Broker tips: Sainsbury, Royal Mail

Sainsbury's mixed second-quarter results and plans for a no-stone-unturned strategic review have led broker Shore Capital to downgrade its earnings and dividend forecasts, and an "uncomfortable hold" stance.

The company guided to a 2% fall in like-for-like sales, but did not change its full year profit guidance, with consensus currently at circa £710m.

Shore's head of research, Clive Black, slashed his expectations for Sainsbury's full-year 2015 retail earnings before interest and tax by 16%, forecasting a 17% pre-tax profit fall to £645m and earnings per share (EPS) of 25.1p.

The company also followed recent pricing initiatives with news that it has reconfigured its 'Brand Match' promotion to just compare prices with Asda, no longer matching Tesco, which has a much larger own-brand offer.

Alongside results, Coupe revealed plans for a wide-ranging strategic review, with details of his plan to be provided with Sainsbury's interim results on 12 November, which has put the wind up investors that the dividend could be cut.

"With respect to one of the key features of Sainsbury's investment case, its dividend, we harbour growing concerns about its sustainability at current levels with recent trading trends and profit trajectories," said Black.

He said he believed it would take "a lot of work" to produce the level of free cash flow to support the group's current dividend stream, including central cost cuts and a further reduction in capital expenditure.

Hence, for 2016 Black has forecast a payout of 11.25p, implying a yield of 4.6%, a cut of around 35%, but admitted he may being overaggressive.

"Should Sainsbury's recent actions on pricing represent a turn of the corner in the recent sales and market share trajectory of the business then the dividend will indeed become more secure and the stock can be expected to bounce back to or near the underlying net asset value of the group, which is currently 305p," he added.

Either way, he concluded that Sainsbury's shares at current levels "feel like a poor risk-return equation", despite its "deserved" de-rating after a poor year so far to current "undemanding valuation ratios".

Letters and parcels group Royal Mail is facing multiple headwinds but there is long-term value to be found in the stock, analysts at Shore Capital believe.

Indeed, evidence from sector peers shows that conditions worsened significantly in August and September, as rival TNT continues with its city-by-city roll-out, for example. Competitive pressures also remain strong due to increased direct deliveries in the B2B and B2C segments through controlled networks.

Furthermore, weak European economies are impacting on volumes.

However, this most difficult trading period may be about to end.

In that regard, the company’s latest Q1 report shows mail activities have been putting in a better-than-initially-expected performance and a positive contribution from European parcels at GLS.

Yet what should really matter for investors is the potential for the firm to achieve industry-standard margins about 100 basis points above the current achieved levels of 8%-plus, the ability to reduce costs, leverage the balance sheet and flex its market position in the UK. The dividend is well covered by the company’s cash flow too.

For all of the above reasons Shore Capital has decided to retain its buy stance.

The news-flow surrounding the mail and parcel delivery sector of late has been quite negative, and merits marking down forecasts for Royal Mail, but the headwinds facing the company are baked into the price already, UBS thinks.

After UK Mail reported weak UK parcel volumes last week and on the heels of reports of adverse pan-European trading (TNT Express) the Swiss broker has decided to cut its estimate of parcel volume growth for this fiscal year at Royal Mail to 2% from 2.5%.

It has also modified its exchange rate assumptions for this year and next to 1.26 and 1.27 € per £ for this year and next.

To the new forecasts for flat EBIT margins one must add the challenges of modernising its network, its high fixed cost base – given its relatively well paid and highly unionised workforce - and the significant changes which the letter and parcel markets are undergoing.

The recent poor share price performance and valuation largely already factor-in all of the above.

Hence, analysts Dominic Edridge and Jarrod Castle have upgraded their view on Royal Mail to ‘neutral’ from ‘sell’ although their price target has been lowered to 400p from 450p.