What Dividend Hunters Need To Know About Tesco PLC

Today I am looking at whether Tesco (LSE: TSCO) is an appealing pick for those seeking chunky dividend income.

Dividends under fire as earnings slip

Against a backdrop of tight consumer spending and intensifying competition, Tesco recorded its second consecutive annual earnings drop in the year concluding February 2014. The relentless rise of budget retailers like Aldi and Lidl has been the main culprits behind Tesco’s slide, and the firm saw like-for-like sales — excluding VAT and fuel — slip 1.4% last year.

Although the supermarket’s 5% earnings decline was a definite improvement from the 16% drop punched in 2013, the firm’s Tescocontinued financial troubles forced it to keep the full-year dividend on hold for the second consecutive year, at 14.76p per share.

For income investors Tesco’s difficulties make for worrying reading. City analysts expect earnings to worsen in 2015, with a 15% drop pencilled in, and brokers expect this scenario to result in a 4.3% cut to the dividend, driving it to 14.13p per share.

The supermarket is predicted to see earnings — and consequently dividends — rise tentatively thereafter, although payouts are only expected to return to last year’s levels in 2018.

Investors should still be aware that the chain’s prospective dividends still chuck up yields far in excess of the big-cap average, however. Indeed, for 2015 and 2016 Tesco currently sports yields of 4.7% and 4.8% correspondingly, beating the FTSE 100 forward average of 3.2% hands down.

A fragile income pick

Still, Tesco’s prospective payouts can hardly be considered the safest available. Based on current earnings projections Tesco is expected to offer dividend coverage below the widely-regarded security benchmark of 2 times forward earnings or above over the next few years, with readings of 1.9 times registered in 2015 and 2016 respectively.

These figures are hardly calamitous, but given that Tesco is only expected to record modest earnings growth in coming years — a scenario which could easily be blown off course given its worsening market share — current coverage levels are a cause for concern in my opinion.

Tesco continues to build on massive growth areas, i.e. convenience and online, to steady the ship and reclaim its aura at the top of the UK grocery tree. Indeed, the supermarket has identified investment in its internet operations — from which sales rose 11% last year — as critical for future growth, and recent measures range from slashing delivery fees through to building more of its mammoth internet-only stores.

But with Morrisons entering the fray and J Sainsbury already a major player in this area, Tesco may see itself having to paddle extremely hard just to stand still. And with new, cheaper retailers continuing to batter footfall at its megastores, Tesco’s appeal as both growth and income stock could come under increased scrutiny.

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Royston does not own shares in any of the companies mentioned in this article. The Motley Fool owns shares in Tesco and has recommended shares in Morrisons.