J Sainsbury (LSE: SBRY) has been the top supermarket performer on the stock exchange this year, gaining nearly 30%. That’s about three times more than Morrisons (+9%) and a lot better than Tesco (-5%).
If you follow the investment rule that says you should back winners and cut losers, then you’d probably back Sainsbury for further gains. Today I want to take a closer look at the firm’s latest figures to see how well this view holds up.
Is bigger really better?
One problem facing management was that many of its stores were too big. Acquiring Argos has helped to solve this problem. By the end of September, there were more than 250 Argos stores inside supermarkets. These have increased Sainsbury’s sales per square foot and enabled the group to save money by closing standalone Argos stores.
The company says that combining the two businesses has already generated savings of £150m. But it hasn’t solved a key problem. Argos is a very low-margin business, as it faces tough competition on price from the big online retailers.
Since acquiring Argos in 2016, Sainsbury’s operating margin has fallen from 3% to 1.3%. In order to try and reverse this decline, chief executive Mike Coupe is now hoping to seal another big merger deal.
What about Asda?
Mr Coupe now wants to combine Sainsbury’s with Asda. The scale of this deal is much greater and it seems fair to assume the combined group would enjoy significant economies of scale.
However, the final shape of the deal could change, depending on the findings of the Competition and Markets Authority. Even if it’s approved, combining two such large and overlapping businesses won’t be easy.
Given these risks, Sainsbury’s stock looks expensive to me on 15 times 2019/20 forecast earnings. In contrast, Tesco stock is available on a 2019/20 forecast P/E of just 12, with a similar forecast yield of 3.8%. I think that the bigger supermarket is a better buy.
This bombed-out business looks cheap
Online competition is a big problem for many traditional retailers. It’s certainly one of the issues faced by Pets at Home Group (LSE: PETS), which aims to offer a complete range of pet supplies and vet services from its network of large stores.
Pets’ share price has fallen by 40% over the last two years, as it’s struggled with falling profit margins. Back in 2015, the group reported an operating margin of 13.3%. That figure is now down to just 5.4%.
In fairness, this margin rises to 9.6% if you ignore £39m of one-off costs relating to the restructuring of the group’s in-store vet business. But there’s no doubt that having to price match big online retailers on staple pet supplies has hurt the group’s profit margins.
A turnaround buy?
It would be easy to dismiss this as a business that’s going nowhere. But it’s worth noting that even now, Pets is more profitable than any regular supermarket. Free cash flow is also strong and sales continue to grow — like-for-like retail sales rose by 4.7% during the first half, while vet practice revenues increased by 15.4%.
Chief executive Peter Pritchard believes he can return the group to profit growth by reshaping the vet business. He’s also pledged to maintain the 7.5p dividend.
The shares now trade on 9.3 times forward earnings with a 6% dividend yield. I’d rate Pets at Home as a buy at this level.
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Roland Head has no position in any of the shares mentioned. 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.