J Sainsbury: buy, sell or hold?

Sainsbury'sI'm always searching for shares that can help ordinary investors like you make money from the stock market.

Right now I am trawling through the FTSE 100 and giving my verdict on every member of the blue-chip index.

I hope to pinpoint the very best buying opportunities in today's uncertain market, as well as highlight those shares I feel you should hold... and those I feel you should sell!

I'm assessing every share on five different measures. Here's what I'm looking for in each company:

1. Financial Strength: low levels of debt and other liabilities;
2. Profitability: consistent earnings and high profit margins;
3. Management: competent executives creating shareholder value;
4. Long-term prospects: a solid competitive position and respectable growth prospects, and;
5. Valuation: an under-rated share price.

A Look at J Sainsbury
Today I'm evaluating J Sainsbury (LSE: SBRY), a major food retailer that also engages in financial services and property investments, which currently trades at 333p. Here are my thoughts:
1. Financial Strength: Free cash flow has been uneven during the past five years, ranging from £350m to £5m, while capital expenditure has been rising and eating up cash flow. Nevertheless, Sainsbury's (LSE: SBRY) balance sheet remains solid with low net gearing of 36% and sufficient interest cover of 8 times. Also, the group has £739m in cash and cash equivalents, more than enough to cover debts maturing during the next five years.
2. Profitability: Sainsbury's performance has been largely unexciting for the past decade, with average annual sales growth of 3% and earnings growth of 7% per year. The average operating margin at 3% has been low compared to Tesco at 6% and William Morrison at 5%, while return on capital employed (ROCE) has been pedestrian at 8% per year.
However, Sainsbury's (LSE: SBRY) performance has significantly improved during the last few years, with sales growing at 6% and earnings at 9% per year, driven by the rapid growth of non-food sales, which have advanced three times faster than food sales.
3. Management: Since CEO Justin King took charge in 2004, sales have grown from £15bn in 2005 to £22bn in 2012, while margins have expanded from 2.2% in 2005 to 3.5% in 2012. In addition, operating profits have increased from £345m in 2005 to £827m in 2012, and dividends have compounded 11% annually from 8p in 2005 to 16p per share in 2012.
4. Long-term prospects: J Sainsbury (LSE: SBRY) is now the third-largest food retailer in the UK after Tesco and Walmart's Asda, and its market share of more than 16% is the group's highest in nearly a decade. The general merchandise, online grocery and convenience-store divisions have potential and could be areas for growth. However, without having any clear sustainable competitive edge and with the economy expected to contract during the next few years, improving margins and returns on capital further will be difficult.
5. Valuation: At a forward P/E of 11, I think Sainsbury's (LSE: SBRY) is already trading around fair value and is a little bit more expensive than Tesco and Morrisons, both of which have a P/E of 10. However, Sainsbury looks cheaper trading at only 1.1 times tangible book value and 0.3 times sales. Plus, according to the company, the market value of its properties could be more than £2bn greater than their accounting value, which means the share may actually trade at a discount to tangible book value.

My verdict on J Sainsbury
Sainsbury's performance during the last few years has been promising, but I am sceptical as to whether the firm can maintain this trend.

Margins and returns on capital have been improving but still remain low and given that the business operates in a highly competitive industry, I would wait for a clearer indication of a sustainable competitive advantage -- that is, margins and returns on capital increasing further -- before buying in.

Besides, Sainsbury's (LSE: SBRY) share price has risen 17% during the last two months and is already trading near its 52-week high. While a 5% yield remains attractive, I believe the company is now reasonably priced and, without sufficient margin of safety in my valuation sums, I would not be comfortable owning it given the issues mentioned. However, I would consider buying if the share price fell below 300p.

So overall, I believe Sainsbury at 333p looks like a sell.

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