Shoppers at Tesco (LSE: TSCO) have learned to examine its special discounts carefully, because they’re not always as good as they seem.
Investors must be equally vigilant, especially when they see this week’s eye-catching offer from Tesco, a juicy yield of 5.9%.
That’s a stonking return, especially in today’s low interest rate world.
Naturally, it’s also a sign of the deep trouble Tesco is in.
Morrisons’ Base Rate Buster
I confess to feeling smug for offloading my stake in Tesco at around 335p late last year. Today, the once-mighty retailer trades at just 250p, a mighty 35% off its year-high. As the share price has fallen, the yield has risen.
Fellow supermarket struggler Wm. Morrison Supermarkets (LSE: MRW) has also seen its share price plunge and yields soar, in an even more dramatic fashion.
At 169p, its share price is 46% below its year-high. It now yields a whopping 7.72%, more than 15 times base rate.
Trouble Brewing
I wouldn’t blame you for being tempted by these alluring income levels. The big supermarkets may also offer capital growth prospects, if they can reverse their precipitate decline.
A frothy, foaming dividend followed by the whisky chaser of a share price rebound? That’s a heady concoction. But beware, the hangover could be severe.
The Cruellest Cut
If profits continue to fall at Morrisons, management may only be able to sustain that sky-high dividend by dipping into its cash reserves. The City reckons it knows how the story ends, with a dividend cut.
Tesco is thought to be more robust, although consensus suggests its will fall from 14.8p per share this year, to 13.8p next year. That would cut the yield to 5.5% next year.
It Could Be Worse
The dividend could face a more brutal cut as incoming boss Dave Lewis looks for ways to fund his turnaround strategy, says Nicla di Palma, equity analyst at brokers Brewin Dolphin.
He predicts “significant” price cuts to close the gap with Asda, greater product availability and a more pleasant shopping experience. Combined, these measures could knock more than 150 basis points off Tesco’s operating margins.
A dividend cut to as little as 10p is possible, di Nicla says.
Historic Decision
Cutting the dividend sends out a negative signal, but Lewis can adopt the simple defensive strategy of blaming it on his predecessor.
This is a time-honoured practice among new leaders. Henry VIII started his reign by chopping off the heads of Richard Empson and Edmund Dudley, hated tax collectors for his parsimonious father Henry VII.
In a rather less dramatic way, Lewis could take the axe to the Tesco dividend. Investors won’t like it, but can probably live with a yield of 4% or so. It will also establish the new boss as a man who can take firm, quick decisions.
Fun While It Lasted
We won’t know for at least six months, as Lewis doesn’t take over until October. But cutting the dividend to 10p would save Tesco £400 million, and give it extra spending power for more store revamps.
If Tesco continues to shed market share, speculation of a dividend cut will only rise, doing even further damage to the share price.
Don’t be dazzled by that 5.9%. It could soon be on the chopping block.