The
Dividend Yield Trap
And
Tesco PLC
Mousetrap,
courtesy Wikipedia
Income is a key
requirement of an investment portfolio for pension funds, life insurance
companies and many private investors. Bonds and
short-term deposits once provided a secure source of income that more than
compensated for the going rate of inflation. No more. Bank Rate has been
stuck at 0.5% since March 2009, banks offer almost nothing for demand deposits
and the yield on 10-year Gilts has been below the rate of inflation
since January 2011. And no let up is in sight.
As a result, investors
have been concentrating their attention more than ever on company dividends. In
response, companies have been increasing their payout. At 23 billion pounds,
the dividends paid by FTSE 100 companies in Q2 2013 set a new record.
Looking at the last
28 years, the return on the FTSE 350 Higher Yield Index (in green) has
outperformed the FTSE 350 Lower Yield Index (in blue) in capital terms. Include the additional dividend that has been
collected by the investor in the higher yielding portfolio and the long-term
investor, who has stuck to higher yielding stocks, has outperformed the lower
yielding portfolio by a country mile:
Courtesy
Yahoo, click to enlarge.
But, according to the
two indices, the position reversed itself in the post-Financial Crisis years
2008-2013:
Courtesy
Yahoo, click to enlarge.
What happened? In 2008 and 2009, many high yielding stocks - mainly in the
banking, housebuilding, property and financial services sectors - stopped
paying dividends entirely. Their share prices collapsed and then they were moved
into the lower yielding index, from where their share prices recovered. Many
stocks, which had a good history of dividend payments, collapsed in this short
period. They stopped paying dividends and their price collapsed. Investors,
who were focussed mainly on yield, were caught in a dividend yield trap.
Nevertheless, an
investment strategy based on dividend income makes sense for the long-term
investor - see the article at http://thejoyfulinvestor.blogspot.co.uk/2013_01_20_archive.html
However, investors
should be wary of the dividend yield trap. A number
of stocks with a seemingly good record for dividend payouts are at risk of
disappointing investors. They include some of the UK's biggest companies that
have fallen on hard times:
1. Vodafone: yield
5.2%; dividend cover 0.97% on the average of the last 3 years earnings. The cash
shortfall on its 2012 dividend was 1.7 billion pounds. (See http://thejoyfulinvestor.blogspot.co.uk/2013_05_26_archive.html)
Competitive pressures and a stagnant economy in its main markets mean that Vodafone's
own business is barely profitable. Vodafone relies on its 45% stake in Verizon
Wireless and dividends that are determined by Verizon to keep going. The
current share price of 197p is buoyed by hope that Verizon will buy Vodafone's
share in Wireless for $100 billion or more and that those funds will go
straight to Vodafone's shareholders.
2. BP: yield
5.2%; dividend cover 1.9 times on the average of the last 3 years earnings. The
gargantuan capital expenditure requirements of BPs' business mean that, in the
last 3 years, operating cash flow failed to cover capital expenditure by 3.1
billion pounds. The dividend was paid from debt and asset sales. BP
is a shadow of its former self. To pay for the liabilities arising from the
Deepwater Horizon disaster, BP has sold assets leaving its oil and gas
production 42% below 2009 and its oil and gas reserves 44% below 2009. And its
liabilities and contingent liabilities continue to rise. (See http://thejoyfulinvestor.blogspot.co.uk/2013_05_05_archive.html)
BP's current share price of 445p is buoyed by the hope that BP
will emerge from the ruinous costs of the Deepwater Horizon disaster and return
to trading approaching pre-2010 levels.
3. GlaxoSmithKline
(GSK): yield 4.6%; dividend cover 1.03 times the average of the last 3
years earnings. Free cash flow covered the 2012 dividend 1.6 times. But GSK
has been accumulating debt. In 2003, GSK held net cash of 1.6 billion
pounds, in 2012; this had turned to a net debt of 14 billion pounds. Meanwhile,
2012 earnings were back at the 2003 level. Generic drugs have destroyed GSK's
business based on research and development. (See http://thejoyfulinvestor.blogspot.co.uk/2013_05_26_archive.html)
The current share price of 1683p is buoyed by the hope that new drugs in Phase
II and Phase III trials with the US Food and Drug administration will bring GSK
back to growth.
Utilities are another
mainstay for income investors. However, the high
valuation on water and energy utilities is difficult to justify on their
trading results and, perhaps more importantly, on their trading outlook post
their regulatory reviews in 2014. For both Ofgem and Ofwat, in
response to the present mood of austerity, have said that they will be
expecting more from energy and water companies. All these companies are heavily
indebted.
1. Centrica:
yield 4.1%, dividend cover 1.4 times is on a P/E ratio of 18. A solid business
has been marred by capital misallocation on nuclear energy and wind farms. (See
http://thejoyfulinvestor.blogspot.co.uk/2013_07_14_archive.html)
2. SSE: yield
5.3%, dividend cover 1.1, is on a P/E ratio of 16. Though sound management has
consistently brought an increase in dividends, the thin dividend cover means
this must come to an end. (See http://thejoyfulinvestor.blogspot.co.uk/2013_01_20_archive.html)
3. The water companies Dee
Valley, Pennon, Severn Trent and United Utilities yield between 4.4 and
4.8% and all are on a declining dividend cover (1.2 to 1.3 time). P/E ratios
between 16 and 18 do not discount the inevitable disappointment of the inevitable
rights issues and more difficult pricing regimes that are on their way. (See http://thejoyfulinvestor.blogspot.co.uk/2013_07_07_archive.html).
Long-term investors
seeking a growing income stream would do well to
look at other sectors and companies. Unilever, Reckitt Benckiser, Pearson,
Royal Dutch Shell, Sage, Interserve, N Brown, Cranswick, Personal Group
Holdings, James Halstead and British Sky Broadcasting all seem to offer
better income prospects. But only buy at the right price. (Earlier articles on
this blog cover these 11 companies). These stocks can be supplemented by
income-orientated funds covering companies in foreign markets that are difficult
for the individual investor to research, value and trade. Earlier articles on
this blog cover BNY Mellon Newton Asian Income OEIC and the J P
Morgan Global Emerging Market Income Investment Trust.
The wise long-term
investor will have a 'buy and hold' strategy, but he or she will avoid the
dividend yield trap by reviewing the portfolio regularly:
1. Companies are subject to sudden shocks
that drastically reduce or improve their value. Think Deepwater Horizon, the
banking crisis or, on the plus side, a takeover bid.
2. The trading outlook is rarely stable.
·
Macroeconomic
changes (economic growth/recession, currencies, and
interest rates) affect some companies more than others.
·
Regulators
or governments, by imposing new conditions on
companies, can significantly damage or benefit a company's trading outlook.
·
The
business climate, via competition, new technology
or a change in the market place, is constantly in flux.
·
Stock
market fads can cause companies to be mispriced.
This can bring stocks into the buying range for a patient investor or,
conversely, push up the value of other stocks in a portfolio to the point where
they are a screaming sell.
3. Management can take decisions that have
a long-lasting impact on a company's earnings. Big acquisitions, mergers, big
disposals and demergers are sometimes the product of restless management. Sometimes
they are the product of inspired management.
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Tesco PLC
WPA
poster, 1937, courtesy Wikipedia
Tesco has been
through the wars. A withdrawal from its US venture
at a cost of 1.8 billion pounds, the cessation of its Japanese venture and the
recent merger of its stores with a Chinese retailer, leaving it with a 20%
share of a business run from Beijing (the company is state-owned), have removed
Tesco from any controlling interest in the world's three largest
markets.
Tesco, with 71% of its operating profits coming from the UK, remains
heavily dependent on the UK consumer. In its UK home market, Tesco
has suffered from a loss in market share, shrinking margins and a 0.8 billion-pound
property write-down for land it no longer plans to develop. The year ending
February 2013 saw the company barely in the black with large impairments and
reduced trading results in the UK, Europe and Asia and in its banking
subsidiary.
Tesco's share price (in blue) has underperformed its largest rival, J
Sainsbury (in green), by 30% since January 2012, when its
difficulties became apparent:
Graph
courtesy Yahoo, click to enlarge
Yet Tesco has
undeniable strengths. Consider:
1. Tesco, with 30% of
the UK grocery market, is almost twice as large as its next largest
competitors (ASDA and Sainsbury).
2. Net debt, at
6.6 billion pounds, is 3 billion pounds less than in 2009. This reflects good
capital management. Net debt is 40% of equity. Standard & Poor gives Tesco
a long-term credit rating of BBB+. This is the lowest but one investment grade.
3. UK revenue
increased by 5% p.a. between 2009 and 2013. Per square foot, revenue was stable
in a period when consumer demand has been flat.
4. Underlying earnings
per share (and for once this is more than a cosmetic number) were 36p in
2013, about the same as in 2012.
5. The dividend
was covered 2.4 times by underlying earnings in 2013.
6. New management has a
clear plan for putting the company back into financial health:
·
The net
margin in the UK has been 'reset' to 5.2% to allow
for better customer service. It has already employed an additional 8,000 staff
in the UK.
·
Investment
criteria are strengthened for its investment in
online selling and international sales.
·
Capital
expenditure is to fall from 4.2% of revenues to 3.5
to 4% of revenues.
·
Financial
objectives are 'mid-single digit increases in
profits', a return on capital employed of between 12 and 15%, and dividend
payout to be around one-half of earnings per share.
It is a sign of the
change from the previous management's attitude that
the Chairman, in the 2013 Annual Report, should write, "One of the
greatest challenges for a business is to face itself honestly." And the
Chairman promises "rigorous capital discipline."
At the current price
of 369p, Tesco shares are rated on a P/E ratio (on underlying earnings) of 11
and yield 4.0% (Sainsbury shares are rated on a P/E of 12 and yield 4.3%). My valuation model values Tesco shares at about 430p.*
The prudent investor
will consider:
1. Tesco is a
massive company with over half a million employees. It could take years to turn
around.
2. The international
operations that remain could still cause more impairment charges.
3. Though Tesco
claims to make money on its online business, it is very likely that margins
here are lower than on store sales. No one else seems to make money from
selling food online.
4. The smaller
grocers (Waitrose, Aldi and Lidl) are still taking business away from the
larger retailers in the UK.
5. The company's
defined benefit pension scheme required a further provision of 735 million
pounds in 2013. This is one-fifth of Tesco's regular annual pre-tax profit. And
further provisions are likely.
*Assumptions: Earnings per share growth 5% p.a. Equity per
share growth 6% p.a. Return on equity of 16%. Average P/E valuation by the market
13. Dividend payout 50% of earnings. All discounted 2014 - 18 at 12.5% p.a.
(5.5% is Tesco's weighted cost of debt, plus 2% for operational risk and 5% as
a margin of safety).
NOTE:
The next article will be posted on 4 September.
