Description

Traditional grocers to see structural sales declines as consumer shift to lower priced discounters. As discounter’s cont. to gain share, we do not expect SBRY maintain market share while having a hold on margins. With Sainsbury having invested £110 mn in price in FY16 and seeing its outperformance vs. Tesco and Morrison narrow to its lowest level in five years, we believe a similar level of price investment will be required in FY17. Market continues to be deflationary (although less deflationary according to the numbers they posted), competitive environment is not easing, they will see cost inflation pressures going forward adding additional margin headwind. Again, Kantar had an under-read – becoming increasingly incorrect, however business is clearly deteriorating with –ve LFL’s although flat vs. Q2 last year. Does not have much self-help, remains worst positioned.

• SBRY may have some geographic protection from a direct ASDA move, but we believe it is the most vulnerable to the domino effect.
• An industry price restructuring in H2 2016 would be a particular problem for SBRY as it starts the Argos integration
• Fragile – most vulnerable of the 3 majors to a price war 
• It has a weak CF – made worse by a high leasehold content, which gives it high operational gearing, leaving it vulnerable to a margin squeeze
• It has a weak balance sheet – with no major assets it could sell
• It lacks scale compared to TSCO and ASDA
• It is losing sales momentum as its opening program slows
• Even without a price war Sainsbury’s long-term prospects seem concerning. It is hard to see where sales growth will come from given the slowing of the opening program, ongoing deflation and increased competition. It is harder to see where margin growth will come from, given the competitive environment, adverse differential inflation (where cost inflation is higher than selling inflation) and Tesco’s volume-driven turnaround. Cost-cutting can help short term, but with nearly 700M pounds of cost savings achieved in the last five years (an amount greater than last year’s retail profit, nearly 3% of sales and over 10% of Sainsbury’s total cost structure), it is fair to think further cost-cutting is limited long term. Weak sales, a margin under pressure, a weak cash flow and a dividend linked to do not make a compelling investment case.

Recent comments about how important pricing is are signs that the pricing war will continue for several years.

Management has said multiple times that the one big question that could hurt the entire market would be if Asda took down pricing by 10-15%; i.e. if Asda “pressed the red button similar to Morrison last year” and decided to take an aggressive stand to stop losing market share.  He also said Tesco or Morrison could try pricing moves downwards, but it would be at least 9 months before they did, b/c they’ve already taken down pricing so much and b/c they’re struggling so much across the board from a margin perspective.   He seemed pretty worried about the damage this would cause the industry and said that it would result in everyone having to take down pricing, perhaps even more than they have over the last 12-18 months.

2Q17 update

Sainsbury reported 2Q17 LFL sales growth of -1.1% vs. Bloomberg consensus -1.0%. Total sales growth of -0.4% is below consensus of +0.3%/0.0%. Sainsbury also reported Argos LFL sales growth of +2.3% for the 13 weeks to August 27 (as per Argos’ original 2Q reporting period), which is an acceleration from +0.1% in 1Q17 (on a 2-year stack (-0.5% vs. -3.8% in 1Q17).

For Sainsbury’s core business this is a deceleration from 1Q (LFL sales growth of -0.8%), though on a 2-year stack there is an improvement to - 2.2% from -2.8%. This is the 3rd consecutive period where SBRY has underperformed vs. Morrisons and, we forecast, Tesco, on a LFL basis. Previously, this had not happened for 5 years. This indicates to us that the investments MRW and TSCO have made have closed the performance gap with SBRY and underpins our belief that SBRY will need to reinvest in margins to drive LFL growth (SBRY retail FY16 EBITDAR margin 7.6%; Tesco UK 5.7%, MRW 5.5%). We also note that SBRY does not say they had LFL volume growth in 2Q. This means LFL deflation in 2Q was at most -1.1%, which we believe means SBRY is investing less in price than the market. Argos’s sequential improvement is a positive surprise and may alleviate concerns about a Brexit-related slowdown. However, it does exclude September when retail sales look to have slowed. We will look for comments on how much price inflation has driven the LFL as an indicator of whether FX-related cost increases will be passed to the consumer.

The SBRY numbers are consistent with our view that margin investment will be required to drive LFL growth. Key questions remain about Argos’ profitability with a post-Brexit £:$ FX rate.

3Q17 update

Sainsbury reported 1H17 Group EBIT of £377mn (margin: 2.7%), +1% ahead of Bloomberg consensus. Underlying PBT was £277mn, 2% below consensus.

Sainsbury states that the market remains competitive and pricing pressures continue to impact margins. Pension: the new triennial pension deficit for SBRY is £740mn (£592mn) and Home Retail £315mn (£157mn). Total annual top up payments are £126mn.

Guide - 1) FY17 Group underlying PBT (including Argos) in line with consensus, stated as £573mn. 2) 2H17 underlying PBT (excluding Argos) to be lower than 1H17 due to continued price investment and a step up in cost inflation. 3) Argos expected to contribute £55mn-£75mn to underlying Group PBT in 2H17. 4) FY17 net debt to be c£1.5bn.

Latest Kantar Data Supports the thesis:

October-

In the four weeks to October 9, 2016, the grocery market grew +0.2% vs +1.0% in the prior period and below +0.4% YTD.

Deflation: For the 12-week period, deflation eased to -0.8% from -1.1%. Discounters: Aldi and Lidl took 79 bp of market share vs 96 bp in the prior

period and 113 bp in 2016 YTD. Despite this sequential slowdown, their combined market share reached an all-time high of 10.9%.

• Sainsbury’s total till roll sales improved to -0.2% (-1.1% in the prior period), with market share losses of -6 bp (-34 bp). On a two-year stack, growth saw a slight slowdown to +0.8% (+1.1%). Implied LFL remained negative at -0.9% (-2.2%).

The overall implied volume slowdown in the market indicates that we are not in recovery mode, and wait for ONS inflation data to see if food is becoming less deflationary.

September–

• No big change in relative performances of the grocers, with market growth of +1.0% vs. 1.1% in the prior period, and deflation easing -1.1% vs. -1.3% in the prior period
• Input costs are however clearly inflationary based on official data (food PPI for July 16 stood at +1.0% and at +1.9% for August), suggest gross margin pressures for the UK grocers
• SBRY sales decline of -1.1% vs. 0.2% in August vs. 2.2% Sept. 2015
• SBRY saw market share declines of -34bps vs. -14bps August

August–

In the four weeks to August 14, 2016, the grocery market grew +1.1%, a marked acceleration vs. -1.1% in the prior period and an improvement on the +0.5% YTD.

Deflation: For the 12-week period, deflation eased to -1.3% vs. -1.4% in the prior two periods.

Sainsbury’s sales were +0.2% (-3.0% in the prior period), with market share declines of -14 bp (-32 bp in the prior period). On a 2-year stack, growth saw a recovery to +0.3% (-2.6%). Implied LFL remained negative at -0.9% (-4.1%).

Input cost inflation –

Rising input costs mean Big 4 likely need to choose between margins and market share

Food input costs were up over 10% in September, the type of rise that has historically led to food inflation of over 5% for the UK consumer (Food CPI). However, we are skeptical as to whether the UK grocers will even try to pass through this level of inflation. The last time UK consumers were asked to pay price rises over 5%, in 2011, this marked the start of a 5-year period, where the big 4 grocers lost a total of 526 bp of market share, while Aldi and Lidl gained 520 bp. Given that the operating margins of the 3 largest listed grocers fell from an average of 4.9% to 2.4% over this period we think there is clear risk that the UK grocers have to absorb some input cost inflation to prevent prices rising too quickly. For every 100 bp of input costs that are not passed through to consumers, we estimate EBIT margins will fall by c.70-75 bp.

Consistent food inflation at lower levels (sub 2%) is generally a positive for food retailers as it allows price rises to offset operating cost increases and does not surprise the consumer, or drive a change in shopping habits. However, when food inflation has moved outside of a -1% to +2% range over the last 15 years, adj. for population growth, there has been a volume response above 0.3x inflation levels. At lower inflation levels (-1% to+2%) there does not seem to be a volume impact. But above 2% we can see a clear volume response.

This behavioral change is key because although total sector volumes tend to only fall slightly in periods of high food inflation, since 2011, the last time food inflation went over 5%, the discounters had gained over 520 bp of market share (to end 2011). More importantly, even excluding the dramatic volume declines seen recently at Asda, the listed 3 saw annual volume declines for over 5 years straight until the end of 2015 (UK LFLs less price inflation per Grocer Price Index). Thus we believe grocery consumers are much more price elastic at higher levels of inflation than headline data would suggest.

As a result, we believe grocers will be unwilling to unilaterally pass price inflation through at the >5% levels implied by input cost pressures, which makes us believe there is a risk of margin pressure resulting from withholding input costs from the consumer to protect market share and volume growth.

Conclusion –

Whether or not the HRG transaction even works out, the performance of the core biz is the center of the investment case – the fact that the company expects y/y margin pressure to sequentially worsen in 2H after three halves in which the pressure has lessened is a concern in my opinion. Difficult to become positive when LFL sales growth is lagging peers and its margins are falling at an accelerating rate – even the stock might appear “cheap”. It is possible that momentum might improve in 2017 as the negative LFL’s sales impact from the elimination of multibuys will annualize and the next financial year should bring faster cost savings – but it feels sensible to wait for more evidence.

Catalyst

Earnings