The challenges posed by rampant inflation might be J Sainsbury’s best chance in almost a decade in levelling the playing field against arch-rival Tesco — at least that’s what investors seem to think.
Sainsbury’s has long attracted a more lowly valuation than Tesco, Britain’s largest supermarket. A longer-term record of weaker sales growth and the greater exposure to discretionary spending that came with the chain’s acquisition of Argos are two reasons for this inferiority in the eyes of investors.
Yet the discount between the two FTSE 100 constituents is now the slimmest it has been since 2014, when Tesco became embroiled in an accounting scandal. An enterprise value of just under five times forecast earnings before taxes and other charges is closing in on the 5.8 figure attached to Tesco, despite shares in both companies declining in price since the start of this year.
There is some good cause for the laggard Sainsbury’s finding more favour with investors. The grocer has been historically slower than Tesco in reducing its cost base, but that now gives the orange-bannered supermarket an additional line of defence against elevated energy, wage and freight expenses.
More crucially, savings derived from cost-cutting, including reducing the standalone Argos store estate and integrating its Argos and Habitat logistics and supply chains, have helped to limit the increase in prices, according to the grocer. A three-year savings programme completing in 2024 will wipe more than £1.3 billion from the cost base — more than analysts had expected. Double-digit inflation remains the biggest uncertainty to hang over whether Sainsbury’s meets profit expectations this year. At the start of this month, Simon Roberts, its chief executive, reiterated guidance for adjusted pre-tax profits of between £630 million and £690 million for the 12 months to the end of March next year, lower than the £730 million recorded last year.
Pressure on profits this year is unavoidable, even without the post-pandemic comedown. Like its peers, Sainsbury’s is battling elevated freight, wage and energy costs, as well as attempting to remain competitive on prices. Hedging roughly 75 per cent of its energy costs for the 2023-24 financial year is one source of relief on margins.
For the 14 weeks ending September 17, the chain reported a 3.7 per cent increase in like-for-like sales on the back of higher prices, which also helped to limit the decline in sales over the entire 28-week period to 0.8 per cent. But lower sales volumes and higher operating costs amplified the decline in underlying pre-tax profits for the core retail business by 8 per cent.
Those figures do not reflect the real impact of higher energy bills on consumers, meaning Sainsbury’s, like its peers, could suffer weaker sales volumes than anticipated in the coming months. Nielsen data shows sales growth for the four weeks to November 5 came in at 5.1 per cent — better than Tesco, Morrisons and Waitrose, but behind Asda: all down to price, not increasing volumes.
Analysts at house broker Shore Capital forecast flat adjusted profits for the 2024 financial year, with cost savings absorbing the persisting pressures of inflation on margins.
The optimistic take? Once inflation settles, a typically fixed cost base could allow profits to recover more quickly on the back of an improvement in sales volumes and more meagre price rises. Analysts have forecast adjusted pre-tax profits of £665 million over the 12 months to the end of March 2025, ahead of the £586 million prior to the pandemic.
The shares look cheap, but then investors expect to be compensated for heightened uncertainty.
ADVICE Hold
WHY The pressures of cost inflation and weaker sales volumes are reflected in the market’s lower valuation
Workspace Group
Flexible office space provider Workspace Group is priced for catastrophe. The FTSE 250 constituent’s shares have fallen 40 per cent since the start of this year, a discount of close to 50 per cent to the net asset value forecast by analysts for the end of March.
Not even a resilient showing during the six months to the end of September could soothe the bears. The underlying value of assets edged 0.8 per cent ahead, driven by a 7.5 per cent rise in the estimated rental value per sq ft. That offset a slight outward movement in the yield — rental income expressed as a percentage of the portfolio value — attached to the portfolio. Occupancy is back to pre-pandemic levels, rising to just under 90 per cent for Workspace’s existing portfolio; rents were 4 per cent higher but are still lagging behind 2019 levels.
The question now is how much more scope there is to push rents forward in the face of the elevated inflation that stands to squeeze smaller businesses, Workspace’s core tenant base, more tightly. Lettings totalled 96 in October, down on the 134 secured in September and the 135 in October last year.
Liquidity should not be an issue in the near term. Capital expenditure is expected to be around £50 million this year and roughly the same in 2023. The property group has cash and undrawn debt facilities totalling £263 million and expects to generate an extra £200 million from selling the non-core industrial assets that accompanied its takeover of McKay Securities earlier this year, as well as the residential properties that form part of a mixed-use redevelopment in south London. A buyer for the latter has already been secured.
Workspace’s business model has an advantage over London-listed IWG, owner of the Regus brand, and WeWork: the group owns all of the properties it lets out to businesses. This removes the mismatch between short-term leases agreed with customers and long-term liabilities owed to properties’ freehold owners.
Workspace might struggle to push earnings much further ahead over the next 18 months but the risks to occupancy and rent prices are already compensated for in the shares’ steep discount.
ADVICE Hold
WHY Further recovery in the NAV might prove difficult as recession looms
