While shares in Tesco have fallen by 26% over the last 12months, Morrisons stock has lost just 5%. Whats more, the smaller firms 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 its a smaller, more nimble business than Tesco? Or is there a more fundamental reason?
Tesco used to be famed for its dividend, but those days are over. Shareholders will be lucky if the UKs biggest supermarket manages a token 1.3p per share payout in 2016/17.
Bycontrast, Morrisons has maintained dividend payments and currently offers a forecast yield of 2.9%, rising to 3.1% for next year.
We dont expect exciting growth from supermarkets, but most investors do want a reliable income. Morrisons ticks that box, Tesco doesnt.
What a burden
Hand-in-hand with Tescos lack of a dividend is the groups debt problem. Net debt is around 10bn, up from 7.7bn two years ago. Tescos 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. Well find out more when the groups results are published on 10 March, but Morrisons big success has been its ability to generate cash despite cutting prices.
One reason for this is that the majority of the groups stores are still owned freehold, whereas a substantial proportion of Tescos big stores are now leased, having been sold to generate cash in years gone by.
The big earnings question
I dont think its 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, Ive calculated potential earnings figures for each supermarket. Ive assumed that sales will remain roughly flat and that each company will manage an operating margin of 2.5%. Based on previous results, Ive 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 dont see obvious value in either stock, but I suspect Morrisons may maintain its lead.
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.