Time to look at Britain’s grocers for some excellent dividend shares?

Always on the lookout for reliable dividend shares, our writer considers whether now’s the time to invest in the UK supermarket sector.

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Over the years, supermarket stocks have built a reputation for being excellent dividend shares. With their defensive properties and strong cash flows, they generally offer better yields than the market as a whole.

But looking at the three grocers in the FTSE 100 it’s not such a clear picture.

Assuming Tesco (LSE:TSCO) keeps its dividend unchanged for a third year consecutive year, the stock is presently offering a yield of 3.7% — below the Footsie average of 3.9%.

When its results for the year ended 24 February 2024 (FY24) are finalised, they are expected to show earnings per share of 24.01p. Over the next two years, analysts are forecasting these to be 25.94p (FY25) and 27.95p (FY26). With a payout ratio of 45%, this could lead to a 1.77p increase in dividend by 2026. It would then be in line with the index average.

With a yield of 4.9%, J Sainsbury (LSE:SBRY) does better. Again, this assumes its dividend for the past two financial years is repeated in 2024. Analysts are predicting that the payout will rise 6.9%, to 14p, by 2026.

Ocado is loss-making and has never returned any cash to shareholders.

Of course, dividends are never guaranteed.

Foreign competition

But the sector’s payouts might come under pressure if the so-called discounters — Lidl and Aldi –continue to make inroads into the UK grocery market.  

However, as the chart below shows, the German pair have hurt Asda and Morrisons more than they have damaged the FTSE 100’s two largest grocers.

Source: Great Britain grocery market share, Kantar

Compared to 10 years ago, both Tesco’s and Sainsbury’s shares have fallen by 1.3 percentage points. Although disappointing, it’s worth noting that both previously had a lower proportion of the market than they do now. I think this demonstrates the resilience of their brands.

And undercutting their larger rivals has come at a cost. Aldi’s annual turnover is approximately half that of Sainsbury’s but its profits are 80% lower. Its gross margin is 3.5%.

Lidl’s margin is lower still — 2.1% — and it makes a loss.

Chart by TradingView

Future prospects

But I don’t see how Britain’s two largest supermarkets are going to significantly change the size and scale of their operations in the coming years. The UK’s competition authorities are likely to block any mergers or takeovers. And Tesco has previously failed to expand overseas.

I therefore don’t think there’s much scope for increasing dividends above their current levels. And while the two offer a reasonable return — particularly Sainsbury’s — I think there are opportunities elsewhere to earn a higher dividend from stocks that have better growth prospects.

However, it’s often overlooked that these companies are also involved in the property business. And there’s a real estate investment trust — Supermarket Income REIT — that’s recently caught my eye.

Please note that tax treatment depends on the individual circumstances of each client and may be subject to change in future. The content in this article is provided for information purposes only. It is not intended to be, neither does it constitute, any form of tax advice.

The trust acquires stores and then leases them back. It currently offers a tempting yield of 8%.

But before investing I’d need to understand more about the £314m write-down in the value of its portfolio over the past two years. Although this is an accounting (non-cash) entry it appears to have made investors nervous.

My conclusion is — a bit like buying groceries — that it’s a good idea to shop around when looking for dividend shares.

Should you invest, the value of your investment may rise or fall and your capital is at risk. Before investing, your individual circumstances should be assessed. Consider taking independent financial advice.

James Beard has no position in any of the shares mentioned. The Motley Fool UK has recommended J Sainsbury Plc, Ocado Group Plc, and Tesco Plc. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

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