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Why I’d avoid Tesco plc and buy this 9% dividend yield instead

Tesco (LSE: TSCO) used to be a byword for solid long-term dividends — yields were only around the FTSE 100 average of about 3%, but they were as dependable as rain in Manchester.

Then came the big crunch as profits collapsed in the face of cut-price competition, and the dividend was scrapped while Tesco embarked on an emergency recovery plan.

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The worst now looks to be over, and after EPS hit rock bottom in 2016 at just 4p (down from 37p back in 2012), things are turning upwards. Tesco recorded a pre-exceptional EPS of 6.75p for the year to February 2017, with the interim stage suggesting forecasts of 10.4p for this year and 12.9p next should be on the money.

Share price stagnation

But at 198p and a forward P/E of 18.5, a share price rally hasn’t really caught on — it’s spiked up a bit in the past month, but we’ve seen a lot of similar short-term volatility over the past three years. I think the reason is twofold, and it’s why I’m not ready to buy Tesco shares.

Even if, as I expect, we do see a renewed EPS and dividend growth phase, I just don’t see Tesco as regaining its old dividend king crown — that was based on the super reliability that has since been shattered as an illusion.

The reality behind that, in my view, is that the days of relatively high margins which allowed Tesco to sit back on its superior market share and just expect the customers to keep rolling in (while expanding overseas, and into banking, etc) are gone forever.

Tesco is simply no longer a must-have stock in any portfolio.

Super dividend

I think the future for dividends now lies with the likes of PayPoint (LSE: PAY), which has 8.8% forecast for the current year, followed by 9% the year after.

To be fair, that’s a total dividend including one-off special payments, and the payment for the full year ended 31 March consisted of an ordinary dividend of 45p, a special disposal proceeds dividend of 38.9p and an additional special of 36.7p.

The total of 120.6p would represent a massive yield of 13% on today’s 922p share price, and that’s obviously not going to happen every year — but just the ordinary portion would still provide a 4.9% yield, which is impressive as a reliable base level.

Interim cash

First-half results released Thursday revealed a handsome interim dividend, with a 15.3p ordinary payment supplemented by an additional 12.2p as the company continues to return surplus capital to shareholders — but there was still £56.6m in net assets on the books, so those extra dividends look safe for at least a couple more years yet.

Revenue and pre-tax profit did fall a little, the latter by 1.5% to £24.4m. EPS remained pretty flat, and the firm’s gross margin dropped by 0.6 points to 48.5% — but that’s still a pretty impressive figure.

Overall, this looks like a decent performance as the company has just completed its restructuring, with a target of growing its retail services — and I see PayPoint’s pro-active restructuring as a good sign that it’s looking forward.

I also like the big competitive advantage that PayPoint has built up which should help keep new competitors at bay.

On a forward P/E of a little over 15, and exhibiting long-term cash-generation characteristics, I think PayPoint shares are a bargain buy.

More dividend cash?

PayPoint looks to me like a long-term investment that should help you to a comfortable retirement, ideally accompanied by a handful of FTSE 100 cash cows. If you like the sound of that, check out our special report outlining Five Dividend Winners to Retire On.

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Alan Oscroft has no position in any of the shares mentioned. The Motley Fool UK owns shares of PayPoint. 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.