Sometimes you have to sit up and take notice but that doesn’t mean you should follow the herd. Shares in unloved supermarket Sainsbury’s (SBRY) stormed almost 14% higher to 261p last week, a seismic upwards move for a FTSE 100 stock, after the embattled grocer guided towards better-than-expected annual profits. This forecast upgrade represents a rare bit of good news for the £4.95 billion cap and indeed a British grocery sector undergoing major upheaval. We remain bearish though as the ‘Big Four’ are struggling to fend off competition from German discounters Aldi and Lidl, as well as cope with a shift in shopping habits towards the online and convenience channels, sector-wide price-cutting and food price deflation.

In a surprisingly upbeat second quarter update (30 Sep), Sainsbury’s reported a 1.1% decline in like-for-like sales (excluding fuel); though this represented a seventh quarterly decline on the spin, the fall was better than analysts feared and represented improvement on Q1’s 2.1% decline.

Guided by CEO Mike Coupe, the retailer said its strategy was progressing well in a challenging market. Moreover, there was pleasing news that the £548 million consensus of analysts’ estimates is now looking light, with a more confident Sainsbury’s stating: ‘Year-to-date we have traded well, with both sales and cost savings ahead of expectations. Should current market trends continue, we expect our full year underlying profit before tax to be moderately ahead of our published consensus.’

Coupe reported quarterly growth in both volume and transactions, with shoppers responding to Sainsbury’s price reductions and the decline in average basket spend continuing to stabilise across the sector. Sainsbury’s is benefiting from the improved quality of its own-brand ranges - Taste the Difference volume grew more than 4% in the quarter - while a reduced level of promotions in favour of lower prices on a regular basis has also enabled the retailer to improve forecasting and product availability, which in turn is lowering levels of waste.

Sainsbury’s continues to progress its strategy in key growth channels, opening another 27 convenience stores in the quarter to take the total to 741 and growing online grocery orders by 15% plus. Coupe also flagged a good performance from the clothing division Tu, which grew sales 13% in the quarter with a positive launch for the dedicated website.

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Holding steady

The Q2 update followed some reasonably encouraging grocery share figures from Kantar Worldpanel (22 Sep), covering the 12 weeks ending 13 September, for Sainsbury’s. Although supermarket growth was static at 0.9% - the sixth consecutive month that sales among the grocers grew by less than 1% as the groceries price war continued to stall growth - Sainsbury’s was the only one of the ‘Big Four’ to keep pace with the market. According to Kantar, its sales grew by 0.9% and the retailer held its market share steady at 16.2%, helped by the ongoing expansion of its convenience estate and the luring of some 250,000 new shoppers into the aisles.

Given a testing backdrop, Sainsbury’s has been toughing things out pretty well, benefiting from faster growing convenience and non-food sales and a store portfolio skewed towards wealthier consumers in London and the south of England. Furthermore, Coupe has taken decisions for the long-term health of the business; cutting the dividend and reining in capital spending in order to preserve the lifeblood that is cash generation as well as balance sheet strength.

As reported by the Financial Times, Coupe says there has been a ‘pause for breath’ in the supermarkets price war, with an expected major price push from bigger rival Tesco (TSCO) at the start of September failing to materialise.

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Buyer beware

Yet despite many encouraging signs, Shares believes it is too early to go shopping for Sainsbury’s stock. The grocery sector remains highly competitive and the forthcoming National Living Wage (NLW) will put further pressure on food retailer’s already-slim margins. And as the latest Kantar data show, discounters Aldi and Lidl continue to gain market share. Casting a shadow over Sainsbury’s is the market leader Tesco, due to report interims (7 Oct) as Shares went to press, which has the capability to turn up the competitive heat on its smaller rival.

Following Sainsbury’s update, Shore Capital sage Clive Black upgraded his ‘sell’ stance to a ‘hold’ and his year to March pre-tax profit estimate by 5.3% to £575 million, though this still represents a sharp year-on-year drop from last year’s £681 million haul. It translates into earnings of 21.9p, twice-covering the re-based forecast dividend of 10.9p (2015: 13.2p), meaning Sainsbury’s does at least offer investors an attractive yield of 4.1%. For 2017, Shore Capital forecasts £561 million at the pre-tax line for earnings of 21.1p and a 10.6p payout.

Yet it is worth noting Shore Capital’s accompanying commentary: ‘We cannot yet rule out further industry pricing, and so gross margin activity, and with Sainsbury stating on the analyst call that it has already invested its planned £110 million net investment for FY2015/16 but that it will invest to remain competitive in the face of further cuts, any such industrywide behaviour can be expected to diminish gross margin. Hence, in upgrading our prevailing Sell stance to hold, we need to point out our nervousness and the upgrade’s tentative nature.’

In a note entitled ‘Sexy Sainsbury?’, Jefferies, sticking with its ‘hold’ rating and 260p price target, points out that the full-year forecast range for Sainsbury’s ahead of the Q2 update was ‘remarkably wide’ at between £424 million and £635 million. This highlights the sensitivity of the grocer’s earnings to analysts’ like-for-like sales assumptions. The broker also says it is too early to tell if sales have turned a corner or to call a margin trough.

Sainsbury’s is once again interesting contrarian investors, hence a sharp relief rebound to 264.6p. Yet like-for-like sales remain negative and the need to respond to the leader’s price cutting could exert further downwards margin pressure. We don’t feel comfortable turning bullish just yet.