Shares in J Sainsbury (LSE: SBRY) (NASDAQOTH: JSAIY.US) have risen by nearly 10% so far in November, and were unmoved by last weeks interim results.
I have to admit I was a bit surprised: in these results, Sainsbury admitted that 25% of its stores were too large, wrote down its property portfolio by 628m, and slashed its dividend.
Perhaps the market view was that this bad news was already in the price: personally, Im not sure. Having looked carefully at last weeks results, Sainsbury is making me nervous.
Heres why.
1. Price cuts that will hurt
I believe one of the big problems for Sainsbury is that its profit margins are already lower than those of its peers and it is only just starting to make serious price cuts.
In last weeks results, Sainsbury reported an underlying operating margin on retail sales of 3.1%. Wm. Morrison Supermarkets, in contrast, reported an underlying operating margin of 2.7%, after already making a substantial investment in price cuts this year.
Whats most worrying is that Morrisons underlying operating margin has fallen by 1.9% since this time last year. If Sainsburys operating margin falls by a similar amount, it would be just 1.2%: borderline unprofitable.
2. Blind faith
As it happens, Sainsbury is only planning to invest 150m in price cuts over the next 12 months half the 300m being spent by Morrisons on price cuts this year.
Sainsburys management believes it can get away with smaller cuts because the store caters to a more upmarket customer base than Morrisons or Tesco: personally, I think this approach smacks of overconfidence, and could backfire horribly.
3. When will profits stop falling?
Although Sainsbury does now have a turnaround plan, the firm still expects profits to keep falling for the foreseeable future, despite the impact of continued new store openings.
Whats more, as Sainsburys chief executive Mike Coupe admitted in a call with analysts last week, we dont yet know how Tescos turnaround plan will impact the supermarket sector.
The latest consensus forecasts show Sainsburys earnings per share falling by 18% this year, and by 11% next year.
In my view these figures may still be too optimistic: despite Sainsburys shares offering a theoretical yield of around 4% and being priced at book value, I think the risk of further losses is greater than the potential near-term gains, and rate the shares as no more than a hold.
Of course, I may be wrong. Aiming at the upper end of the market is often a profitable strategy, and Sainsbury has done this more successfully than either Tesco or Morrisons.
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Roland Headowns shares in Wm. Morrison Supermarkets and Tesco. The Motley Fool UK owns shares in Tesco. We Fools don’t all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.
