Fat Prophets take profits

J Sainsbury (SBRY) took the mantle of 'Supermarket of the Year' at the Retail Industry Awards in September. Interim results released this week for the period ending 7 October provide ample evidence of why the grocer was such a deserving winner. Despite the competitive nature of the industry, management have successfully guided the company to seven consecutive months of sales and market share growth.

Buoyant investor support reinforces this view in our opinion. Last Friday the stock touched an intraday high of 439.5p. This is the highest level since July 2001 and represents an increase of more than 42 percent since June.

Following such rapid appreciation, the upward trend of any stock would be at risk of pausing for consolidation. Already, Sainsbury has slipped back from the highs and we believe a period of consolidation will develop in the near term. However, as shown on the weekly chart below, the long term upward trend in Sainsbury remains strong. In our opinion, a temporary pause would not damage the underlying upward momentum.

Performance is improving across all areas of the group. As such, it is little surprise that Chief Executive, Justin King was able to concede the first six month results were "our best performance for many years."

Turnover was up a respectable 8.3 percent to £9.5 billion with closely watched like-for-like sales registering a healthy 6.2 percent gain. Operational improvements, better operating margins and strong sales drove underlying pre-tax profits 60 percent higher to £189 million.

The sales led recovery plan announced in March 2005 was targeting £2.5 billion in additional sales in three years. These results mark the halfway point of the programme. Encouragingly incremental turnover is up £1.3 billion, putting Sainsbury's slightly ahead of target.

Getting to this point has involved a tremendous effort on behalf of the group. This has seen Sainsbury's re-double efforts in areas regarding quality, availability and customer service all whilst keeping a lid on and at times reducing prices. Clearly the effort is paying off.

Cost savings targeting £440 million over the same three year period have complimented operational improvements in this investment in the customer offer. We anticipate further savings as they relate to IT, central support and stock loss to continue, however higher energy costs are going to begin to filter through in the second half.

Sainsbury's core grocery business is performing well across three platforms - supermarkets, convenience stores and on-line.

The supermarkets and convenience business is benefiting from the 'Try Something New Today' campaign that began just over a year ago. The reinvigorated 'Taste the difference' range now includes over 1,100 products and is set to break the £1 billion sales mark next year. In addition, new stores and refurbishments are adding and improving valuable new space in line with Sainsbury's target of adding 5 percent more trading space per annum over the next 3-5 years.

The internet is making an ever larger contribution to the group as well. With coverage of 83 percent of the UK, sales during the first half rose 40 percent. Further gains are likely as the service's coverage expands.

An important component of Sainsbury's sales target is the non-food category. Targeting £700 million in new sales, results have been encouraging. Improvements in store design and presentation have been a big contributor to the success. Pharmacies are now open in 192 stores while TU, Sainsbury's clothing range, is available in 232. Plans to continue rolling these out will help accelerate the non-food contribution to the traditional grocery business.

Sainsbury Bank is still the laggard within the group. However, once again these results offer a glimpse of an improving situation. Costs in the segment are under control and bad debts are improving. Stricter lending criteria should ensure that loans do not return as a problem later in the year. Profits are on track for 2007/08 after breaking even this year.

There is now doubt in our view that management is implementing a successful strategy to re-invigorate Sainsbury's. We believe these recent results are a clear indication of this. However, on the horizon are higher energy costs, improving comparables and ever present competitors. As such while we believe strongly the recovery will continue, growth will likely moderate which brings into question Sainsbury's current valuation.

We believe the prospective price earnings multiple of around 30 times reflects both the anticipation of a possible takeover and the group's undervalued property portfolio. These two factors go together as a typical private equity player would purchase Sainsbury's and immediately go about recognising the market value of the group's property.

Speculation regarding corporate activity intensified with recent resignation from government of Lord Sainsbury. While in government Lord Sainsbury's shares were in a blind trust, however now after a short cooling off period, he will regain control. Due to already owning around 16 percent, Lord Sainsbury could team up with or sell-out to a private equity consortium making a bid for the company.

We are fully behind the group's management and the recovery they are engineering. However, the shares are looking more fully priced due to speculation a takeover could be on the cards. Therefore, we believe it is prudent to lock in some profits now while maintaining a holding for exposure to further long-term gains. Accordingly, we recommend Members sell half of their holdings in Sainsbury at around 408p.