Will WM Morrison Supermarkets PLC Continue To Beat Tesco PLC?

The last year hasn’t been great for supermarket shareholders, but if you backed Wm Morrison Supermarkets (LSE: MRW) over Tesco (LSE: TSCO) you may be feeling slightly smug.

While shares in Tesco have fallen by 26% over the last 12 months, Morrisons stock has lost just 5%. What’s more, the smaller firm’s recovery over the last three months has been quite remarkable. Shares in Morrisons are worth 20% more than they were at the end of November. Tesco has only climbed 7.5%.

Is Morrisons recovering more quickly because it’s a smaller, more nimble business than Tesco? Or is there a more fundamental reason?

Buying yield

Tesco used to be famed for its dividend, but those days are over. Shareholders will be lucky if the UK’s biggest supermarket manages a token 1.3p per share payout in 2016/17.

By contrast, Morrisons has maintained dividend payments and currently offers a forecast yield of 2.9%, rising to 3.1% for next year.

We don’t expect exciting growth from supermarkets, but most investors do want a reliable income. Morrisons ticks that box, Tesco doesn’t.

What a burden

Hand-in-hand with Tesco’s lack of a dividend is the group’s debt problem. Net debt is around £10bn, up from £7.7bn two years ago. Tesco’s forthcoming results should show an improvement in the debt position following the sale of its Korean business, but the group is still likely to have gearing of well over 100%.

Morrisons has managed much better. Net debt has fallen steadily from a 2014 peak of £2.8bn, and is expected have fallen below £2bn during the year just ended. We’ll find out more when the group’s results are published on 10 March, but Morrison’s big success has been its ability to generate cash despite cutting prices.

One reason for this is that the majority of the group’s stores are still owned freehold, whereas a substantial proportion of Tesco’s big stores are now leased, having been sold to generate cash in years gone by.

The big earnings question

I don’t think it’s realistic to expect supermarket earnings per share to recover to historic levels, at least not in the next few years. Prices are falling and profit margins have been cut at both firms to try and win customers back from Aldi and Lidl.

However, the big question is how much earnings will rise from current levels. Tesco currently trades on a 2017 forecast P/E of 20, while Morrisons is on an equivalent figure of 17. This suggests to me that the market is pricing-in further earnings growth.

As a rough estimate, I’ve calculated potential earnings figures for each supermarket. I’ve assumed that sales will remain roughly flat and that each company will manage an operating margin of 2.5%. Based on previous results, I’ve also assumed that each company will pay around 35% of operating profits in tax and interest.

My calculations suggest ‘back to normal’ earnings per share of 11.1p per share for Tesco and 11.2p for Morrisons.

Interestingly, this equates to a P/E of about 16 for both supermarkets. I may be being too cautious, but based on this I reckon that both supermarkets are probably fully priced at the moment.

I don’t see obvious value in either stock, but I suspect Morrisons may maintain its lead.

However, I'm fairly sure that there's better value elsewhere in today's market.

The five blue chip stocks featured in 5 Shares To Retire On all have the potential to outperform supermarket stocks over the next few years.

The Motley Fool's investment experts have chosen these companies for their long-term growth potential and strong pricing power. These are two qualities UK supermarkets don't seem to have.

If you'd like full details of the five companies in this exclusive free report, then download your copy today.

Just click here now for immediate access.

Roland Head owns shares of Tesco and Wm Morrison Supermarkets. The Motley Fool UK has no position in any of the shares mentioned. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.