Can supermarkets still provide a safe source of income?

Tesco’s (LSE: TSCO) shares rallied 11% following today’s upbeat first-half trading update and management’s new bullish outlook on margins. The company delivered its third consecutive increase in UK quarterly sales, with like-for-like sales growth of 3.3% and volumes up 2.1%. This turnaround in its sales trend is further evidence that the recovery is strengthening.

But what was most significant from today’s trading update was the announcement of its new operating margin target of between 3.5% and 4% for the 2019/20 financial year. Up until now, management had avoided giving investors forward-looking guidance because of the uncertain market conditions, so this change shows us the renewed confidence that management has in its recovery.

The new operating margin target compares very favourably to its current figure of 2.2%, and would be achieved by cutting a further £1.5bn from its cost base. This renewed focus on margins comes after a difficult period for Tesco in the face of intense competition from the German budget chains, Aldi and Lidl, which forced the company to abandon its long-held progressive dividend policy.

The recent update will no doubt boost hopes that a return to dividend payments should follow, but shareholders may have a longer wait than expected. Management intends to increase capex investments to £1.4bn a year, up from around £1bn now.

Meanwhile, following the collapse in bond yields following the Brexit vote of 23 June, Tesco’s pension deficit ballooned to almost £5.9bn, from just £2.6bn in February. And although management doesn’t believe it needs to increase its contributions to its pension scheme immediately, there’s no doubt that the deficit will need to be plugged by future contribution increases in later years.

All this indicates that a resumption of dividend payments will not come quickly. After all, margins have a long way to climb from current levels and there may be few more hiccups along its recovery path.

Sainsbury’s and Morrisons

Evidence of Tesco’s turnaround is good news for shareholders in Sainsbury’s (LSE: SBRY) and Morrisons (LSE:MRW) too. Shares in both supermarkets are trading significantly higher today, as Tesco’s upbeat outlook reflects an easing in price competition and shows that cost efficiency improvements, improved customer service and simpler product lines are beginning to deliver results.

Both companies have made steep cuts in their payouts, and shares in Sainsbury’s currently yield 4.8%, while those in Morrisons trade at 2.3%. These yields may not seem massively impressive, but with the turnaround in trading performance for the sector taking hold, the risk of dividend cuts is much reduced.

The bottom line

So while it’s clear that the dividend outlooks for the supermarket sector have improved in recent months, I’m still not sure that supermarket stocks can still deliver a safe source of income. The fundamentals for the sector have shifted dramatically in recent years and although the incumbent supermarkets have made significant steps to adjust to these ‘new’ market conditions, finding enough free cash flow to pay shareholders will remain a huge challenge.

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Jack Tang has no position in any shares mentioned. 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.