Stockwatch: why I’m changing my view on this blue-chip share

It’s a bit odd how Sainsbury (J) (LSE:SBRY) engaged with JD.com Inc ADR (NASDAQ:JD) on the disposal of Argos only to terminate talks, but insist on “delivering the strongest and most successful future” for Britain’s second-largest retail merchandise operation.

That the 2016 acquisition hasn’t worked out as planned – to improve sales density in larger Sainsbury’s stores – is shown by its £1.4 billion purchase price last valued at £344 million in Sainsbury’s accounts.

Sainsbury’s also no longer discloses Argos profits, which adds to a sense how competing with Amazon.com Inc (NASDAQ:AMZN) as sales increasingly happen online, is not great for margin.

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So, it was understandable how last Saturday Sainsbury confirmed that it was considering an approach from the Chinese retail giant that last year considered an offer for Currys (LSE:CURY) – as if looking to create a springboard in the UK, by acquisition. The sale could “accelerate Argos’s transformation”, Sainsbury’s said, as if admitting that their ownership was sub-potential. 

Then, on Sunday, it appeared that JD had turned the tables and would engage only on “materially revised terms and commitments”. Was this mainly the art of negotiation, or that they had more thoroughly considered the Argos books? Discussions had concluded, Sainsbury’s said, because terms and commitments were “not in the best interests of Sainsbury’s shareholders, colleagues and broader stakeholders”.

I was therefore surprised to see Sainsbury’s shares jump as much as 6% to 326p mid-morning yesterday, even though JP Morgan has raised its target from 330p to 363p, and the price closed up 3.5% at 318p. It appeared to reflect current bullish sentiment on how “all news is good news” as I explained in my last piece.

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At this level, the 12-month forward price/earnings (PE) is around 13x versus Tesco (LSE:TSCO) on 15x at 440p per share. Moreover, Sainsbury has a slightly better ordinary dividend yield over 4.5% versus 3.4% for Tesco, and while Tesco trades on 2.5x book value, it is only 1.1x for Sainsbury.

On a 10-year view, Tesco shares have performed much better than Sainsbury’s volatile-sideways trend, but since April both have joined the wider “risk-on” momentum trade.

Source: interactive investor. Past performance is not a guide to future performance.

Food retailers have enjoyed a remarkable rally considering how, in March, the sector took fright as Asda issuing a profit warning owing to required investment as its grocery share fell in an increasingly competitive market.

Despite management framing it as an “investment not profit warning”, implicitly they were behind the curve.

A special dividend due, and another share buyback under way

Consensus forecast data suggests a dividend rise from 13.6p per share to 18.7p in respect of Sainsbury’s current year to end-February 2026, then an 18% fall to 15.4p in 2027. This likely reflects some brokers including a special dividend element [following] last April’s prelims [in which] the board declared that it would return £250 million proceeds from the disposal of Sainsbury’s Bank to NatWest, with a special dividend in the second-half year (September to February).

If fully paid out, this equates to 13.0p per share implying 27p per share altogether for the current year – equivalent to 8.5% - if the ordinary dividend continues to edge up around 4% to 14p. 

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The medium to longer-term scenario seems more important given that the yield has in recent years propped up Sainsbury shares. It is a glass half-empty view, but if management has just been willing to shed circa £5 billion of turnover for Argos within £33 billion overall, the sense is that Argos is (or is becoming) a relative drag on profit.

Reassuringly, earnings cover for the ordinary dividend was 1.3x in the last financial year and consensus expects 1.7x for the year to February 2027. Moreover, and given a retailer’s strongly cash generative set-up, Sainsbury’s record for annual free cash flow per share has typically exceeded any definition of earnings per share (EPS) – and is actually a better record than Tesco’s:

J Sainsbury - financial summary
Year to end-Feb

Source: company accounts.

In the last financial year, the dividend was therefore covered 3.5x by free cash flow.

The last five years also shows resilience in the operating margin – up to 2.8% in the last fiscal year, if behind Tesco on 3.8%.

Encouragingly, Sainsbury’s has just embarked another £200 million buyback programme after it paid out £308 million as ordinary dividends in the last financial year, and invested £825 million in the business.

It comes after a 1 July first-quarter trading update asserted the highest market share for Sainsbury since 2026 – with total retail excluding fuel up 4.9% year-on-year, grocery up 4.9%, general merchandise also clothing up 4.2%, and Argos up 4.4%. In revenue terms, Argos is plenty respectable considering that it attracts mostly discretionary spending.

Management said that it expects grocery volumes to grow ahead of the market this financial year, for underlying operating profit to be around £1 billion and retail free cash flow over £500 million. This appears lower, however, than the 1,036 million, underlying operating profit achieved in the last financial year, itself up 7.2%.

The apparent irony of 7.0% of share capital out on loan

Sainsbury’s is the second most-shorted share on the London market, and that 7% refers to positions over 0.5% of the issued share capital of a £7.3 billion company; but the true short percentage is likely higher.

This is even higher than Ocado Group (LSE:OCDO) at 5.3% - for a chronically loss-making business that is free cash flow-negative and pays no dividends.

Amusingly, Sainsbury’s short position rose from around 3% in early 2025 to over 7.3% by mid-April, since when the shares have soared over 30%.

While this invites ridicule of hedge funds, Odey Asset Management made a good long-term call on Home Retail Group (the listed previous owner of Argos) that it shorted aggressively and the write-down on Sainsbury’s balance sheet affirms.

This outstanding short in Sainsbury’s looks incongruous given that there is zero disclosed for Tesco. Even B&M European Value Retail SA (LSE:BME), which has struggled to deliver like-for-like retail sales performance, has only 1.1% of its equity disclosed on loan.

A general answer would be the continued expansion of Aldi and Lidl, with Aldi, for example, yesterday declaring a £1.6 billion expansion in the UK with 21 new stores opening in the next 13 weeks and a further 80 by 2026-27. Such a strategy, despite a fall in operating profit amid price cuts, implies quite a war for UK market share.

Yet this fear has existed for at least five years and Sainsbury’s delivered a strong first quarter despite Aldi price matches on many hundreds of items.

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I have also defied the short position having drawn attention to Sainsbury entering a “buy” zone last November at 248p when it offered a circa 5.5% yield with net tangible assets constituting 97% of market value. The disclosed short position was then around 6%, but at 317p this morning, the price is still up 28%.

The dividend payout looks secure and intangibles constitute just 12% of net asset value. I think the appeal of Aldi and Lidl has limitations, and Sainsbury’s pitches well in grocery across range, quality and value.

It leaves debt as the chief potential culprit. The end of February balance sheet shows £1,114 million as chiefly long term, also £5,494 million leases; albeit £2,777 million cash. The net interest charge arising took 30% of operating profit on an underlying basis, or 31% on group total. It’s not what you want to see, if incapable of cutting equity value unless interest rates soar.

After this rally, I therefore moderate my stance to “hold” but believe Sainsbury’s yield credentials remain strong.

Edmond Jackson is a freelance contributor and not a direct employee of interactive investor.