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Produce a report for a shareholder, based upon the latest available Sainsbury's report and accounts.

Terms of Reference

Produce a report for a shareholder, based upon the latest available Sainsbury's report and accounts to:

Objective of Report

To determine whether Sainsbury's shares represent good shareholder value

Brief statement

An analysis of the accounts has shown weak performance over the past two years and troubling signs of potential future problems if improvements are not made. This report looks at the evidence.

Evidence brief review of sources of information

The primary source for this report was Sainsbury's published accounts for 2005. Analysis has been made using industry standard ratio analysis techniques, but some ratios were adapted to improve understanding of underlying, rather than exceptional, performance.

Findings

Profitability

Gross profit for 2005 was 4.43% (percentage of turnover). There was a gross operating loss of £167m, compared to £656m profit in 2004. The 2005 figure is misleading, as the gross operating profit bore the full cost of the £507m business transformation programme.

Stripping out this extraordinary item produces an adjusted operating profit margin of £345m or 2.23%.  This figure has been used to calculate adjusted ratios for overall capital employed (3.70%) and return on operating capital (5.68%).

Capital efficiency

The asset turn ration shows the operating capital efficiency - £2.53 is being returned for every £1 of working capital invested.

Working capital is typical for a supermarket. The working capital ratio is -8.58% - Sainsbury's needs -8p to hand to generate sales (goods are sold before they need to be paid for). This is supported by the quick ratio of 0.58 (demonstrating net current liabilities rather than assets). So the poor returns on working capital are caused by weak profit margins.

To improve the margins Sainsbury's would need to either:

  1. Increase prices (undermining a £400million price reduction programme). 
  2. Improve sales of high-profit goods (but the Chief Executive's report talks of relaunching the "low price products" range).
  3. Reduce cost of sales (the report alludes to supply chain and stocking issues).

Margins could be increased by improving the overhead cost ratio. At 4.99% there may not be great savings to be made, but an increase in volumes (in line with the sales expansion plan) or a reduction in supply and distribution costs may help.

Cash Flow

Overall net cash inflow is greatly improved (2005 £978m inflow, 2004 £409m outflow). Liquidity also improved (2005 unadjusted quick ratio 4.83, 3.88 in 2004).

Net cash inflow from operations was up by £67m on last year, and the net spend on fixed assets was down, although more interest and dividends on preference shares were paid out. The most significant impact on cash flow was a large net injection of £1,018m, mostly from the profits of the Shaws disposal.

Because of this, Sainsbury's had sufficient total cash flow to pay equity and non-equity dividends, reduce overall debt, perform the share consolidation exercise and retain more cash, as well as pay for operations and the business restructuring. This was a one-off. Sainsbury's has used the proceeds well to consolidate and improve its position, but without an increase in sales next year, cash flow may deteriorate. This would put further pressure on the dividend.

Investment Ratios

Earnings per share (EPS)

EPS is a measure of shareholder value - the higher, the better. The trend in EPS was steady rises for the first three years, a 13% drop in 2004, and a precipitous 83% drop in 2005. Each share is now earning one quarter of what it was making five years ago.

The Chairman's report blamed the exceptional restructuring costs incurred in 2005. The underlying EPS, which strips out the effects of exceptional items and other accounting conventions (e.g. amortisation of goodwill), gives a closer idea of real earnings from the underlying . The underlying EPS shows the same three year rise, a 3% drop in 2004 and a 62% drop in 2005, ending half what it was five years ago. This suggests:

Dividend Cover

The dividend halved from 15.69p (2004) to 7.80p (2005). Dividend cover was 1.49 in 2004. It is now 1.15. A weak position has deteriorated, despite the large cut in dividend. This reflects the large fall in EPS. The Chairman's report notes this, stating a goal of restoring the 1.5 ratio (which has not been exceeded in the past 5 years).

This will happen only by cutting the dividend further (unpopular) or improving earnings per share by increasing sales. The dividend cover, and the dividend itself, look vulnerable to any deterioration in cash flow, discussed above. 

Conclusion

Sainsbury's has had a bad year - marginal growth in core UK food retail and bank activities has not prevented a further deterioration in profit margins. The company has used proceeds from one-off disposals to improve its position, invest heavily in a restructuring, and preserve the appearance of shareholder value by maintaining pay out of a dividend and consolidating shares, but this cannot disguise the fundamental decline in shareholder value, as shown by diminishing EPS.

The company this year enjoyed good solvency and cash flow, and efficient working capital, but the extraordinary spending was financed by extraordinary gains. The cash flow is put at risk by very poor profitability and the target to increase sales by £2.5bn by end 2007 looks optimistic ("growth not seen…for over a decade").

Sainsbury's is vulnerable, a lot depending on achieving growth. Management strategy for food pricing and product mix does not suggest that this growth will be achieved profitably.

Recommendations

The performance over five years has shown declining shareholder value. Currently, these shares are not a good proposition. It would be prudent to compare this year's accounts with those for 2006 (when published) to determine if growth has recovered profitably.

References

McKenzie, Wendy (2003) The Financial times guide yto using and interpreting company accounts, 3rd. ed., Edinburgh: Prentice Hall

Sainsbury's plc (2005) What will it take to make Sainsbury's great again? Annual report and financial statementss, 2005, London: Sainsbury's

Appendix

Calculation of ratios

  1. Gross profit margin

Gross profit / turnover

£683m / £15,409m = 4.43%

  1. Adjusted Operating profit margin

Operating profit - exceptional items + the share of associates and joint ventures operating profit + interest receivable and similar income / Adjusted capital and reserves + minority interests +total debt + provisions for liabilities and charges.

Operating profit - exceptional items:

(Turnover continuing and discontinued operations = £15,409m
Minus cost of sales = £14,295m
= gross profit of  £1,114m
Minus admin = £769
£1,114m - £769m = £345m adjusted operating profit)

Plus share of profit in joint ventures = £1m.
 
Minus net interest payable = £92m.

Top line: £345m + £1m - £92m = £254m.

Adjusted capital and reserves = Capital employed from Balance sheet = Capital and Reserves + minority interests - revaluation reserve.

= £4,437m     (£4,374m + £85m - £22m = £4,437m).

Plus Total debt = £2,094m (all borrowings from balance sheet - total shown note 23).

Plus Provisions = £332m.

Bottom line:  £4,437m + £2,094m + £332m = £6,863m.

£254m / £6,863m = 3.7%

3. Return on Operating Capital employed.

Operating profit - exceptional items / Adjusted capital and reserves + minority interests +total debt +provisions - all investments - cash

= £345m / (£6,863m - £114m - £673m) = £6,076m

Equals = 5.68%

4. Asset Turn

Turnover/operating capital employed

Turnover = £15,409m
Operating capital employed = £6,076m as calculated above.

£15,409m / £6,076m = 2.53%

5. Working capital ratio

Working capital / turnover.

Working capital = stock plus trade debtors - trade creditors

£559m + £271m - £2,152m = -£1,322m

-£1,322m / £15,409m = -8.58%

6. Quick ratio

Net assets / Creditors falling due in a year

Unadjusted -

£3,760m / £778m = 4.83

7. Overhead cost ratio

Administrative expenses / turnover

£769m (Source note 3) / £15,409m = 4.99%

8. EPS

No need to calculate as stated in Accounts

9. Dividend Cover

Underlying diluted earnings per share before non-equity dividends / Equity dividends per share

9.0 / 7.8 = 1.15

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