Sainsbury's and the future of UK retail

Sainsbury's is the second largest supermakret chain  in the United Kingdom with a share of the UK supermarket sector of 16.5%.The company was founded in 1869 by John James Sainsbury and became the largest grocery retailer in 1922, pioneered self-service retailing in the UK, and experienced it's best days during the 1980s. In 1995, it's no.1 market position was overtaken by Tesco. Among it's shareholders are Lord Sainsbury (descendant of the founder) with 5% and Qatar Investment Authority with 26% of shares outstanding.

Sainsbury’s has been the best performer of the big four supermarkets since the financial crisis, but recently, it's market share suffered the worst drop in a decade (16.9pc to 16.5pc) in the 12 weeks to March 30 2014. The company posted the slowest growth in a decade (5.3%) and same-store sales fell for the first time after 36 quarters of uninterrupted growth. This is mainly due to the intense competition in the UK retail sector, big rivals like Tesco and Asda on one side, and smaller discount stores like Aldi and Lidl on the other. Also, their long time CEO, who successfully guided the company throughout the last decade, is going out in July.  But, they pay a nice 5% dividend. 

Source: Company reports

The company has slightly improved margins over the period, while growing steadily every year. This was partly due to introducing branded products and clothing (which increased gross margins) and cost savings in administrative costs (improved operating margin). However, operating costs reductions have their limit and I believe gross margins will decrease as a result of competitive pressures from other retailers. If we look at the YoY growth in profits and margins, the picture looks worse:

Valuation

SBRY is selling for 6.2 billion (3.26 GBP per share), with a P/E of 8.7 and Price to Sales ratio of 0.25. The company looks undervalued using a DCF and the following assumptions:

- after-tax profit of 716 million GBP
- 0% growth for the next 10 years and 0% thereafter
- discount rates of 6%, 8% and 10%

According to this analysis, Mr. Market expects the sales and profits to decline  over the following several years, but by how much? Assuming a 5% decline for the next 10 years and a 8% discount rate, I arrive at the current market price.

Now, the question is, will that decline be higher or lower? Will they continue to lose market share to discount retailers and other supermarkets? Some hedge funds think so, it's actually one of the most shorted stocks on the London Stock Exchange. Among those who hold short positions are: Eton Park International, Marshall Wace, Lone Pine Capital, Odey Asset Management and Lansdowne Partners, all with billions under management and well known investment skills. 


Although the price has already declined almost 25%, I am initiating a small short position because of slowing growth and intense price competition in the industry.