Sainsbury’s (LON:SBRY) has a rather strange growth strategy, given the outlook for the UK economy. Its purchase of Home Retail Group mans that it is becoming less defensive and more cyclical at a time when real disposable incomes seem certain to come under pressure.
A mix of higher inflation and uncertainty regarding the economic outlook should mean that consumers delay or avoid sales of products which Argos typically sells. Therefore, Sainsbury’s may struggle to make the acquisition work.
In fact, I believe that Sainsbury’s is doing what Tesco did a handful of years ago, but on a smaller scale. Tesco attempted to diversify and cross-sell, while taking its eye off the ball when it came to the grocery market.
I fear that Sainsbury’s may end up doing the same thing at a time when competition within food retailing is likely to increase due to a greater focus on food by M&S and the continued rise of discount operators such as Aldi and Lidl.
Brexit challenges
The full impact of Brexit has not yet been felt in my view. While consumer confidence fell to its lowest level since July last month, inflation has remained relatively low.
However, according to the Bank of England inflation is forecast to rise from the current level of 0.9% to around 2.7% in 2017. Food retail inflation could be much higher, though, since it involves a disproportionate number of imports.
Looking ahead, Brexit is likely to cause the pound to weaken further over the medium term. The negotiations between the UK and EU are unlikely to progress smoothly.
The EU has been at pains to point out that the UK will not get what it wants, while the government has remained tight-lipped about its negotiating tactics. This could mean high uncertainty and a lack of investor interest in the UK, which may lead to a weaker pound and exacerbate the already bleak outlook for inflation in 2017.
Against this backdrop of higher inflation is relatively low wage growth. Although real wage growth was present prior to the EU referendum, real disposable incomes are set to come under pressure from higher inflation.
Alongside this, many businesses may delay or avoid pay rises, citing an uncertain economic outlook. The result could be a consumer who becomes increasingly price conscious, which may lead to lower margins or lower sales for supermarkets such as Sainsbury’s.
A questionable strategy
During what is likely to be a difficult time for retailers, Sainsbury’s is attempting to integrate Argos into its business. In theory, this is a good idea since Argos concessions within its stores should lead to cross-selling opportunities.
However, the reality is that lower real disposable incomes could cause demand for the discretionary items sold by Argos to fall. Products such as laptops, TVs and home items can all be delayed until consumers feel more confident about their financial futures. Therefore, Sainsbury’s may have bought a struggling business which struggles even more in 2017.
Sainsbury’s may have bought a struggling business which struggles even more in 2017.
Allied to this problem is the amount of capital which Argos may consume in the next year. By capital, I don’t just mean cash, but also management time and effort. This cost Tesco a few years ago, since it was apparently more interested in building an empire than in being the biggest and best grocery store.
I fear that Sainsbury’s may end up devoting a significant amount of effort to Argos, only to take its eye off what will become a more competitive food retail space. This could lead to its struggling to a greater extent in food retail than it otherwise would have done without the integration of Argos to divert its attentions.
Aldi and Lidl are pure play grocers, while M&S is moving in that direction. These stores could steal customers away from mid-tier operators such as Sainsbury’s unless its pricing strategy and customer offer remain compelling. While this could still be the case, the acquisition of Argos makes this more difficult.
Value trap
Sainsbury’s valuation is low, but could prove to be a value trap. It has a P/E ratio of 10.2, but its EPS is forecast to fall over the course of 2017 and 2018. It is due to be 12% lower in financial year 2018 than in financial year 2016.
In my view, there is scope for a downgrade in guidance if Brexit uncertainty causes consumer confidence and real disposable incomes to fall. Therefore, Sainsbury’s appears to be cheap for good reason.
Using its 2018 forecast EPS puts Sainsbury’s on a P/E of 12.4. At a time when the wider retail sector is at a low ebb, this does not indicate a wide margin of safety in my view.
While the integration of Argos could realise some synergies and will inevitably produce a degree of cross-selling, I believe that it has come at the wrong time for the business. In other words, it is an acquisition to make ahead of a retail boom, rather than when the UK is on the cusp of retail woes.
Outlook
While Sainsbury’s is not a bad company in terms of its financial strength and product offering, I believe that it faces a difficult outlook and has the wrong strategy through which to cope.
The UK economy is likely to experience significant uncertainty in 2017 and a weak pound could cause inflation to spike. In such a scenario, real disposable incomes may turn negative as wage growth stutters from reduced business confidence.
In such a scenario, price competition within the grocery market may rise and spending on consumer discretionaries could fall. The acquisition of Argos could therefore be a drag on the overall performance of Sainsbury’s, with it sapping capital from the more important food retail part of the business.
Therefore, I’m bearish on the future of Sainsbury’s, with Brexit and a risky growth plan likely to cause its shares to struggle in 2017.