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Is A Profit Warning Around The Corner At Tesco PLC & J Sainsbury plc?

A profit warning would be a big blow for Tesco (LSE: TSCO) and Sainsbury’s (LSE: SBRY), but just how likely is that? 

No Signs Of Recovery

Wal-Mart’s British supermarket chain Asda slumped to its worst quarterly sales performance in the 16 years it has been owned by the U.S. group, with results on Tuesday highlighting its struggles in the face of an onslaught from the discounters,” Reuters reported this week. 

There are no “signs of green shoots“, according to chief executive Andy Clarke. 

The fundamental problem at the big four in the food retail world is that promotions should be aimed at winning back market share from their German rivals, but it looks like a price war is the most obvious outcome — and this could be a long war game indeed. 

Financials

Sainsbury’s is informally guiding the market to £650m of operating income (Ebit) this year, which is about £150m below the level that the grocer recorded last year, for an implied Ebit margin of 2.7%. Just like at Tesco, there’s limited room for error. 

That level of core profitability should yield earnings per share of about 20p on a statutory basis, but the drop in Sainsbury’s annual EPS could be more painful if sales declines persist and additional price investment is required to preserve market share rather than to win back customers.

Things aren’t much different at Tesco, whose core pre-tax income margin stands at about 2%. 

We said we had an aspiration to get to a level of (trading) profit of £1.4bn for this year,” chief executive Dave Lewis said in a follow-up call with analysts when first-quarter results were announced. 

Tesco has not issued a firm guidance for its fiscal year 2016, but investors expect its operating income to hover around £1.3bn (low estimate $1bn; high estimate £1.4bn), which should yield annual EPS in the region of 8p, although EPS could halve to 4p if the bears are right. Furthermore, if a worst-case scenario plays out, a zero dividend policy becomes a distinct possibility. 

Recent news is less encouraging for the bulls, but it’s possible that a nightmare scenario is already priced into the shares of both Tesco and Sainsbury’s, at least based on the fair value of their assets, in my view — yet big risks remain. 

Stats

The Office for National Statistics (ONS) said on Thursday that “year-on-year estimates of the quantity bought in the retail industry grew for the 28th consecutive month in July 2015,” up 4.2% compared with July 2014.

This was the longest period of sustained year-on-year growth since May 2008, BUT increases “reported by department stores, other stores, household goods stores and non-store retailing (were) offset by falls in predominantly food stores, textile, clothing and footwear stores and petrol stations.

Well, trends are not good.

Also consider this: the value of online sales, which are important for future growth at both food retailers, increased by 13% in July 2015 compared with July 2014, yet there was no growth at all in July 2015 compared with June 2015. 

Finally, there’s talk that food retailers may invest more in their supply chains to pursue a deeper level of vertical integration, which would help them promote and sell private-label goods, hence preserving margins. 

I doubt that’s a solution, given the favourable terms that most food retailers enjoy with their suppliers. 

Considering all this, it is clear that there are other opportunities in this market. 

Give a look to this list of 10 value plays, many of which have recorded performances in the region of 100%-200% in recent times, for instance!

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Alessandro Pasetti has no position in any shares mentioned. The Motley Fool UK owns shares of 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.