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Is the Sainsbury’s share price unfairly beaten down?

It has been a rough ride for shareholders of J Sainsbury (LSE: SBRY) over the last 12 months. The stock is down almost 39% year-on-year, due to the collapse of the Asda merger plan, as well as the ongoing pressure on the retail sector as a whole from Brexit. Has the market overreacted, or does this lower price represent a fair valuation? Let’s dig in.

Recent developments

Sainsbury’s is currently the second-biggest supermarket chain in the UK (splitting second place with Asda). Its market share has declined markedly over the last few years, and it risks slipping into third spot. The Sainsbury’s-Asda merger, which would have made the resulting company the largest supermarket in Britain, was promoted by management as a way of driving down costs. But it was blocked by the Competition and Markets authority back in April when the watchdog decided it would lead to a “substantial lessening of competition at both a national and local level”.

What is the problem?

A major issue for all shopping chains has been growing competition from low-cost chains Aldi and Lidl. However, in comparative terms, Sainsbury’s has lost a far larger proportion of its market share to the discounters than the rest of the Big Four. Brick-and-mortar retail shopping is a famously low-margin business, but Sainsbury’s margins are low even for this tight industry – last year they came in at just 1.1%.

Is it cheap?

With all that being said: is Sainsbury’s fairly valued? It trades at a current P/E ratio of 9.35, which is a significant discount to its historical average of almost 14. The difficult question for would-be bargain hunters with this stock is whether the current ratio represents a temporary deviation from the mean, or whether it’s the new normal. Personally, I think it’s more likely to be the latter than the former. Competition in the industry is fierce, as evidenced by those low margins.

The only way to beat the competition is to lower costs. Originally, Sainsbury had hoped to do so via the cost synergies that it would have reaped from the merger, but without the deal, it has had to fall back on reducing capital expenditures in order to cut costs, a decidedly less appealing proposition. In the long term, reducing capex can only lead to further erosion of market share, which will drive costs higher.

What about income? Shares of Sainsbury’s currently have a dividend yield of 5.6%, making it a somewhat attractive buy based on yield alone. But the real question is whether cash flows will be sufficient to cover the dividend. Free cash flow has risen over the last few years (£296m in 2016, £345m in 2017 and £432m in 2018), which suggests the dividend is safe for now. But as the increases have come primarily from cuts to capex, I once again question whether the policy is sustainable long-term. In my opinion, with the direction that the retail industry as a whole is taking, there would have to be a significant catalyst for investors to change their opinion on this stock. For now, I’m staying away.

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Stepan Lavrouk has no positions in any shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. 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.