Could Tesco PLC (LON:TSCO) be an attractive dividend share to own for the long haul? Investors are often drawn to strong companies with the idea of reinvesting the dividends. If you are hoping to live on the income from dividends, it’s important to be a lot more stringent with your investments than the average punter.
A high yield and a long history of paying dividends is an appealing combination for Tesco. We’d guess that plenty of investors have purchased it for the income. During the year, the company also conducted a buyback equivalent to around 0.7% of its market capitalisation. There are a few simple ways to reduce the risks of buying Tesco for its dividend, and we’ll go through these below.
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LSE:TSCO Historical Dividend Yield April 14th 2020
Payout ratios
Dividends are typically paid from company earnings. If a company pays more in dividends than it earned, then the dividend might become unsustainable – hardly an ideal situation. Comparing dividend payments to a company’s net profit after tax is a simple way of reality-checking whether a dividend is sustainable. Looking at the data, we can see that 95% of Tesco’s profits were paid out as dividends in the last 12 months. With a payout ratio this high, we’d say its dividend is not well covered by earnings. This may be fine if earnings are growing, but it might not take much of a downturn for the dividend to come under pressure.
Another important check we do is to see if the free cash flow generated is sufficient to pay the dividend. Last year, Tesco paid a dividend while reporting negative free cash flow. While there may be an explanation, we think this behaviour is generally not sustainable.
Is Tesco’s Balance Sheet Risky?
As Tesco’s dividend was not well covered by earnings, we need to check its balance sheet for signs of financial distress. A quick check of its financial situation can be done with two ratios: net debt divided by EBITDA (earnings before interest, tax, depreciation and amortisation), and net interest cover. Net debt to EBITDA measures total debt load relative to company earnings (lower = less debt), while net interest cover measures the ability to pay interest on the debt (higher = greater ability to pay interest costs). Tesco has net debt of 1.10 times its EBITDA, which is generally an okay level of debt for most companies.
We calculated its interest cover by measuring its earnings before interest and tax (EBIT), and dividing this by the company’s net interest expense. Interest cover of 3.61 times its interest expense is starting to become a concern for Tesco, and be aware that lenders may place additional restrictions on the company as well.
Consider getting our latest analysis on Tesco’s financial position here.
Dividend Volatility
From the perspective of an income investor who wants to earn dividends for many years, there is not much point buying a stock if its dividend is regularly cut or is not reliable. Tesco has been paying dividends for a long time, but for the purpose of this analysis, we only examine the past 10 years of payments. Its dividend payments have declined on at least one occasion over the past ten years. During the past ten-year period, the first annual payment was UK£0.12 in 2010, compared to UK£0.091 last year. The dividend has shrunk at around 2.6% a year during that period. Tesco’s dividend hasn’t shrunk linearly at 2.6% per annum, but the CAGR is a useful estimate of the historical rate of change.
We struggle to make a case for buying Tesco for its dividend, given that payments have shrunk over the past ten years.
Dividend Growth Potential
With a relatively unstable dividend, it’s even more important to evaluate if earnings per share (EPS) are growing – it’s not worth taking the risk on a dividend getting cut, unless you might be rewarded with larger dividends in future. It’s good to see Tesco has been growing its earnings per share at 81% a year over the past five years. Earnings per share have been growing very rapidly, although the company is also paying out virtually all of its profit in dividends. While EPS could grow fast enough to make the dividend sustainable, in this type of situation, we’d want to pay extra attention to any fragilities in the company’s balance sheet.
Conclusion
To summarise, shareholders should always check that Tesco’s dividends are affordable, that its dividend payments are relatively stable, and that it has decent prospects for growing its earnings and dividend. It’s a concern to see that the company paid out such a high percentage of its earnings and cashflow as dividends. Next, earnings growth has been good, but unfortunately the dividend has been cut at least once in the past. Overall, Tesco falls short in several key areas here. Unless the investor has strong grounds for an alternative conclusion, we find it hard to get interested in a dividend stock with these characteristics.
Companies possessing a stable dividend policy will likely enjoy greater investor interest than those suffering from a more inconsistent approach. At the same time, there are other factors our readers should be conscious of before pouring capital into a stock. Just as an example, we’ve come accross 4 warning signs for Tesco you should be aware of, and 1 of them is significant.
Looking for more high-yielding dividend ideas? Try our curated list of dividend stocks with a yield above 3%.
If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned.
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