MIGUEL LUIS M.

PALIMA

Analysis, Forecasts and

Recommendation Regarding
Sainsburys and Morrisons
Coursework Report from University of Nottingham
Financial Analysis Module

As per coursework requirements, this report on two major British grocery chains examines
various fundamental aspects of firm and share performance including strategy, accounting
statements, and ratios, and is drafted in such a way as to satisfy the needs of a given target
audience: a novice UK investor approaching retirement. A five-person team of students
created this report, with all editing, tables, Excel calculations, and graphics done by me, in
addition to the sections of the report over which I had primary responsibility. With the
exception of this additional cover page, all contents remain unaltered from the submitted
original.

-Miguel Palima

Nottingham University Business School

Undergraduate Programmes
FINANCIAL ANALYSIS
Group 1-
Morrisons & Sainsburys Analysis and Recommendations

GROUP MEMBERS:

MELAS, Vasilis
HUANG, Xinyi
PALIMA, Miguel Luis
PENG, Wen
ZHANG, Tian

Page | 1

Executive Summary
This report aims to provide an investment suggestion with regard to J Sainsbury plc
(Sainsburys) and Wm Morrison Supermarkets plc (Morrisons). These detailed analyses are
conducted with regards to the industry, business strategy, accounting policy, financial
performance, and prospects for both companies. The main finding of this comprehensive
analysis is that the current share price of Sainsburys is undervalued while Morrisons is
overvalued. Hence, it is highly recommended that the client invest in Sainsburys and avoid
investing in Morrisons. All analysis is done with regard to these two companies fiscal years,
which both end within the first three months of the calendar year. While care and due
diligence form the foundation of this analysis, no warranty is made on any investment
decision made as a result of this report. News and historical performance may not always
accurately represent future results, and unforeseen events may impact on performance.

1.

Industry Analysis

The UK grocery market is dominated by four big companies that account for approximately
75% of the overall market1, indicating the presence of an oligopoly in the supermarket
industry. Nonetheless, the fight for industry market share, the breakdown of which is shown
in Figure 1 below, is characteristic of the moderately-high concentration of competition in the
industry. Such concentration of various players means that each tends to compete against
each other intermittently over low prices, product range and quality, and various promotions.
Moreover, the UK economy continues to recover from the recent recession, which has
created a stagnant economy where the

Market Shares

greater price-sensitivity of shoppers to

has only heightened the intensity of
competition

among

supermarkets.

3.2%
4.1%
4.9%

2.3%

0.7% 2.0%

29%

Recent industry data showing that

growth in the grocery market has

6.1%

slipped slightly to 2.4%, thus indicating

11.3%

the need for firms in the industry to take

shares

from

prosperity

to

their

competitors

occur2.

Further,

17%
17.1%

for
the

stagnant economy has led to a loss in

Tesco
ASDA
Sainsbury's
Morrisons
The Co-operative
Waitrose
Aldi
Lidl
Iceland
Farm Foods
Other

Figure 1: UK Supermarket Industry in 2014

sales for most large supermarkets,

Page | 2

including Tesco, ASDA and Morrsions, while price discounters like Lidl and Aldi continue to
achieve sales growth3.

2.

Strategy Analysis

2.1 Sainsburys
Competitive strategy analysis:
The strategy of Sainsburys is to offer high quality products at a fair (but not necessarily
low) price, meaning that the firm commits itself to both improving food quality and cost
reduction. While Sainsburys may lack a cost advantage against its competitors, the company
still manages to outperform the market by reinforcing its differentiation from several
perspectives4. Firstly, Sainsburys positions itself to avoid partaking in endless price wars by
providing high quality products at a competitive price, thus compete with other high-end
supermarkets such as Waitrose. Also, Sainsburys endeavors to improve customer
satisfaction, such as through the use of its Nectar loyalty card scheme which rewards
consumers by offering advantage points for each purchase. In addition to benefiting the
customer by offering tailored recommendations and promotions, the Nectar scheme allows
the company to collect data that is then used to gain better comprehension of customer needs
and thus encourage return purchases. It is reported that there are over 11.5 million active
users of the Nectar, which is the largest loyalty program of its kind in the UK5. Moreover,
Sainsburys seeks to build a strong brand image through an emphasis on sustainability. In
2010, the company claimed to be the worlds largest Fairtrade retailer with one in every
four pounds spent on Fairtrade products being spent within Sainsburys stores6.
Furthermore, Sainsburys has published its 2011 20*20 Sustainability Plan to take
environmental issues into consideration, outlining future commitments and assisting the longterm sustainability of their business7. It appears that this commitment to quality has allowed
Sainsburys to not only retain, but also increase its market shares. Additionally, other factors
such as its investment in high quality human resources and application of advanced
technology benefit Sainsburys to a great degree.

Corporate strategy analysis:

As previously mentioned, Sainsburys has diversified beyond its original supermarket
business into other areas including banking, property, energy, and entertainment as to
increase revenues8. Sainsburys benefits from this multi-business strategy by taking
Page | 3

advantage of low transaction and communication costs incurred between its different units, as
internal mechanisms assure both confidentiality and credibility in inter-unit dealings9.
Additionally, the sharing of human resources, branding, and other resources among the
various business units can reduce costs and aid in maximizing the bottom line10. Moreover,
Sainsburys envisions itself to be the most trusted retailer, where people love to work and
shop.

So far, adherence to the goal of delivering high quality, value, and service to

customers has led to good profit and sales growth in a competitive market. Overall, it
appears that Sainsburys actions have been consistent in meeting its mission statement.

2.2 Morrisons
Competitive strategy analysis:
Morrisons has sought to sell quality, fresh goods to customers at low prices. With this in
mind, Morrsions has positioned itself in the market by being food specialists for everyone.
Further, Morrisons is unique in that it is the only major supermarket to have ownership and
control over its supply chain, including the facilities that create and process fresh food. Such
vertical integration of operations allow Morrisons to manufacture, package, distribute, and
sell the vast majority of fresh products. This integration also provides an opportunity for the
company to further reduce both costs, promote efficiency, and potential business risks. In
terms of its brand image, Morrisons seeks to be known as a reliable provider of fresh and
high quality foods. To this end, it has established good relationships with local farmers and
has sought to limit outsourcing of its fresh food to a local level. Its brand image based on
quality and freshness has allowed Morrisons to experience less blowback from the 2013
horsemeat scandal which continues to challenge big supermarkets11. Morrisons believes that
unique values and strong culture are at the heart of their success. Like Sainsburys, Morrsions
has invested large amounts of money on human resources, with the focus centering on the
training of skilled employees. In its goal to be a company of food specialists, Morrisons
seeks to employ and train specialist in-store butchers and bakers to work on Morrisons
Market Street as to ensure that customers can get special and tailored services12. Despite all
this, however, Morrisons has recently lost significant market share, resulting in losses for the
company. In response, Morrisons has begun to rely more on introducing lower prices,
beginning with its recent announcement of price cuts worth 1billion. Whereas Sainsburys
focus on quality has allowed it to remain buffered from price competition, Morrisons has not
been as fortunate perhaps due to its greater reliance on price

Page | 4

Corporate strategy analysis:

Morrisons utilizes a corporate strategy where its overall aim is to be Different and Better
than Ever. For Morrisons, this quest to be different involves focusing on providing
customers with fresh food, utilizing craft skills, and as previously mentioned being a
company of food specialists13. Also, its ownership of its supply chain allows Morrisons to
eliminate mark-up costs associated with external sourcing, as well as enable it to achieve
economies of scale. This should prove key in any attempt to minimize the loss in profit
margins resulting from the new price cuts. The company has chosen to focus on providing
fresh and high quality food, instead of being a generalist. Morrisons has begun to shift
towards a multi-format and multi-channel shopping experience for customers by opening
more trial convenience stores and launching a separate online facility that specializes in the
sale of wine14. Further, Morrisons has increased its market share in Southern England through
its acquisition of Safeway. The company plans to continue offering great value on its Market
Street with its pick of the street deals and launch Morrisons online food offer in 201413. It
would seem that returns on these expanded channels have yet to realize their full return.

3.

Accounting and Financial Ratio Analysis

3.1 Effects of Assumptions, Estimates, and Differences in Accounting Policies:

As is the inevitable case with all companies, Morrisons and Sainsburys each had to make
judgments and estimates when reporting certain figures8, 13. While such estimates are based
on historical performance and reasonable expectations of future events, they rarely equal the
actual results. Subjectivity in such calculations thus have significant effect with regard to the
recognized values of property, plant and equipment, investment property (PPE), goodwill,
provisions made for leases and dilapidations, and pensions for both firms8, 13. Costs relating
to changes in the values of these and hence to a smaller extent, reported profit figures are
likewise subjective. While figures from statements of cash flows are unaffected, many of
those from balance sheets and income statements are subject to some degree of distortion.
Further, and despite the presence of accounting standards to alleviate this, the comparison of
reported accounting figures between firms remains hindered by differences in company
accounting policies. Upon comparing such policies of both Morrisons and Sainsburys, it was
found that a few substantial dissimilarities exist.

Page | 5

During the 2010/2011 fiscal year, Sainsburys changed its inventory accounting system from
the first-in, first-out (FIFO) method, in which the inventory acquired first is assumed to be
sold first, to the weighted average cost method, in which assigned costs are based off the
average cost of inventory items available for sale during the period (cite). When Sainsburys
originally disclosed its 2009/2010 inventory under the old FIFO method, inventory was
valued at 650 million15. In the following year, Sainsburys restated its 2009/2010 inventory
to reflect the new weighted average method, valuing it at 800 million16. It therefore appears
that this changing of policy slightly increased the value of inventories. However, it does not
create significant impacts on the asset valuation for the company. Morrisons, meanwhile, has
been consistent in using the weighted average cost method for valuing inventories.
Another area prone to material discrepancy is the depreciation (i.e. systematic devaluing) of
PPE. While Morrisons charges most of its depreciation to cost of sales13, Sainsburys instead
assigns all of it to the overall operating (also known as administrative) expense8. Charging
depreciation to cost of sales makes the reported gross profit seem lower. Hence, one can view
Morrisons reported gross profit as being artificially deflated or, conversely, Sainsburys
reported gross profit as being artificially inflated. Subsequent profit measures, however,
including operating profit, profit before taxation, and net profit for the year, remain
unaffected. While Morrisons depreciates all PPE on a systematic (specifically, straight-line)
basis at rates both fixed and reported13, Sainsburys depreciation amounts are based entirely
on judgments8. Because of this, Sainsburys reported depreciation expenses and PPE asset
values are both more subjective and less transparent than the corresponding figures for
Morrisons. Again, this has an impact on the reported value of noncurrent and total assets on
the balance sheet, as well as profit figures from the income statement.
However, and unless otherwise stated, such effects are deemed to be negligible in view of
this overall analysis.

3.2 Profitability Ratio Analysis:

Return On Equity:
Return on equity (ROE) measures how much profit a company has earned in relative to its
total shareholder equity17. The presence of a high ROE ratio sustained over time may indicate
that the company has a sustainable competitive advantage21. As seen in Figure 2, Morrisons
had higher ROE ratios than Sainsburys since 2008, showing that Morrisons was better at
generating more returns to its shareholders equity investment. The sustained higher ROE
Page | 6

may have been due to Morrisons vertical integration of its business, as it provides a
nonreplicable and sustainable competitive advantages for the company. However, forecasted
net losses as will be discussed later

Return on Equity Ratio

20.00%

negative return to equity is

15.00%

anticipated for Morrisons in the years

ahead. Sainsburys, as net profits are

ROE Ratio

on indicate that a sharp change to

10.00%
5.00%

projected, would thus have better

0.00%

ROE as it remains positive.

2008 2009 2010 2011 2012 2013

Year
Industry
Sainsbury's
Morrisons

However, Sainsburys could still do

more to increase its ROE to industry

Figure 2

levels.
Operating Profit Margin:
Operating profit indicates a companys

to controlling costs and expenses

17

associated with business operations .

As low prices are common in the food
retailer industry, it is typical that the
profit margins of supermarkets remain
18

relatively low , as can be seen from

Figure 3. From 2008, Sainsburys has

Operating Profit Margin

efficiency (or lack thereof) with regard

Operating Profit Margin

8.00%
6.00%
4.00%
2.00%
0.00%
2008 2009 2010 2011 2012 2013
Year
Sainsbury's
Morrisons
Industry
Figure 3

maintained an operating profit margin

ratio of around 3.5%, versus the UK food and drug retail industrys average of about 5% over
the same period. Morrisons ratio, meanwhile, has been comparable to that of the industry,
thus indicating that Morrisons is better than Sainsburys in terms of control over operating
expenses.

3.3 Efficiency ratios:

Sales Revenue per Employee:
The sales revenue per employee ratio is a measure of workforce efficiency, and companies
seek to maximize their revenue per employee24. Overall, both companies are becoming more
efficient, with Sainsburys having higher labor productivity than Morrisons. Sainsburys
Page | 7

higher return per employee could be

Sales Revenue per Employee

attributed in part to the companys

employee
example,

training

programs.

Sainsbury's

supermarket

staff

For

members

of

given

the

are

160,000

opportunity to study for qualifications

in shelf-stacking and stock control as

140,000

120,000
100,000
2008 2009 2010 2011 2012 2013
Year
Sainsbury's
Morrisons
Figure 4

part of the overall push to enhance

employee

education25.

Also,

Sainsburys expansion and the hiring

that make its performance even stronger. As for Morrisons, its overall strategy to provide
fresh food at low cost means that the company invests less money on employee retail skills
education. From 2010, however, Morrisons launched a nationally recognized qualification
scheme to train its employees to a higher standard not only in traditional craft and bakery
skills but also in retailing and management skills, hence the subsequent rapid increase in
revenue per employee time26. Therefore, although Morrisons has a lower return per
employee, it has the potential and capacity to perform better, as shown by the decreasing of
the gap between the two companies from the year 2012 onwards (see Figure 4).

Average Inventories Turnover Period:

Average inventories turnover period
Average Inventories Turnover Period

measures the average number of days in

18.00

which inventories are held. A short

longer one because holding inventories

16.00
Days

inventories period is preferred to a

14.00

is costly in terms of storage space, shelf

12.00

space and the opportunity cost of funds

10.00

tied up27.

2008 2009 2010 2011 2012 2013

Year
Sainsbury's
Morrisons

For supermarkets, this

turnover period tends to be low,

especially in light of the perishability of

Figure 5

many products. Figure 6 shows that both firms usually sell stocks in approximately 16 days.
Moreover, the inventories turnover ratios for both companies are, overall, increasing each
year. As it is now, this ratios increasing behaviour is quite unsettling.

Page | 8

Operating Cash Cycle:

Figure 6

Operating cash cycle (OCC) is the time period between the payment made to the supplier for
goods concerned and the cash received from the credit customer. OCC is usually used to
measure the liquidity of a business, and the longer the cycle, the greater the financing
requirements of the business and the greater finance risks, so investors usually prefer a firm
with a shorter OCC17. Due to the lack of credit sales figures, total revenue figures were used
as proxy in calculating the average settlement periods for trade receivables. As the vast
majority of supermarket sales are settled with cash as opposed to credit, this proxy is far too
high, thus resulting in average settlement periods for receivables that are far lower than the
reality. Hence, OCC as calculated here is of no practical value due to this large distortion.
The calculated settlement periods for trade receivables, however, remain acceptable despite
the use of Cost of Sales as a proxy for the credit purchases figure (also unreported). For
supermarkets, most purchases are made on credit, hence the validity of the proxy used. The
fact that the nations few supermarket chains have far greater bargaining power than their
numerous, often small, suppliers means that the supermarkets are able to take their time in
paying back suppliers who are very dependent. No proxies were needed in calculating
Inventory Turnover Period.

3.4 Liquidity analysis:

Current Ratio:

Figure 7

The current ratio compares current assets with current liabilities. The higher the ratio, the
more liquid the business, and such liquidity is vital for the firms survival28. Supermarket
chains usually have a relatively low current ratio, as they hold only fast-moving inventories
of finished goods. In addition, virtually all ordinary sales are performed with immediate cash
and no credit sales. Generally, the current ratios do not fluctuate drastically for either
company. Thus, both companies appear to be stable in their ability to cover their current
Page | 9

liabilities. However, even though a low current ratio is characteristic of the supermarket
industry, the issue of insufficient liquidity remains a potential threat.

Specifically,

Morrisons lower current ratio of around 0.50 (as opposed to Sainsburys 0.60) means that it
is marginally more likely to find itself facing liquidity problems.
3.5 Debt and Coverage Analysis:
Gearing Ratio:

Figure 8

Gearing, also known as leverage, measures the level of a companys external borrowings
relative to the equity in the company that shareholders possess. As interest payments are taxdeductible for the firm, holding an appropriate amount of debt can benefit the company.
However, high leverage (i.e. too much debt) may increase the firms long-term risk of
bankruptcy29. For the past six years, the Sainsburys gearing has been quite higher than
Morrisons. From a theoretical standpoint, Sainsburys high gearing imposes greater longterm financial risks for the company, which may cause the firm to reach the point of financial
distress due to the continuously high interest payments imposed. Specifically, Sainsburys
gearing has been relatively stable at around 37%. As for Morrisons, the leverage ratio was
stabilized at around 26% from 2008 to 2012, but it has since increased to 32% in 2013. This
increase due to the companys launching of a 400 million, fourteen-year Sterling bond issue
at the end of 201230.

Interest Coverage Ratio

The earnings-based interest coverage ratio indicates the amount of operating profit available
to cover interest payables. Lower levels of operating profit coverage mean greater risk borne
by shareholders that lenders will take actions against the company31. The interest coverage
ratio for Sainsburys has remained largely stable at around 7, meaning that if its operating
profit shrank 7 times, the interest payable would be still covered by the amount of earnings.
Morrisons, however, is better able to meet its interest payment obligations due to its having a
higher coverage ratio than Sainsburys (Morrisons is currently at 16.85, earnings-based).
However, due to its increasing debt level from the end of 2012, Morrisons interest coverage

Page | 10

ratio has declined from 22.98 to 16.85, earnings-based. This should not be too much of a
concern, considering that Morrisons

Interest Coverage Ratio

Figure 9 shows that the cash-flow-based

20.000

interest coverage ratio of each firm

15.000

follows

trend

corresponding

similar

to

their

Ratio

interest-coverage ratio remains high.

25.000

10.000
5.000

earnings-based

counterpart. As cash flows move in a

remains no indication that earnings

2008 2009 2010 2011 2012 2013

Year
Sainsbury's EB
Morrisons EB
Sainsbury's CFB
Morrisons CFB

were manipulated in either company.

EB = Earnings Based CFB = Cash Flow Based

manner similar to earnings, there

Figure 9

3.6 Dividend and Investment Ratios:

Dividends per Share Ratio and Dividend Yield Ratio:
Both Morrisons and Sainsburys distribute

Dividends per Share

20

with payment dates generally occurring in

15

November and June for Morrisons13 and

Pence

dividends on an interim and annual basis,

10

January and July for Sainsburys8.

5
0

Dividend per share ratio shows how much

2008 2009 2010 2011 2012 2013

Year
Sainsbury's
Morrisons

the dividend attributable to each share by the

shareholders32. On an absolute, annual per-

Figure 10

share basis the dividends of both Sainsburys

and Morrisons have been growing steadily at

Dividend Yield Ratio

year respectably since 2008, as illustrated in

Figure 10. Such steady dividend policy may
be indicative of managements confidence
that earnings growth will be stable for in the
future. While dividends of Morrisons have

Dividend Yield Ratio

an average rate of 1 pence and 1.4 pence a

historically been higher than those of

Sainsburys, Morrisons higher dividend

Page | 11

6.00%
4.00%
2.00%
0.00%
2008 2009 2010 2011 2012 2013
Year
Sainsbury's
Morrisons
Figure 11

growth rate indicates a narrowing gap. This narrowing is more pronounced when dividend is
considered in terms of yield, or annual dividend per share as a percentage of market share
price, as shown in Figure 11. However, despite the apparent trend that Morrisons will offer
greater dividends than Sainsburys within the next few years, this is highly doubtful as the
year-after year net loss forecasted for Morrisons as discussed later on in this report will
likely render Morrisons dividend growth unsustainable.

3.7 Cash Flow Analysis

Operating Cash Flow Ratio:
Unlike earnings, cash flows are much
Cash Generated from Operations to
Maturing Obligations (Cash Flow Ratio)

harder for managers to manipulate,

hence problem areas not revealed by

0.60

through cash flow analysis. One such

Ratio

other financial analysis can be revealed

0.40

use of this type of analysis is to judge a

0.20

firms

0.00

ability

to

meet

short-term

2008 2009 2010 2011 2012 2013

Year
Sainsbury's
Morrisons

obligations and fund internal operations

using cash generated.
Specifically, the firms cash flow ratio

Figure 12

is an indicator of its ability to meet short-term (i.e. maturing) obligations using cash
generated from operations. Both Sainsbury and Morrisons have had relatively stable ratios, as
indicated in Figure 12. Over the past three years, however, Morrisons has maintained a higher
operating cash flow ratio than Sainsburys, implying that Morrisons has had better cash
performance. While the cash flow ratios of both companies, being less than one, indicate that
cash alone is insufficient to fund upcoming obligations, such is commonplace among
supermarkets. Further, that the ration of neither company shows an overall downtrend is
reassuring, as a substantial fall in this ratio would indicate less cash available for maturing
obligations.

4.

Prospective Analysis and Forecasts

4.1 General notes

Past data, current news, and predictions of future market trends have are utilized to create
probable forecasts of the future. While there appears there will be no substantial changes in
Page | 12

the strategic direction of Sainsburys in foreseeable future, Morrisons announcement to

address their recent net loss with substantial price-cutting34 has been considered. In addition
to presenting the likely future results of both firms, this report includes scenarios which are
reasonably believed to be the best- and worst-case scenarios for each firm as to illustrate the
reasonable extent that future results may deviate.

4.2 The Scenarios

Over the past few years, the size of the supermarket industry (as measured in total revenues)
has increased steadily at a declining rate of growth. In the absence of announced future
intentions, the same is assumed with regard to Morrisons and Sainsburys retail space
expansion. These trends are expected to continue on as such in the next five years. Scenario
analysis for each firm is conducted in terms of the following aspects: revenue resulting from
changes in either market share or retail space, changes in profit margins, and the resulting net
profit or loss attributable to shareholders. In considering whether to use revenue calculated on
the basis of market share expectations or revenue calculated on the basis of anticipated net
growth in retail space, judgement was used to determine which of these revenue figures is
most appropriate for each companys scenario and circumstances. No reason was found to
justify any increase in the profit margins (i.e. the proportion of revenue the company keeps
after all expenses and tax). Hence, an overall constant profit margin is assumed for each
firms best-case scenario, while a decreasing profit margin is assumed for each worst-case
scenario. Of these, what is deemed the most probable for each company is used for the
likely-case scenario, as shown in Figure 13 below.

Decreasing
Steady

Profit for the year attributable to shareholders Margin

Year
2014
2015
2016
2017
2018
Sainsbury's 2.56% 2.48% 2.40% 2.33% 2.26%
Morrisons -1.00% -2.20% -2.38% -2.58% -2.79% Also the likely case
Sainsbury's 2.63% 2.63% 2.63% 2.63% 2.63% Also the likely case
Morrisons -1.00% -1.00% -1.00% -1.00% -1.00%
Figure 13: Net Profit Margin forecasts

Figures in m
Best Case
Revenue
Likely Revenue
Worst Case
Revenue

Year:
Sainsbury's
Morrisons
Sainsbury's
Morrisons
Sainsbury's
Morrisons

Revenue Forecasts
2014
2015
2016
23,932
30,696
31,673
17,680
19,626
20,018
23,932
24,977
25,571
17,680
19,626
20,018
23,932
23,618
23,618
17,680
15,867
13,813
Figure 14: Revenue forecasts

Page | 13

2017
32,390
20,238
26,040
20,238
23,618
11,567

2018
33,412
20,643
26,408
20,643
23,618
9,353

The Likely Scenario

Sainsburys:
Revenue is expected to increase steadily and in line with forecasted retail space expansion.
Like retail space expansion, sales growth is predicted to taper off over the years. Profit
margins are expected to stay the same as Sainsburys remains committed to avoiding price
wars. Thus, there is little to no need to slash prices and/or increase costs over-proportionately
to sales. As a result, net profits are likely to increase over the next five years, at a slow and
dwindling rate. Beyond this, the trend in net profits is expected to continue at about an
average rate of around 1% per year.
Morrisons:
Due to their announcement to slash prices, Morrisons is expected to see its market share
remain the same, instead of declining as would be the case if higher prices were maintained.
Revenue based on market share is likely to increase in line with the industrys modest
growth.

Because price-slashing is done mainly to prevent losses in market share, no

significant increase in market share is expected.

Another likely result of the firms

commitment to slash prices is the lowering of profit margins, presumably at an increasing

rate equal to the magnitude of the previous years (2013/2014) decrease. Therefore, net
losses are expected, with such losses expected to increase in the near future. It is expected,
however, that Morrisons will eventually achieve profits that will increase at a very modest
rate, such as 0.5% per year, but not until sometime after 2018 when the firm is finished
managing the realignment of its strategy to market demands for lower prices.

The Best Case Scenario

Sainsburys:
Under this reasonable best-case scenario, market share would increase, but at a lower
magnitude each year, thus continuing previous years trend. Under this market-share-based
assumption, revenue expectations are more optimistic than under the afore-mentioned
scenario where revenue is a result of retail space expansion. As in the likely scenario, profit
margins would remain the same as opportunities for further cost-cutting remain few and
increasing prices to achieve higher profit margin is improbable due to the firms commitment
to fair prices. The higher expected revenue, however, would result in higher and fastergrowing net profits. Beyond the foreseeable future, net profits would increase at around
2.9% a year, in line with increases over the first five years into the future.

Page | 14

Morrisons:
Market share would remain stable, and revenue growth would increase slowly in line with
market growth. In this best-case scenario, however, the Morrisons management would find
ways to gain even greater efficiencies from the wholly-owned supply chain such that profit
margins remain the same despite lowering prices. Even then, profit for the year attributable
to shareholders is still predicted to be negative, with such losses to increase slowly each year.
These losses and the rate at which they increase are projected to be significantly lower. In the
long-term, Morrisons would eventually achieve profits that would increase at a less-modest
rate of 1.5% per year once the firm has finished realignment of its strategy.

The Worst Case Scenario

Sainsburys:
Market share would begin to decline slowly, as recently experienced by other large members
of the UK supermarket industry. Slight growth in industry revenue, however, would leave
Sainsburys revenue about the same for the foreseeable future. Sainsburys profit margins
would also decline due to the eruption of a price war where Sainsburys would be forced to
introduce slight decreases in prices as to remain reasonably competitive. Hence, while
Sainsburys would continue to make net profits, these will decrease by about 3%.
Morrisons:
Market share would plunge in line with the previous two years average annual decrease until
some floor is reached due to the fact that the firm would still have brand recognition and a
wide physical presence, as well as retain customers that are far-less price-sensitive. Here, a
market share of 4.5%, compared 10.2% in 2014, is deemed to be a reasonable estimate for the
floor. Plunging market share would mean that revenue would rapidly decline as well. In
effect, cutting prices would still not be enough to save Morrisons from declining revenue.
Price cuts will also cause a decrease in profit margins, presumably at a rate equal to the
magnitude of last years decline. Hence, there would be continued, large net losses that
would increase each year until insolvency or hostile takeover by another firm.

4.3 Further Expectations

(a): Morrisons effective interest rate on debt for the next five years is expected to remain
constant at 4%, as it has been over the past four years13. However, given Morrisons
persistently increasing net losses increasing the likelihood of default, it is reasonable to
Page | 15

expect that creditors will demand higher interest rates to compensate for this increased risk.
The increase in Morrisons effective rate of interest will essentially depend on changes in its
credit ratings and the judgement of its creditors. As for Sainsburys, its effective interest rate
on debt, as calculated by the weighted average of the interest rates of its two main secured
debt facilities8, is expected to be between 3.9% and 4% for the next five years.
(b): It is assumed that the net working capital required will increase with the growth of sales
revenues. This is calculated by multiplying the working capital/sales ratio by the forecasted
revenue for each year under each of the three scenarios. The applicable working capital/sales
ratio for each firm is expected to continue the steady decrease that began in 2009.

Non-current assets
to sales
Debt to equity
ratio
Effective Interest
Rate on Debt

Sainsbury's
Morrisons
Sainsbury's
Morrisons
Sainsbury's
Morrisons

Working Capital
Required m

Sainsbury's
Morrisons

Working Capital
Required m
Working Capital
Required m

2014
44.58%
46.94%
65.16%
48.55%
3.98%
4.00%

2015
44.58%
46.94%
64.59%
48.16%
3.97%
4.00%

2016
44.58%
46.94%
64.05%
47.79%
3.95%
4.00%

Likely Scenario
1,130.3
1,126.5 1,101.3
920.1
976.0
951.4
Best Case Scenario
1,130.3
1,384.4 1,364.1
Sainsbury's
920.1
976.0
951.4
Morrisons
Worst Case Scenario
1,130.3
1,065.1 1,017.1
Sainsbury's
920.1
789.1
656.5
Morrisons
Figure 15: Other forecasts

2017
44.58%
46.94%
63.55%
47.44%
3.94%
4.00%

2018
44.58%
46.94%
63.08%
47.11%
3.92%
4.00%

1,070.9
919.2

1,037.1
896.0

1,332.1
919.2

1,312.2
896.0

971.3
525.4

927.5
405.9

Notes

(a)

(b)

The required rate of return:

Rf

Rm
35

Proxy:

CAPM: Re=Rf + (Rm-Rf)

Sainsbury's
Morrisons

2.756%
5.12%
10-year GILT (British Average post-recession
government bond) yield FTSE-100 annual change
0.591236
Required return on equity:
4.152%
Figure 16: CAPM and the Required Rate of Return

Page | 16

0.371437
3.633%

4.4 Income Statement and Balance Sheet Forecasts The Likely Scenario
Sainsbury's Income Statement for year end March:
Figures in m
Revenue
Cost of sales
Gross profit
Operating profit
Profit before taxation
Profit for the year attributable to shareholders

2014
23,932
(22,621)
1,311
911
809
631

Net Operating Profit After Tax (NOPAT)

Net Investing Profit After Tax (NIPAT)
Interest Expense AfterSainsbury's
Tax
Balance

2015
24,977
(23,609)
1,369
951
845
658

2016
25,571
(24,169)
1,401
973
865
674

701
751
779
0.06%
15
15
16
111
116 end March:
118
Sheet (over 0.46%
year avg. figures)
for year
% of Total
Assets

Non-current assets
Current assets
Total Assets
Current liabilities
Net current assets (liabilities) - ie working capital
Non-current liabilities
Total Liabilities
Net Assets (Liabilities)

100.00%

29.64%

Shareholder's Equity
Forecasted D/E Ratio

2017
26,040
(24,613)
1,427
991
881
686

2018
26,408
(24,961)
1,447
1,005
893
696

793
16
121

804
16
122

2014
10,669
2,026
12,695
(3,157)
(1,130)
(3,763)
(6,920)
5,776

2015
11,135
2,115
13,250
(3,241)
(1,126)
(3,928)
(7,169)
6,081

2016
11,400
2,165
13,565
(3,266)
(1,101)
(4,021)
(7,287)
6,277

2017
11,609
2,205
13,813
(3,276)
(1,071)
(4,095)
(7,370)
6,443

2018
11,773
2,236
14,009
(3,273)
(1,037)
(4,153)
(7,426)
6,583

5,776
65.16%

6,081
64.59%

6,277
64.05%

6,443
63.55%

6,583
63.08%

2017
20,238
(19,289)
950
812
(522)
(522)

2018
20,643
(19,755)
888
774
(577)
(577)

Figure 17: Sainsburys Income Statement and Balance Sheet Forecast

Morrisons Income Statement for year end January/February:
Figures in m
Revenue
Cost of sales
Gross profit
Operating profit
Profit before taxation
Profit for the year attributable to shareholders
Net Operating Profit After Tax (NOPAT)
Net Investing Profit After Tax (NIPAT)
Interest Expense
After Tax
Morrisons
Balance Sheet

2,014
17,680
(16,602)
1,078
866
(176)
(176)

2015
19,626
(18,529)
1,097
900
(431)
(431)

2016
20,018
(18,993)
1,025
858
(476)
(476)

667
711
687
649
0.02%
4
4
4
4
0.31%
56
62
63
64
(over year avg. figures) for year end January/February:

% of Total
Assets
Non-current assets
Current assets
Total Assets
Current liabilities
Net current assets (liabilities) - ie working capital
Non-current liabilities
Total Liabilities
Net Assets (Liabilities)

100.00%

25.13%

Shareholder's Equity
Forecasted D/E Ratio

2014
8,299
1,300
9,599
(2,220)
(920)
(2,412)
(4,632)
4,967

2015
9,212
1,443
10,655
(2,419)
(976)
(2,677)
(5,096)
5,559

2016
9,396
1,472
10,868
(2,423)
(951)
(2,731)
(5,154)
5,714

2017
9,499
1,488
10,987
(2,407)
(919)
(2,761)
(5,168)
5,820

2018
9,689
1,518
11,207
(2,414)
(896)
(2,816)
(5,230)
5,978

4,967
48.55%

5,559
48.16%

5,714
47.79%

5,820
47.44%

5,978
47.11%

Figure 18: Morrisons Income Statement and Balance Sheet Forecast

Forecasted financial statements for the best- and worst-case scenarios are excluded for
brevity.
Page | 17

619
4
65

4.5 Equity valuation

Figure 19 below shows how the discounted abnormal earnings model was is used to evaluate
the likely-case equity value of Sainsburys, and follow this example we calculated the best
case, worst case and likely scenarios of the equity valuation for both companies. Moreover,
Figure 19 shows the current share price valuation for three scenarios, indicating the likely
range that the market share price may be in. It is assumed that the number of shares will
remain at the current number of shares outstanding for both Sainsburys and Morrisons.
As of now, the markets share price of Sainsburys is around 311.000 GBp38. From these
forecasts the most likely true value of Sainsburys share is around 713.2 GBp, indicating that
the share price is vastly undervalued and that, based purely on this information, the
companys shares are worth buying for a likely profit of 129%. Further, based on these
forecasts, the share price of Sainsburys has the potential to be worth approximately 2309.8
GBp, hence indicating a potential gain of up to around 569%. However, there also exists the
potential to lose up to about 19% of the amount invested, as the minimum reasonable
valuation is deemed to be 252.9p per share.
Currently, the market price of Morrisons is 204.8 GBp per share39. Based on these forecasts,
the most likely true valuation of a share in Morrisons is about 138.2 GBp, indicating that
Morrisons is currently overvalued and that investors should not invest in the company. While
exists the potential to profit by 54%, there also exists the potential to lose 100% of the
investment as shares may reasonably fall to 0 GBp should Morrisons continue losing market
share and experience falling profit margins. Therefore, investors are recommended to buy
shares of Sainsburys and refrain from investing in shares of Morrisons.

Figure 18

summarizes the range of possible share values.These abnormal earnings-based valuations,

have been confirmed using discounted cash flows, the results of which were similar to these
valuations.
Calculations
using each
method are
shown below
in Figure 20
for the likely
scenario.

Figure 19: Current share price valuation for the three scenarios

Page | 18

Figure 20: Methodologies and calculations for valuing under the likely scenario

5.

Recommendations and Conclusions

From the analysis above, it is clear that both companies are engaged in intensive competition.
However, the fact that inelastic demands for necessities will likely prevent a large drop in the
overall supermarket industrys demand coupled with the domination of the industry by the
Page | 19

Big Four mean that the industry as a whole is relatively low risk for the established
enterprises like Sainsburys and Morrisons. It is believed that Sainsburys will be able to
achieve further synergies as to achieve economies of scales and reduce transaction costs,
while Morrisons may find some more significant cost reductions in its vertically-integrated
supply chain.
Despite the use of subjective estimations and judgements in accounting policies, the
information in both firms financial reports are generally prudent and reliable, such that
investors can trust the figures for investment analysis. While gross and operating margins of
Morrisons vertically-integrated cost-reduction strategy has allowed it to achieve slightly
higher gross and operating margins than Sainsburys, this is likely to change as Morrisons
responds to losing market share with extensive price-cutting Sainsburys, meanwhile will
likely maintain some level of immunity from these price wars through a continued focus on
quality. Sainsburys is also in a better position to maintain healthy cash flows.
While different valuation models namely discounted abnormal earnings and discounted
cash flows are used to predict future share prices, similar results indicate that current share
price of Sainsburys is likely undervalued while Morrisons is likely overvalued. This signals
that investors are better-off investing in Sainsburys rather than Morrisons. However, it is
important to remember that unforeseen events may occur and that

Share price of

actual future results may vary. Nevertheless, the forecasts and

J Sainsbury plc

recommendations included in this report remain within the

as of market close
April 4, 2014

bounds of reason, due diligence, and probability.

From this comprehensive analysis of these two firms, it is
recommended that the client invest in Sainsburys as to gain
profits not just in the form of eventual capital gains, but also in
the form of steady, reliable dividends. Given the clients long
term investment horizon and likely dependence on lower-risk
steady income streams, the stability of dividends is especially
important as it is a source of supplementary income. It is also
recommended that the client not allocate her entire portfolio to
shares of this single company.
across

various

securities.

Instead, she should diversify

While

recommendations

for

diversifying is beyond the scope of this report, it is advised that

Morrisons should nonetheless remain absent from any portfolio.

Page | 20

Symbol:

SBRY.L
Summary
of
Recommendations
Buy shares of
Sainsburys
Expect stable
dividends
Diversify
Do not invest in
Morrisons

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