Investors used to view the UK supermarket sector as defensive. Repeat purchasing of foodstuff staples leads to reliable cash flow for paying steady dividends, went the argument.
So the fundamental requirement for a defensive investment is consistent cash flow. We are not seeing that at J Sainsbury (LSE: SBRY) right now, and the firm is perhaps the slickest and most trusted of all the British supermarket chains.
Cash flow is falling
Theres been a downward trend in the firms operating cash flow for some time:
Year to March |
2012 |
2013 |
2014 |
Net cash from operations (m) |
1067 |
981 |
939 |
The recent half-year results show the fall continuing, with the firm generating 398m of net cash from its operations for the six months to September 2014. That compares to the 566m Sainsburys received in cash the equivalent period in 2013.
Thats grim, and the directors know it. Sainsburys is losing its defensive credentials, along with the rest of the London-listed supermarket sector. If a low-margin, high-volume sales business cant even deliver steady cash flow, whats the point in taking the risk of investing in it?
Whats the plan?
With the bottom falling out of its business model, Sainsburys recently conducted a strategic review. The results sound like the firm is pitching into a fight for survival.
Sainsburys reckons the grocery sector is undergoing structural change as customers shop more frequently, using online, convenience and discount channels. The firm expects supermarket like-for-like sales in the sector to be negative for the next few years. Thats a sobering statement. The very sector is set for a period of decline. That investing environment is not ideal.
In response, Sainsburys aims to improve quality and reduce prices with its food products, and to balance such lower margin turnover by growing the non-food business with a focus on design-led clothing, cookware, homeware and seasonal products. The firm aims to dedicate more store space to non-food items. Theres also the companys banking operation, which has opportunity to expand.
What else could they do?
When faced with a broken business model, something has to change. Food retailing as a profit generator seems something of a busted flush thats serious if you happen to own a food supermarket chain.
Maybe, from now on, food retailing as a whole is set to be a loss leader, or at least a very low-margin proposition designed to get footfall through the door. The real profits will then likely come from non-food retailing.
Thats a massive change in modus operandi for Sainsburys and its peers such as Tescoand Wm Morrison Supermarkets. Non-food retailing is far less defensive than food retailing and prone to the affects of macro-economic cyclicality. On top of that, the non-food retailing space seems set to become very crowded as once strong and vibrant food retailers, such as Sainsburys, switch to the sector. Maybe non-food retailing may not prove to be as profitable as the supermarkets hope.
Sainsburys shares are well down this year. At 257p per share, the forward P/E rating runs just over 10 for year to March 2016, and theres a dividend yield of 5%. That might seem like a fair price, but forward earnings continue to fall and the sector is in structural decline.
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Kevin Godbold has no position in any shares mentioned. The Motley Fool UK owns shares of 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.