Where Next For Tesco's Dividend?

Published in Company Comment on 27 December 2012

Can Tesco (LSE: TSCO) afford its dividend payments, or is a dividend cut likely?

Many investors focus on earnings per share when judging a company's performance. However, earnings can be manipulated and adjusted in all sorts of ways, meaning they don't tell you a lot about how much spare cash a company has generated. Similarly, since dividend cover is calculated using earnings, a good level of dividend cover doesn't necessarily mean the payout is actually being funded from a company's profits.

A company's cash flow can tell you a lot about a firm's financial health. Is the company burning up its cash reserves on interest payments and operating expenses, or does it generate spare cash that can fund dividends or be retained for future investment? If a dividend isn't funded by cash flow, then there is a greater chance the payout will become unaffordable and be cut, which is bad news for shareholders like you and me.

In this series, I'm going to take a look at the cash flow statements of some of the biggest names in the FTSE 100 (UKX), to see whether their dividends are being funded in a sustainable way, from genuine spare cash. Today, I'm looking at Tesco (LSE: TSCO) (NASDAQOTH: TSCDY.US).

Tesco's troubled year

This has not been a good year for Tesco. In January it was forced to issue a profit warning, sending its share price down by 22% in just a few days. For most of the year, its sales results have lagged behind those of Morrisons and Sainsbury. Tesco has also had to face up to slowing growth in its Asian and Eastern European stores.

However, there are signs that Tesco is turning things around -- in its last quarterly update, it moved ahead of Morrisons in terms of sales growth and also announced the disposal of its loss-making US operation, Fresh & Easy.

Does Tesco have enough cash?

As private investors, we want to back businesses that are able to pay their dividends out of free cash flow each year. I define free cash flow as the cash that's left over after capital expenditure, interest payments and tax deductions. With that in mind, let's look at Tesco's cash flow from the last five years:

Year20082009201020112012
Free cash flow (£m)389-2,0142,8682,3661,225
Dividend payments (£m)7948869701,0831,183
Free cash flow/dividend*0.5-2.33.02.21.0

* A value of >1 means the dividend was covered by free cash flow

Source: Morningstar, Reuters, Tesco annual reports

Tesco's heavy capital investment program and loss-making US business has had a serious impact on its free cash flow. Averaged over the last five years, its ratio of free cash flow to dividend payments is 0.9, indicating that it has not generated enough free cash to pay its dividends, and has had to top up its payouts with borrowed money.

It's worth noting that despite not being covered by free cash flow, Tesco's dividends have remained more than twice covered by reported profits. This shows how reported profits can be used to make dividends seem more affordable than they really are, and is a useful warning sign for investors.

Tesco's failure to pay its dividends out of free cash flow isn't good news, but it isn't necessarily disastrous, either. Everything hinges on whether the firm can now start to reverse its declining profitability and improve its cash flow situation. Failure to do this could mean that the company's 28-year record of dividend growth may come to an end.

The problem is that despite scaling back plans for mega-sized new stores, Tesco's turnaround plan still involves spending a lot of money to rejuvenate existing stores and improve staffing levels. According to the firm's latest half-yearly report, Tesco is planning to spend a further £1bn on its UK turnaround plan, Building A Better Tesco. Could this threaten the supermarket's dividend growth record?

Is Tesco's dividend safe?

Tesco's cash flow has been quite badly stretched over the last five years, but I think that by disposing of its US business and focusing on improving its existing UK stores, Tesco should be able to reverse the decline in its UK sales and improve its cash flow.

I'm also quite keen on the growing income from Tesco Bank; personal finance products tend to provide much higher profit margins than food, and Tesco reported an operating margin of 18.3% for Tesco Bank in its most recent interim results, compared to 5.2% for its UK supermarket operations.

I think that Tesco will manage to avoid cutting its dividend, but any dividend growth is likely to be pretty minimal for the next couple of years, while the company's turnaround plans work through the system and start to deliver results.

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> Roland owns shares in Tesco but does not own shares in any of the other companies mentioned in this article. The Motley Fool owns shares in Tesco.

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Comments

The opinions expressed here are those of the individual writers and are not representative of The Motley Fool. If you spot any comments that are unsuitable hit the flag to alert our moderators.

TheFoolishDave 27 Dec 2012 , 10:28am

Roland

Where can I find the figures for free cash flow in companies results or do you have to calculate it?

Cheers

FundDamager 27 Dec 2012 , 2:02pm

TheFoolishDave,

You're unlikely to find free cash flow in company reports unless its something the company want to boast about.

Calulating it isn't hard, just a little time consuming.

http://en.wikipedia.org/wiki/Free_cash_flow

BigJC1 27 Dec 2012 , 4:57pm

You shouldn't always be fooled by free cashflow, having lots of it is not necessarily a good thing.

I would rather Tesco reinvest free cashflow in opening stores in Asia, sprucing up the UK stores, etc. In the period 2008 - 2012 Fixed assets have risen from £24bn to £38bn.

They will not always get it right (as per the USA) but in general I trust the management team to invest wisely and carry on growing. It is that long term growth I am most interested in because it will fund dividend growth more effectively than hoarding cash.

However, the recent disclosure of their secret subsidiary for buying executive jet travel for their management is disconcerting, perhaps the new management is not quite as reliable as the old ?

Arborbridge 27 Dec 2012 , 7:43pm

I get different figures for free cash flow after capex. In 2011 the dividend was covered 2.4 times, and in 2012 by 1.6 times on my numbers. But don't just take my word for it. Check Company REFS. Subtracting the capex from the free cash and dividing by the cost of the dividend gives us a free cash flow cover in 2011 of 2.6 times, and in 2012 of 1.6 times.
And the net borrowings have been reducing in the past three years, not increasing, so the dividend does not appear to be financed by borrowings. Admittedly, borrowings increased substantially in 2009, but since then they seem to have got a handle on it.
All in all, I don't see any problem paying the dividend unless there are real disasters in the years ahead.
Tesco is a huge money making machine, and that's why I topped up when the price fell.
Arb.

TheFoolishDave 28 Dec 2012 , 8:59am

Thanks Guys

jackdaww 28 Dec 2012 , 9:40am

what is buffett doing ???

presumably he would exit if tesco managers are not up to it now.

goodlifer 28 Dec 2012 , 10:53pm

FundDamager
"You're unlikely to find free cash flow in company reports."

I'm sure you're right, but WHY?

If I were the boss of a company with a healthy free cash flow, I'd want every b,,,,r and his brother to know about it.
I'd have it trumpeted from the rooftops.

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