Sainsbury's (SBRY) was the leading U.K. grocer until the mid-Nineties, but Tesco and Asda – which is now owned by Wal-Mart – garnered scale by building out store concepts and better articulating value propositions, and both of these firms now lead the market ahead of Sainsbury. We think Sainsbury has enough scale to remain reasonably competitive on price, but we don't believe it possesses a cost advantage relative to other market leaders.
Despite challenges, Sainsbury is well positioned to capture incremental share
Moreover, switching costs are virtually nonexistent in the grocery industry, and it's not clear that Sainsbury's points of differentiation are strong enough to ensure that excess returns on capital can be sustained over the long term. As such, we do not assign Sainsbury an economic moat.
The U.K. grocery industry is highly consolidated, with Tesco, Asda, Sainsbury, and Morrisons controlling a large portion of this £170 billion market. The industry is also extremely competitive, and rivalry has intensified over the past few years. Most firms spent the better part of the past decade increasing square footage to drive sales growth, but these investments failed to produce expected returns once the global economy began slowing and consumers started spending more money in alternative channels – namely convenience, online, and discount channels.
In response to the evolving market environment, many firms have reduced square footage growth plans, opting to invest more money in higher-margin, faster-growing convenience store formats and online capabilities. Despite numerous challenges, Sainsbury is well positioned to capture incremental share in the faster-growing convenience store channel, in our view.
The company increased its convenience store base by more than 60% over the past five years, operating more than 700 stores at the end of fiscal 2015, and we still see a long runway for growth, since we estimate Sainsbury's store count represents only 1% of convenience stores.
Returns on capital could also improve, given that c-stores tend to be higher margin and consumers shopping in multiple channels tend to spend much more than those shopping in supermarkets alone.
Why We Are Downgrading Sainsbury Shares
We are lowering our fair value estimate to £2.70 per share from £2.95 as we have lowered our near- and medium-term sales growth and margin assumptions. Our fair value estimate implies forward price/earnings of 12 times, enterprise value/earnings before tax of 6 times, and a free cash flow yield of 7%.
We expect Sainsbury to increase its total square footage by a low- to mid-single-digit percentage, annually over the next 10 years, with a majority of the growth driven by convenience store expansion. Elevated capital expenditure levels, associated with convenience store expansion, weigh on near-term cash flow projections, but we expect free cash flow to increase over the medium term as capital expenditures moderate and revenue from new stores comes on line.
We also project low-single-digit like-for-like sales growth over the next decade, incorporating inflation and a modest increase in volume, and we believe Sainsbury has enough scale to maintain an operating margin around 3% over the next 10 years, which is below its historical average of 3.5%-4% and our previous forecasts.
