Why I won’t be buying shares in Sainsbury’s anytime soon

Sainsbury’s has been one of the better-performing Big Four supermarkets in recent years but the company still faces some enormous challenges.

Chief among these challenges is the changing nature of its customers’ shopping habits.

The way people shop is changing

In the good old pre-recession days, customers would mostly do a once-per-week Big Shop at their local supermarket, which suited Sainsbury’s, Tesco’s and the other big-name supermarkets just fine.

But the recession gave shoppers more spare time and less money, and the result was a switch to more frequent shops, both online and offline, targeted at a specific subset of the weekly shop:

• Branded and non-branded items – These can be bought more cheaply in different places; big supermarkets for the former and discounters for the latter
• Items that will be consumed almost immediately – Food-on-the-go like sandwiches can be picked up more easily at small high street convenience stores
• Massive growth in online grocery shopping – Big out-of-town supermarkets are even less relevant to a growing number of shoppers who shop online

All of this has driven down customer numbers for the big supermarkets as well as prices. The result for Sainsbury’s is revenues that have flatlined and earnings and dividends that are on the way down.

Slow growth and low profitability

Here are Sainsbury’s financial results compared against the wider UK stock market (represented by the FTSE 100):

• 10-Year growth rate = 3% (FTSE 100 = 1.6%)
• 10-Year growth quality = 63% (FTSE 100 = 42%)
• 10-Year profitability = 5.4% (FTSE 100 approx. 10%)

Looking at those stats (which you can calculate for any company here), Sainsbury’s is certainly not setting the world alight with its financial performance.

Its growth rate is barely better than inflation and given its position as a very mature company in a very mature sector, I doubt that future growth will be much better than inflation either.

Profitability (measured as the 10-year average of return on capital employed) is very weak. In fact, it’s so low that it breaks one of my rules of thumb:

• Only invest in a company if its 10-year profitability is above 7%

I use 7% as a cut-off for profitability because the expected rate of return on a FTSE 100 index tracker is about 7%.

If a company cannot consistently beat that rate of return on retained profits then those profits should instead be paid out to shareholders as a dividend to invest as they see fit.

As Sainsbury’s profitability is below 7%, my assumption is that shareholders would have been better off if the company had historically paid out more in dividends rather than using that cash for capital investments such as store refurbishments and new store openings.

Large capital investments generating low returns

Not only has Sainsbury’s produced low rates of return on its capital expenses, its capex requirements have also been huge.

Over the past decade, the company spent more than twice as much on capex (mostly store refurbishments, new store openings and supply chain improvements) as it generated in profits.

I call this ratio between 10-year capex and 10-year profits the capex ratio, and Sainsbury’s has a capex ratio of 212%. This also triggers one of my rule-of-thumb warnings:

• Be wary of companies that have a capex ratio of more than 100%

I will occasionally invest in companies that spend more on capex than they generate in profits, but they are often higher-risk investments.

That’s partly because capex can be a relatively fixed cost, but also because it means the company has to invest huge amounts of cash into capital assets in order to grow, and that makes growth much more difficult.

Large debts and pension liabilities

Another downside of Sainsbury’s as an investment is its large financial liabilities.

In the last five years, the company has generated about £0.5bn in post-tax profits while today the company has £2.4bn in borrowings and £7.6bn in defined benefit pension liabilities.

That gives the company the following financial liability ratios:

• Debt ratio = 4.7
• Pension ratio = 14.8
• Debt + pension ratio = 19.4

My related rules of thumb are:

• Only invest in a defensive company if its debt ratio is below 5
• Only invest in a company if its pension ratio is below 10
• Only invest in a company if its debt + pension ratio is below 10

Sainsbury’s debt level is quite close to the maximum that I’m comfortable with, but the real problem is its defined benefit pension scheme.

This is a recurring theme with many large and established UK companies such as Marks & Spencer which I reviewed recently.

Sainsbury’s pension scheme has a deficit of about £400m compared to the company’s average profits of £500m.

That deficit has been reduced from £650m in the last year or so after the company pumped £250m into the scheme in an effort to fix the problem.

And that is exactly why large defined benefit pension schemes are a risk; they have a nasty habit of falling into deficit.

Companies then have to reduce those deficits by pumping in huge amounts of cash, which usually comes either by raising additional debt or equity (which is what Sainsbury’s did) or by starving the company of capital investment or shareholders of dividends.

Home Retail Group: A massive impending acquisition

The icing on the cake in terms of reasons why I won’t be investing in Sainsbury’s is its decision to acquire Home Retail Group (the company behind Argos and HomeBase).

I’m sure the directors of Sainsbury’s know more about Home Retail Group than I do, but personally, I wouldn’t have touched it with a barge pole:

Generally speaking, I’m not a big fan of big acquisitions anyway, and this is definitely a big one. With Home Retail Group valued at £1.4bn, the acquisition is almost three times Sainsbury’s average profits of around £0.5bn, which flags up another of my rules of thumb:

• Be wary of companies that spend more on acquisitions than they make in profits

The problem with acquisitions is that the price paid is often excessive and the integration process can be lengthy, expensive and disruptive.

To make matters worse, Sainsbury’s expects to take on around £400m more in debt to fund the acquisition, which would push its debt ratio above my rule of thumb maximum of five.

So all in all, and irrespective of price, I don’t expect to see Sainsbury’s in my model portfolio anytime soon.