No-moat Sainsbury's (SBRY) second-quarter sales suggest that stabilisation in the U.K. grocery market may be in its early innings. Moreover, management indicated that profits would be modestly higher than consensus forecasts of around £650 million. After enduring multiple years of declining sales, contracting margins, and abysmal share price performance, investors welcomed positive news, and Sainsbury's shares increased by more than 10% following the release.
We believe that Sainsbury's is in a stronger position than its main rivals
We viewed shares as undervalued prior to this announcement, and believe the current market valuation better reflects the company's efforts to adjust to the evolving U.K. grocery market. We're planning a modest increase to our £2.70 fair value to reflect better near-term results, but believe investors may find other opportunities elsewhere in the space, such as with Tesco or Casino Guichard.
A core tenet of our long-term thesis on the U.K. grocery market has been that market conditions will normalize as the industry works through overcapacity, but that it could be a bumpy road to the new market equilibrium.
Sainsbury's comments give us confidence that our thesis is still intact, although we caution that rivalry could further intensify from current levels. Second-quarter like-for-like sales declined 1.1%, as deflationary pressures offset volume increases. However, this decline was a sequential improvement, and positive volume was encouraging.
Moreover, Sainsbury's move to everyday low prices makes it easier for the firm to predict demand, reducing stress on the supply chain and improving Sainsbury's in-stock position. These factors are leading to better-than expected profitability.
These results, along with the expected increases to the minimum wage--bringing it in line with the living wage--have investors more optimistic that we could see inflation in the U.K. grocery market for the first time in several quarters. In our base case, we expect modest declines in like-for-like sales during the next two years, but anything better than this expectation could bolster investor confidence and push share prices higher.
We assign Sainsbury's a medium uncertainty rating, because we believe that it is in a stronger position than its main rivals, but we still don’t assign the firm an economic moat. None of its major competitors has pricing power, as customer switching costs are virtually non-existent in the grocery industry. Moreover, the established U.K. grocers have enough regional scale to remain competitive with one another on cost and price. Overall, retailers don’t have many nonfinancial levers that they can pull to improve results.
