Why Sainsbury’s low valuation and its revised strategy could produce a share price recovery

Robert Stephens discusses why Sainsbury’s has turnaround potential.

The second quarter trading update from Sainsbury’s (LON:SBRY) may not seem all that impressive at first glance. The retailer posted a rise in total sales of 0.1%, while its like-for-like sales declined by 0.2%.

However, it provided details of a refreshed strategy which could catalyse its financial performance over the long run.

Alongside a low valuation and the potential for a rising dividend, the stock could offer recovery potential following its 30% share price decline over the last year.

A revised strategy

With a large amount of competition within the supermarket and wider retail sector, Sainsbury’s is seeking to differentiate its offer from those of rivals. A key part of this will be its increasing investment in the customer offer, as well as service levels and value for money. In order to achieve this, it is refreshing its operating model. Thus far, it has received a positive response from customers.

The business is making substantial changes to its store estate, as it seeks to boost its competitive advantage. This includes a plan to open new supermarkets, Argos concessions and convenience stores at the same time as it closes unprofitable existing stores. This should deliver an ongoing net operating profit benefit of £20 million per year.

Sainsbury’s is aiming to structurally reduce costs by £500m over the next five years, as it merges its various operations. This should help it to reduce debt levels, with it seeking to cut net debt by at least £750 million over the next three years. This should support its free cash flow and make its dividend payments more sustainable.

Potential threats

In spite of UK wage growth recently reaching an 11-year high, consumer sentiment is weak. The GfK consumer confidence index reported a figure of minus 12 last month, with it having been below zero for over three years. Given the uncertain outlook for the UK from a political and economic standpoint, Sainsbury’s may need to continually invest in pricing in order to attract increasingly price-conscious consumers.

Weak consumer sentiment provides fertile growth opportunities for no-frills retailers such as Lidl. It plans a £500 million expansion in London that will see it open 40 stores in the capital over the next five years. This could stymie the growth prospects of Sainsbury’s and lead to continued pressure on prices across the sector.

Investment prospects

Following its share price decline over the last 12 months, Sainsbury’s now has a price-earnings ratio of 10. This could mean that investors have priced in the uncertain prospects which the business faces, thereby providing a margin of safety versus the company’s intrinsic value.

The retailer’s dividend yield of 5% is expected to be covered twice this year by earnings per share. Sainsbury’s will seek to maintain its current dividend policy of paying out 50% of net profit to shareholders. This could mean that dividend growth is similar to net profit growth over the medium term.

Within a retail sector that faces a challenging outlook, Sainsbury’s may struggle to deliver improving profitability in the short run. However, with a low valuation and a strategy that could enable it to more easily differentiate itself from sector peers, its long-term investment prospects may be relatively bright.