Shareholders in J Sainsbury (LSE: SBRY) shouldn’t feel too smug: although this week’s final results made surprisingly pleasant reading, the current supermarket price war has only just begun. I’m fairly confident that Sainsbury’s will eventually be dragged into the fray, sooner or later.
Despite a 5.3% increase in underlying pre-tax profits last year, I believe Sainsbury’s biggest weakness lies in its profit margins, which are already much lower than those of its two UK-listed peers, Tesco (LSE: TSCO) and Wm. Morrison Supermarkets (LSE: MRW).
Although I don’t expect Sainsbury’s to experience a Morrisons-style slump, I believe shareholders should watch these three key indicators this year, each of which could provide early warning of falling profits.
1. Like-for-like sales
Sainsburys reported a 2.7% increase in sales last year, but only a 0.2% increase in like-for-like sales, which exclude new shops, and look at the change in sales at stores which have been open for at least one year.
Sainsbury’s like-for-like sales fell by 3.8% during the final quarter of last year — if this rate of decline continues, then I believe Sainsburys will be forced to enter the price war and start slashing prices. This could be painful, as I explain below.
2. Operating margin
For many years, one of Sainsbury’s most consistent weaknesses has been its operating margin, and this is the one problem outgoing CEO Justin King has failed to fix.
Sainsbury’s underlying operating margin rose slightly to 3.65% last year, but this was mainly thanks to a £120m round of cost-cutting, and still compares poorly to Tesco (5.0%, UK) and Morrisons (4.9%).
Sainsbury’s is planning to reduce costs by a further £120m-£130m this year, but if the slide in sales seen in the fourth quarter of last year continues, and Sainsbury’s is forced to start cutting its prices, the firm’s fragile operating margins could come under pressure.
3. Gearing
There’s no doubt that Sainsbury’s scores highly in the debt department.
Despite a small rise in net debt last year, to complete the acquisition of Sainsbury’s Bank from Lloyds Banking Group, Sainsbury’s gearing remains lower than any of its peers, at 39.7% — compared to 52% for Tesco, and 59% for Morrisons.
If Sainsbury’s profits start to fall this year, it could be forced to increase its borrowings to complete its capital expenditure commitments. This would be bad news, in my view, and would erode one of the firm’s strongest financial advantages.