for our weekly and top-up food shopping. Chances are the majority of Britain’s population is within striking distance of more than one food-retail brand. For me, there’s a fag-paper’s distance between shopping at Sainsbury’s, Tesco, Morrisons, Aldi, Lidl, Co-op, Marks & Spencer or any number of smaller food-retaining enterprises.
So, if we choose retailing rather than production for our hypothetical food-space business, we are limited to a retail mark-up on cost from which to generate a profit margin. As such, food retailers like Sainsbury become something of a commodity style business proposition characterised by very little pricing power and a great deal of competition.
2) Low margins
Such competition puts the squeeze on already thin margins. It’s true that the supermarket sector enjoys high volumes due to the vast national demand for food staples. However, the downside is that generating wafer-thin margins in the sector takes a huge logistical effort. Before tipping the financial spreadsheets from red to black, supermarkets such as Sainsbury’s have to first record massive costs run up by handling huge volumes of goods.
Big numbers for revenue and costs don’t have to shift very far to affect the ‘little’ numbers for profit that they throw out: there’s huge potential for something to go wrong. A policy gaff could soon wipe the smile off profits and that’s what we’ve seen lately with some of Sainsbury’s big competitors. So far Sainsbury’s has performed well, but a low margin brings risk.
What now?
Despite such concerns, Sainsbury’s forward dividend yield of about 5.4% looks attractive.
