Should smart investors buy Tesco plc and sell J Sainsbury plc?

If you’re looking for good value and a reliable dividend income, J Sainsbury (LSE: SBRY) might seem more attractive than Tesco (LSE: SBRY). But before you plunge your remaining savings into the orange-topped supermarket, I think it’s worth considering a different view.

Tesco and Sainsbury are currently travelling in very different directions. Tesco is pulling back hard from its attempts at diversification. Instead, the group is focusing on being the biggest and best grocery retailer in the UK.

Sainsbury is heading the opposite direction. The group’s £1.4bn acquisition of Home Retail Group completed on Friday, marking a major shift in strategy towards non-food sales. Sainsbury has already announced plans to more than double the number of Argos concessions in stores by Christmas, while also beginning trials of a small-format Habitat concession in some stores.

Sainsbury could succeed

For both Sainsbury and Tesco, the move into banking has been a success. Home Retail’s financial services arm — which allows Argos customers to buy on credit — will add about £600m of loans to the Sainsbury’s Bank loan book. These should help to launch the next phase of the bank’s expansion.

Sainsbury’s plan to close down standalone Argos stores and move them into supermarkets could also work well, cutting rent costs and boosting profit margins for both groups.

What could go wrong?

Sainsbury estimates that in three years from now, the Home Retail deal will deliver an extra £160m of earnings before interest, tax, depreciation and amortisation. That would be a worthwhile gain, but it won’t come cheap.

Over the next three years, Sainsbury expects to spend £130m on “the realisation of the identified synergies” plus a further £140m on store fit-outs. That’s a total of £270m, in order to generate an extra £160m per year of earnings.

In my view, there’s a risk that the Argos acquisition won’t generate enough of a profit boost to justify the ongoing outlay. Argos sales from stores located within Sainsbury may be lower than from standalone stores. And costs could be higher than expected, due to the greater complexity of the combined businesses.

Tesco is simplifying

Tesco’s focused and disciplined turnaround appears to be returning the business to its core strengths. The group remains by far the UK’s largest supermarket, with a 28% share of the market, versus 16% for Sainsbury.

Tesco’s UK like-for-like sales rose by 0.3% during the first quarter, despite continued price cuts. Sainsbury’s like-for-like sales were down by 0.8% over the same period.

While Tesco shares look expensive on 25 times 2016/17 forecast earnings, the group’s sales momentum looks increasingly strong. Earnings per share are expected to rise by 40% next year, bringing the stock’s forecast P/E down to a more reasonable 18.

In contrast, Sainsbury’s earnings per share are expected to be largely flat next year, thanks to the dilutive effect of the shares issued as part of the Home Retail acquisition.

Today’s top buy?

Sainsbury shares currently trade on a forecast P/E of 12 and offer a forward yield of 4.3%. This sounds attractive, but I think the group’s low valuation is partly a reflection of the risk involved in the Home Retail deal.

I remain a Tesco shareholder, and rate the stock as a long-term buy at current levels.

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Roland Head owns shares of Tesco. 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.