Income investors should brace themselves for bad news as incoming Tesco (TSCO) chief executive Dave Lewis may cut the company’s dividend in a quick bid to improve cash flow. The stock currently has a yield of 6%, and features in many of the top equity funds’ portfolios, including offerings from Schroders, BlackRock Fidelity and First State.
But according to Templeton Growth fund manager Dylan Ball, Tesco investors could be due some bad news – first the dividend will be cut, and then the share price will plummet.
“Tesco has had a bad time, which means it is interesting to us as value investors,” said Ball. “But things will probably have to get worse before they get better. Incoming chief executive Dave Lewis will have to make some big changes, and we expect cutting the dividend will be one of them.”
Ball drew comparisons with insurance company Aviva (AV.), which he bought in 2009 – purely because the shares were so cheap. Aviva, like Tesco, was a dominant player in an entrenched market, but due to overexpansion and inefficient spending it was in need of significant cost-cutting and restructuring.
In 2012 new management team came in and cut costs across the company: property, staff and infrastructure. As part of this revolution, much to the annoyance of shareholders, new chief executive Mark Wilson cut the dividend by a hefty 40% in March 2013, sending the share price plummeting to £3. Now the share price is close to £5 and the dividend is creeping back up, currently yielding 2.9%.
“It is impossible to please your employers, your shareholders and your customers all at the same time,” said Ball. “Current chief exec Philip Clarke claimed he could, but that ended badly. Tesco will have to shrink to grow as companies such as Carrefore and British Airways have done. Focusing on the core business and restructuring the business will be a several-year plan that we believe will eventually come good.”
Morningstar analyst Ken Perkins currently rates Tesco as a five star stock, meaning it is considered significantly undervalued. Currently trading at around £2.40, Morningstar’s fair value estimate for the stock’s share price is £3.60, although this has recently been lowered from £3.80 thanks to weaker-than-expected first-half sales and management's commentary that profits have been weaker than expected during the first half of this fiscal year.
Perkins lauded Tesco’s recent decision to refocus business in the UK, having divested its unprofitable Fresh & Easy concept in the US after several years of attempting to make the business profitable.
“We think these have been prudent moves and should allow the firm to better compete in the years to come,” said Perkins.
“Dave Lewis will replace Philip Clarke on October 1. And while Lewis does not have extensive retail experience, he did work directly and indirectly with Tesco during his leadership tenure at Unilever. Tesco's board hopes that his experience at Unilever will allow him to make important decisions, such as how to balance branded versus private-label offerings and how to extend this thinking to confront competition from discounters Aldi and Lidl.”
