“Be fearful when others are greedy and greedy when others are fearful” is a well-known mantra from Warren Buffett. The Oracle of Omaha apparently forgot about it, though, when he sold his Tesco holdings some time ago, but does it apply now to Morrisons (LSE: MRW) and Sainsbury’s (LSE: SBRY)?
Their valuations have been stuck around their current levels since the end of 2014, and much of their fortunes hinge on whether investors will trust again the food retail sector as they did before fierce competition emerged domestically.
Unfortunately, competition brings news that doesn’t bode well for their shareholders.
In The News
“The Competition and Markets Authority (CMA) has criticised major supermarkets after a three-month probe, saying their pricing is ‘confusing’,” Sky News reported today.
In short, more clarity regarding their promotional offers is being sought — which essentially means more investment and lower returns for companies that need lower investment to deliver higher returns in order to attract new investors.
“The rate of UK Consumer Prices Index inflation fell to 0% in June, from 0.1% in May, official figures show,” the BBC reported earlier this week.
Food retailers are intent on cutting prices at a time when their customers carefully consider their options, and although the shares of Morrisons and Sainsbury’s are not incredibly expensive at 181p and 266p respectively, it’s hard to see how their shareholders could record meaningful returns unless consolidation takes place in the industry.
Morrisons: Not Much Fat On The Bone
Revenues will likely hover around £16bn and £16.5bn into 2018 and, assuming an operating margin of 3%, its underlying economic profits will stand at around £500m annually. Once its operating profit is taxed and interest costs are considered — and assuming no additional write-downs over the period plus a constant number of shares outstanding — its stock would trade on forward trading multiples in the region of 20x net earnings, which doesn’t strike me as being a particularly attractive valuation.
Morrisons has done better in recent months than in the past and it remains a restructuring story, but its new management team has a lot of work to do if it aims to preserve margins, earnings and its dividend policy.
Sainsbury’s: Too Big To Fail?
Sales are expected to come in between £23bn and £24bn over the next few years.
Assuming a forward operating margin in the region of 2.5%, its underlying economic income will come in at around £600m annually over the next three years. Once its taxes and interest costs are taken into account, Sainsbury’s stock would be cheaper than that of Morrisons — based on similar assumptions for write-downs and other elements — but not cheap enough to be considered a bargain.
That’s because its recent market share figures suggest that Sainsbury’s will continue to find it very difficult to compete not only with Morrisons, but with Tesco and its German rivals, too. Also consider that if more investment in their marketing campaigns is needed, their core margins — which historically stood about one percentage point higher — could come under more pressure. Under a worst-case scenario a cash call should not be ruled out, and that might be the reason why Mr Buffett abandoned his Tesco trade recording a huge loss on his investment at the end of 2014.
Such a big risk should be enough for you to avoid both names, but if you are hunting for value in other sectors, I urge you to consider the full potential offered by a few value investments whose prospects have been investigated by our team of analysts.
As opposed to food retailers, these companies trade low in spite of solid prospects for dividends, earnings and level of investment being required. It's easy to argue, for instance, that the shares of two defensive pharmaceutical and transport companies trade in bargain territory right now and could deliver outstanding returns over the medium term!
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Alessandro Pasetti has no position in any shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.