Why J Sainsbury plc Could Outperform Tesco PLC This Year

Shares in the UK’s largest retailer, Tesco (LSE: TSCO) have been on a roll this year as confidence grows that the company’s turnaround plan is finally starting to yield results.

Indeed, year-to-date Tesco’s shares are up by 28%, outperforming the wider FTSE 100 by a staggering 29% excluding dividends.

However, Tesco’s impressive performance this year hasn’t filtered through to the company’s peers. For example, shares in Sainsbury (LSE: SBRY) have only gained 12% year-to-date, but now that the company has finalised its bid for Home Retail, this performance could be about to change.

Bigger and better

Sainsbury’s initial bid for Home Retail surprised the market, and a number of the company’s shareholders instantly announced their lack of support for the deal.

But by merging with Home Retail, Sainsbury’s will become a £6bn general merchandise business – larger than that of Marks & Spencer or John Lewis. The deal will also help Sainsbury’s fill under-used space within its stores by bringing more Argos outlets into its supermarkets, reducing costs and improving earnings per square foot. Management is targeting £160m of cost savings and wants to bring 55% of Argos outlets into a Sainsbury’s.

And Sainsbury’s plan to integrate with Home Retail may help the company achieve something Tesco has been struggling to do for a long time, drive footfall into vast superstores by bringing in other businesses. Tesco has acquired businesses such as restaurant chain Giraffe and coffee chain Harris & Hoole, but both are still heavily lossmaking for the company.

There are some concerns that Sainsbury’s will have the same issues with Home Retail. Argos sales are coming under pressure from online consumer internet plays like Amazon, and it’s hardly the destination of choice for kids to spend their pocket money anymore.

Still, the existing Argos-Sainsbury’s network has already seen some success, and it appears that management is betting on the continued success of this network. Moreover, Sainsbury’s Bank acquired the Argos consumer loan book as part of the buyout, a raft of new customers to sell products to, as well as picking up the interest on the existing loans.

Valuation is key

If Sainsbury’s can successfully integrate Home Retail, the company’s earnings will almost certainly benefit. However, it seems as if the market doesn’t have any confidence in the company’s ability to complete the merger successfully. Sainsbury’s currently trades at a forward P/E of 12.5 and yields 3.9%. In comparison, shares in Tesco trade at a forward P/E of 40.2 and yield only 0.2%.

Overall then, Tesco may have outperformed over the past three months but after recent gains, the company’s shares are trading at a premium to peers. Meanwhile, Sainsbury’s shares are trading at an attractive valuation, and if the company successfully integrates Home Retail, earnings should grind steadily higher, which will drive a rerating of the shares. 

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Rupert Hargreaves 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.