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Why the Sainsbury share price rose by 31.5% in the first half of 2018

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After a slump lasting more than four years, the share price of supermarket group J Sainsbury (LSE: SBRY) has finally come to life.

The first six months of this year saw Sainsbury’s share price climb 31.5%, during a period when the FTSE 100 index has gone pretty much nowhere.

But although the group’s full-year results at the end of April showed that underlying pre-tax profit rose by 1.4% to £589m, what got investors hot under the collar was news of a plan to combine its business with Asda.

This combination would create a group with annual revenues of £51bn, big enough to rival Tesco, which reported revenue of £57.5bn last year. And because Sainsbury’s management has already integrated the Argos business successfully, investors are prepared to believe that this much bigger project could succeed.

Why is such a big deal necessary?

Many investors — including me — thought that the acquisition of Argos was all that Sainsbury needed to solve the problems caused by having too many large stores. By shutting Argos branches and moving them in store, it could increase sales per square foot and boost profits.

Sales figures suggest that the integration of Argos has been successful. Group retail sales rose by 8.2% last year. But there are still a couple of problems.

The first of these is that Argos has lower profit margins than Sainsbury’s core supermarket business. This means that while Argos has boosted Sainsbury’s total sales, it’s reduced its profit margins.

The combined group’s underlying retail operating margin fell from 2.4% to 2.2% last year. Although that may seem like a small reduction, it meant that underlying operating profit fell slightly despite the rise in sales.

The second problem is that Sainsbury’s annual sales are only about half those of Tesco. This means the orange-topped supermarket doesn’t have the buying power of its larger rival. Despite this, it’s been forced to cut prices to compete with lower-cost rivals.

The only logical solution to this problem was to merge with another supermarket group.

The numbers that really matter

The two supermarkets plan to keep trading under their own brands. No store closures are planned at the moment, but Sainsbury believes it will be able to make cost savings of “at least £500m”.

The majority of these savings will come from having greater negotiating power with suppliers. As a result, the group plans to cut prices by around 10% on many popular products, which should be popular with customers.

How will investors benefit?

According to information provided by Sainsbury, Asda generated an operating profit of £720m on £22.2bn of sales in 2017. That’s equivalent to an operating margin of 3.2%, significantly higher than the Sainsbury figure of 2.2%.

One reason for Asda’s higher margins is that around 75% of its store estate is owned freehold, compared to 50% for Sainsbury. So Asda’s rent bill is lower than Sainsbury’s.

So even without any cost savings, the combined group should have a higher profit margin. Cash generation should also be stronger, supporting debt repayments.

What’s it going to cost?

Asda’s US parent Wal-Mart will own 42% of the combined group. The US giant will also receive £2,975m of cash from Sainsbury, valuing Asda at about £7.3bn.

In this month’s trading update, Sainsbury confirmed that it has agreed a £3.5bn financing package for the Asda deal. Assuming this is all used, I estimate that this will leave the combined group with net debt of close to £5bn. This looks manageable to me.

My verdict

Fellow Fool Royston Wild thinks that the Asda deal could be risky. I’m a bit more optimistic. Asda’s chief executive, Roger Burnley, spent 10 years working at Sainsbury, so he knows both businesses well. I think there’s a good chance that Sainsbury could make a success of this deal, if it’s approved by the competition authorities.

What I’m less sure about is whether Sainsbury’s shares are good value at current levels.

The combined business should be more profitable than either company was on its own. But I’m not sure how quickly this will happen, or how much improvement we’ll see. I’m tempted to wait until we know more about the combined group’s financials before deciding whether to invest.

A more profitable alternative

Supermarkets are under constant price pressure, essentially because they all sell the same products. That’s not true for companies such as consumer goods giant Unilever (LSE: ULVR), which sell branded products that attract strong consumer loyalty.

The differences are fairly marked — whereas Sainsbury reported an operating margin of 2.2% last year, the equivalent figure for Unilever was 17.5%.

Both groups carry some debt, but Unilever’s free cash flow represented 10% of its annual sales. Sainsbury’s free cash flow was just 1.4% of its annual sales. This suggests that Unilever has a much greater ability to repay debt or return extra cash to shareholders.

However, I believe the best test of long-term profitability for businesses of this kind is to compare the returns they generate on capital employed. Known as ROCE, this ratio compares profits with the capital invested in the business.

Sainsbury generated a return on capital employed of just 4.4% last year, after exceptional costs. The equivalent figure for Unilever was 21.8%. This means that for every £1,000 Unilever invested in its business, it generated a profit of £218.

The value of Unilever’s portfolio of brands is that it gives the company a defensive moat. People want to buy these specific products, not a generic alternative.

Should you buy Unilever?

Unilever stock usually looks expensive. The shares currently trade on about 21 times 2018 forecast earnings, with an expected dividend yield of 3.2%.

This may not seem cheap, but the group’s ability to generate high returns and invest this cash in new growth has served investors well. The shares have doubled since 2011, during a period when Sainsbury’s share price has pretty much stood still.

I’d be happy to add Unilever shares to a long-term income portfolio today.

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Roland Head has no position in any of the shares mentioned. The Motley Fool UK owns shares of and has recommended Unilever. The Motley Fool UK has recommended Tesco. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.