In February, a month before Justin King was appointed chief executive of J Sainsbury - before the botched appointment of a successor to Sir Peter Davis as chairman, the three profit warnings, the resignations of half the operational board and a handful of non-executive directors - one investor said: "What you have to remember is J Sainsbury is not a normal company."

With so much going awry at what was once Britain's leading supermarket chain, questions are being raised over whether Sainsbury still has a place in the UK's supermarket landscape which is worth £115bn, and whether Mr King is the person to turn it round.

The company has positioned itself as the sole occupier of the middle ground on the assumption that shoppers are prepared to pay a little more for better quality food. Hence its slogan: "Good food costs less at Sainsbury".

This leaves it squeezed between Marks and Spencer and Waitrose, where shoppers are prepared to pay a higher price for innovation and quality, and Tesco, Asda and Wm Morrison and their "every day low prices".

Ten years ago, Sainsbury was industry leader, a spot it lost in 1995 to Tesco. Last year, it lost its second place to Asda, owned by Wal-Mart, and earlier this year it looked close to being knocked off the third spot by the combined Morrison/Safeway group.

Taking the middle road has taken a toll on Sainsbury. Tesco has strengthened over the past several years and now its market share is 40 per cent bigger than Sainsbury's. By market capitalisation, Tesco is more than five times bigger at £22.4bn. Even Morrison is worth more at £5.1bn, compared with Sainsbury's £4.2bn. Sales at Sainsbury have fallen from £17.4bn in the year to the end of March 2003 to £17.1bn the following year and are forecast to fall to £15bn in 2004-5.

Sainsbury's problems do not end at falling sales and profits. Its latest profit warning - issued this week - was prompted by a series of investment rating downgrades by analysts and came after talks with the Financial Services Authority, the City watchdog, about whether the company needed to make a public statement about its financial health. The FSA is also looking into whether Sainsbury broke listing rules when it told Merrill Lynch analysts that their first-half forecast for this year was high.

Analysts are now expecting pre-tax profits of between £200m and £300m for this year, against expectations of £800m a year ago. There is even talk of a fourth profit warning before the year is out, possibly as early as next week when Mr King, who took over as chief executive from Sir Peter in March, reveals his turnround plan.

So what went wrong? Observers say the problems are both cultural and structural and are not helped by Sainsbury's attempt to fill the middle of the market in pricing.

The Sainbsury family, which founded the company 135 years ago, continued to occupy the top management positions until Sir David Sainsbury stepped down as chief executive in 1997 and as chairman a year later. The following year, the departure of Tim Sainsbury ended the family's representation on the board.

According to one observer, the family's involvement in managing the company meant that it was run by non-professionals who believed their birth right was the only qualification needed. Their legacy is not just a management style; it is also responsible for a poor record of communication with the City.

With members of the Sainsbury family making up the largest group of shareholders - the family still holds about 38 per cent of shares - the management has historically turned to them first and other investors second, if at all.

In return, the family has supported the board in some difficult periods - such as Sir Peter's controversial pay-off this summer when shareholders, including the Sainsbury family, approved his remuneration package despite falling profits and share prices. Four years ago, the shares were on an upward path towards 400p - on Friday they closed at 246p - as Sir Peter, then newly installed as chief executive, embarked on an ambitious £3bn investment in the chain's distribution systems.

His plan was to fill the gap between the low and high priced supermarkets while cutting costs through modern warehouse and distribution systems, with the aim of boosting the profit margin.

But it has now become clear that the new systems do not work. Dogged by problems - such as difficulty reading bar codes, information technology failures and even issues over the life expectancy of equipment, which continually breaks down -the systems have led to worse than ever product availability in the shops and further loss of customers.

Philip Dorgan, analyst at Panmure Gordon, says that the £3bn spent over the past four years has achieved an increase in profit before interest and tax of only £23m.

The problem is now Mr King's.He faces some tough choices: to abandon the middle ground and lower prices - a process he set in motion when he arrived - or to stay put but address the question of how customers can be persuaded that they are still getting value for money; to write off the £3bn investment or work at fixing the problems with the systems.

Analysts believe taking on Tesco and Asda, with their much deeper pockets, in a price war would be suicidal, especially given how ahead they are in market share. They also rule out Sainsbury's taking on the higher end of the market, which is not large enough for it fully to utilise its scale of operation.

Instead, they say, Mr King would be better advised to continue trimming prices, which have been about 5 per cent higher than Tesco's, and invest in improving value for customers. But this is a risky strategy. According to one analyst: "If Sainsbury cuts prices by 3 percentage points, this will cost it about £400m in sales, tipping it into losses, at least for the short term." But as a long-term strategy, some retailing experts believe it would work, because Sainsbury still has a good brand and some valuable assets.

One of Britain's leading retail entrepreneurs says: "I don't think it's all just about price. If you offer people nice stuff, they will buy it. Sainsbury is a good mid-market brand and it's still doing £15bn a year."

The question is how Sainsbury can get back on track.One industry veteran who has worked with Mr King says: "It has lost track of what it is. It's a supermarket not a hypermarket - it does food first."He believes there is a place for Sainsbury, but with a much simpler offering. "Non-food has been a huge distraction. Waitrose has taken a lot of its position, but it doesn't have the distribution. Sainsbury can get it back. It's very do-able. But Justin's got to be focused and tough." Cutting out the non-food lines would also help solve some of the problems with the distribution and warehousing systems,he adds.

"The systems aren't really the problem, it's the processes. There's a huge disconnect between the stores and the head office that he needs to look at. I think he will do some write-downs - that's financially what you do - but really he's stuck with it."

Some investors are urging the company to make use of the £4.3bn worth of freehold properties it owns. But Mr Dorgan at Panmure says: "Given the huge underperformance of the business, we do not believe that it could afford to commit to future rising rental bills." The departure this month of Desmond Taljaard as property director indicates that a complicated property strategy is unlikely. Investors should also be bracing themselves for a likely cut to the dividend, says Mr Dorgan.

So if investors do not get a pay out will a venture capitalist, as some have speculated, buy them out? Analysts dismiss this, pointing to the competitive nature of the UK supermarket sector.

They also rule out the possibility of a takeover by a rival retailer because the Competition Commission would limit expansion by the dominant domestic players while foreign retailers can get better returns elsewhere.

This means the company's best chance of a turnround is with the current management. "The most important thing for Justin is having it in his own mind what he's trying to do and having the right people to help. This is a three to five year turnround," says the person who formerly worked with Mr King.

Asked whether investors will give Mr King long enough, an industry insider replies: "He has to have that long. If he's not given enough time, who'll take it on?" One friend of Mr King's, with years of retail experience, says: "Quick change is superficial change and it's the job of the chief executive and chairman to convince investors that change is worth waiting for."

Sources for charts: Thomson, Datastream, Verdict, UBS

German retailer faces similar problems

J Sainsbury is not the only venerable retailer to have slid into trouble in Europe, writes Bettina Wassener in Frankfurt. Across the channel KarstadtQuelle, the German department store and mail-order giant, has just had to announce the most radical restructuring programme in its history. It remains to be seen how successful it will be.

Like Sainsbury in the UK, KarstadtQuelle is a household name in Germany. It includes the Karstadt department stores that are a staple of shopping streets across the nation, as well as the famed Quelle and Neckermann mail-order businesses.

The group’s current problems have thus come as a shock to many Germans and caused an outcry among politicians and the public.

KarstadtQuelle - again like Sainsbury - embarked on a change of management earlier this year as the extent of the slide in earnings and sales became clear. But while Sainsbury is profitable, underlying losses before interest and tax widened at the German group to €388.5m (£268.9m) during the first half, while sales fell by 6 per cent to €6.87bn.

Its problems are partly home-made, and partly due to Germany’s retail environment, which is deemed to be the toughest in Europe.

Like Sainsbury, the German retailer has in recent years increasingly found itself squeezed between cheap-and-cheerful rivals and upmarket retailers, leaving it struggling for a well-defined customer target group in the middle.

Under its new supervisory board chairman Thomas Middelhoff - the former head of the Bertelsmann media empire - and Christoph Achenbach, chief executive since June, a drastic overhaul plan has been drawn up.

The strategy aims to focus on the group’s core businesses and the management hopes that proceeds from upcoming disposals will amount to €1.1bn.

KarstadtQuelle plans eventually to sell 77 of the smaller Karstadt stores. At the 89 that will remain, more space will be devoted to higher-margin products such as jewellery, cosmetics and books.

A key part of the revamp strategy fell into place on Thursday, when a €760m cost-cutting programme was agreed with the group’s 100,000 employees.

But analysts said on Friday that new details of a planned deeply-discounted €500m share issue signalled a lack of confidence in KarstadtQuelle’s future.

Poor sales at the Karstadt department stores, in particular, have highlighted the problems that its non-niche positioning has caused.

The stores have tried to straddle the entire discount-to-upmarket range, and to offer “everything under one roof” from socks and evening dresses to washing machines, DVDs and toys.

That format may have worked well until a decade or two ago. But retail experts now speak of a “hybrid customer” who might shop at H&M in the morning but buy Chanel in the afternoon - and who is hard to tempt into department stores.

The Karstadt all-in-one format fails to appeal to Germany’s modern shoppers. The expansion of discounters, in particular, has hurt.

“In clothing, they may be doing all right, but nobody buys a television at Karstadt these days. If you want a TV, you go to [the electronics outlets]MediaMarkt or Saturn,” says one private equity expert who is closely watching the situation at KarstadtQuelle.

Analysts caution that the overhaul at KarstadtQuelle may not manage to produce sales growth at what will remain of the group.

Consumer confidence in Germany has been dismal for years due to feeble economic growth and high unemployment.

With no spending pick-up in sight in Germany, the future does not bode well for KarstadtQuelle.

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