Outlook: Sainsbury will never catch Tesco, but there's gold there still

Dollar pressure; EMI on a roll
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Worryingly, it's looking as if Sir Peter Davis, chief executive of J Sainsbury, may have pulled it off after all. I say worryingly because Sir Peter's corporate obituary has been written so many times in the financial press and the City over the past year that if he actually succeeds in the turnaround he's promised, an awful lot of people will have to eat their words.

Not that yesterday's figures are anything to boast about. Like-for-like sales are only marginally ahead in the core, UK supermarkets business for the first half and group pre-tax profits are virtually the same as a year ago. The interim dividend is up only 2.5 per cent, against the targeted 5 per cent, and there's plainly been a slight slippage in the timetable for re-engineering the group's distribution system. Yet the underlying message is a positive one.

Sir Peter has made an excellent hire in Justin King as his new chief executive. He's another of Allan Leighton's protégés, having worked with Portfolio Man at both Mars and Asda. The way things are going it won't be long before the entire high street is run by Mr Leighton's luminaries, Richard Baker, another Mars and Asda man, having just started as the chief executive of Boots. The Asda diaspora just keeps growing.

Yet Mr King joins with the heavy earth-moving at Sainsbury's already done. By next autumn, the three main planks in Sir Peter's strategy for turning what he has likened to "a rundown boarding house" into the hoped for five-star luxury hotel will be largely complete. From the summer onwards capital spending on refurbishment and new distribution centres declines markedly, underpinning the sustainability of the group's relatively generous dividend payments.

The proof of the pudding will be in the results. Nobody yet knows for sure whether the strategy will work in reversing years of relative decline against both Tesco and Asda, and it is fair to say that the sceptics still outnumber the faithful. Were it not for the continuing support of the Sainsbury family, reaffirmed yesterday, Sir Peter would in all probability already be out on his ear. As it is, he's being elevated to the chairmanship before his turnaround strategy is given sufficient time to demonstrate results. Crafty or what?

None the less, I suspect that the worst is now over, both for Sir Peter and the company. Sainsbury's still trails its leading rivals in much of what it does, the most recent example being its extraordinarily slow expansion into non-food lines. Yet it now seems fully reconciled to entering the war on price, and frankly, if the almost total refurbishment Sainsbury's has undergone over the past three years doesn't work, then nothing will.

Size isn't the only determinant of success in supermarkets. Both Tesco and Asda came from behind to overtake Sainsbury and eventually completely trounce it. The problem Mr King has got is that neither of them are bogged down in the complacency that afflicted Sainsbury's when it was still market leader. He also has to meet the challenge of the new force on the supermarkets scene that promises to be created out of the merger of Wm Morrison and Safeway. Tesco will never be overtaken, or not in Mr King's lifetime anyway, and Asda looks equally well-toned for the long haul. Morrisons is already a formidable competitor, about to get even more so. But what Mr King can do is reverse the decline. It's not rocket science, just hard graft, and Sir Peter has given him an excellent base on which to build.

Dollar pressure

President George Bush's intransigence on steel tariffs and the now looming threat of a trade war with China - the US wants to impose quotas on Chinese fabrics - are driven more by political considerations than economic ones (there's a presidential election next year, stupid), yet the ballooning size of the US trade deficit gives US economic policy makers every reason to panic. According to some estimates, the trade deficit could reach getting on for 7 per cent of gross domestic product by 2005 if nothing is done to stem the tide of imports, which, as Mr Bush once famously pointed out, come mainly from abroad.

With the US economy recovering much more swiftly than anywhere else, the position is made more acute still. In the past, foreigners have been happy to fund the trade deficit by investing heavily in US assets. Recent figures have shown a sharp fall-off of capital inflows. Indeed, there are already signs of an outright flight of capital. In September, foreign investors made net sales of US equities of $6.3bn, against net purchases of $11.6bn the month before. Foreign appetite for US Treasury bonds and direct investment in the US has also fallen sharply in recent months.

A big trade deficit in combination with a flight of capital means only one thing - that the currency will correct until the balance of trade is restored. Already the process is under way. Since its 2002 peak, the dollar has declined by nearly 25 per cent against other major currencies. There's almost certainly further to go, endangering the export-led recovery in Europe and Japan. China, whose currency is pegged against the dollar, meanwhile becomes more competitive still. All the ingredients are there for the perfect trade storm.

EMI on a roll

With all eyes still firmly focused on whether EMI can pull off the acquisition of Warner Music, yesterday's interim figures from EMI were always going to struggle to command attention, but actually they were well worth waiting for. Flat sales and level pegging operating profits may not seem much to write home about. On the other hand, set against an industry where sales are declining by more than 10 per cent a year, they look positively miraculous. At a time when competitors are being forced to discount heavily just to keep sales from falling off a cliff, EMI has managed both to grow market share and to hold its operating margins.

Heavy cost cutting has helped but, more encouragingly, the group is beginning to produce a steady flow of creative success. Alain Levy, EMI's head of recorded music, seems to have achieved just the right balance of new and old in his roster of artists - from Norah Jones and Coldplay to old reliables such as re-releases of the Beatles. His success with recorded music is complemented by exceptionally strong growth in some areas of music publishing, most notably mobile phone ring tones, whose success in selling music has come as a genuine surprise to all.

Eric Nicoli, the chairman, would like us to believe that such a creditable performance shows that EMI doesn't need a deal. If he can secure Warner Music, then great, but the company is capable of standing on its own two feet without support. Well, perhaps, but much depends on whether Sony and Bertelsmann manage to achieve their own rival merger. If they succeed, then both EMI and Warner Music on their own will look much smaller than the two market leaders, Sony/Bertelsmann and Universal Music, and however well they perform against the goliaths, they are bound to feel the squeeze.

Mr Levy claims to be making headway in the battle against music piracy, but despite the recent success of paid for download services such as iTones, it's an uphill struggle and it's still far too early to say the tide has been turned. To really motor in what Mr Nicoli calls "an industry going through unprecedented change", EMI needs that deal.

Negotiations to buy Warner Music from Time Warner are at an advanced stage, but the pitch has been queered by the emergence of a private equity rival headed by the US based media moguls, Edgar Bronfman Jr and Haim Saban. The advantage to Time Warner of selling to Mr Bronfman is that it's a clean cash exit and there is no regulatory risk. The advantage of selling to EMI, whose offer is partly in shares, is that Time Warner gets a share of the very considerable synergy benefits.

EMI has demonstrated that it can survive without Warner Music, but it may be a pretty miserable existence.