Shareholders ultimately lose out when too-high payouts prevent companies from responding well to problems. Right now, Tesco needs all the financial flexibility it can muster. Its current dividend is dangerously constricting.
In pure financial terms, the UK-based supermarket has the wherewithal to maintain the payment at current levels. The last 14.76 pence annual dividend was twice covered by underlying earnings per share, and the 1.2 billion pound payment was roughly the same as the free cashflow, HSBC calculates. If profit falls short, Tesco could cut capital expenditure – currently 2.5 billion pounds a year. And it could easily borrow more. Trading profit in 2014 was nearly eight times the interest bill.
But renewed commitment to the dividend would burden the company at a bad time. It needs to cut prices to fight off threats from discounters. Investments in infrastructure and logistics are required if Tesco is to maintain leadership in convenience stores and online shopping. There could also be writedowns on property values of out-of-town stores.
If the money spent on the dividend was reallocated to price cuts, Tesco’s trading profit margin would fall to around 3 percent, from 5-plus percent earned up to 2013. But a clear commitment to give customers lower prices may be the quickest route back to renewed profit growth and a sustainable dividend policy – albeit starting from a lower base.
There’s a governance advantage to acting soon. Tesco has a new chief executive and chief financial officer waiting to take up their roles later this year. They could dodge the recriminations that normally come with a dividend cut. They may even be lauded for boldness.
The share price might suffer. But Tesco stock has already sunk to the point that suggests investors think a downwards move is likely. The historic yield is nearly 6 percent, twice the average for Europe’s Stoxx 600 index.
Timing matters. If it fails to cut now, it may be forced to do so later, from a weaker competitive position. There is a window of opportunity that the grocer would be wise to climb through.