Where Next for Tesco's Dividend?

LONDON -- Many investors focus on earnings per share when judging a company's performance. However, earnings can be manipulated and adjusted in all sorts of ways, meaning they don't tell you a lot about how much spare cash a company has generated. Similarly, since dividend cover is calculated using earnings, a good level of dividend cover doesn't necessarily mean the payout is actually being funded from a company's profits.

A company's cash flow can tell you a lot about a firm's financial health. Is the company burning up its cash reserves on interest payments and operating expenses, or does it generate spare cash that can fund dividends or be retained for future investment? If a dividend isn't funded by cash flow, then there is a greater chance the payout will become unaffordable and be cut, which is bad news for shareholders like you and me.

In this series, I'm going to take a look at the cash flow statements of some of the biggest names in the FTSE 100 (UKX) to see whether their dividends are being funded in a sustainable way, from genuine spare cash. Today, I'm looking at Tesco  (LSE: TSCO  ) (NASDAQOTH: TSCDY  ) .

Tesco's troubled year
This has not been a good year for Tesco. In January it was forced to issue a profit warning, sending its share price down by 22% in just a few days. For most of the year, its sales results have lagged behind those of Morrisons and Sainsbury. Tesco has also had to face up to slowing growth in its Asian and Eastern European stores.

However, there are signs that Tesco is turning things around -- in its last quarterly update, it moved ahead of Morrisons in terms of sales growth and also announced the disposal of its loss-making U.S. operation, Fresh & Easy.

Does Tesco have enough cash?
As private investors, we want to back businesses that are able to pay their dividends out of free cash flow each year. I define free cash flow as the cash that's left over after capital expenditure, interest payments and tax deductions. With that in mind, let's look at Tesco's cash flow from the last five years:

Year 2008 2009 2010 2011 2012
Free cash flow (in millions of pounds) 389 -2,014 2,868 2,366 1,225
Dividend payments (in millions of pounds) 794 886 970 1,083 1,183
Free cash flow/dividend* 0.5 -2.3 3.0 2.2 1.0

Source: Morningstar, Reuters, Tesco annual reports. *A value of >1 means the dividend was covered by free cash flow.

Tesco's heavy capital investment program and loss-making U.S. business has had a serious impact on its free cash flow. Averaged over the last five years, its ratio of free cash flow to dividend payments is 0.9, indicating that it has not generated enough free cash to pay its dividends and has had to top up its payouts with borrowed money.
 
It's worth noting that despite not being covered by free cash flow, Tesco's dividends have remained more than twice covered by reported profits. This shows how reported profits can be used to make dividends seem more affordable than they really are, and is a useful warning sign for investors. Tesco's failure to pay its dividends out of free cash flow isn't good news, but it isn't necessarily disastrous, either. Everything hinges on whether the firm can now start to reverse its declining profitability and improve its cash flow situation. Failure to do this could mean that the company's 28-year record of dividend growth may come to an end.The problem is that despite scaling back plans for megasized new stores, Tesco's turnaround plan still involves spending a lot of money to rejuvenate existing stores and improve staffing levels. According to the firm's latest half-yearly report, Tesco is planning to spend a further £1bn on its UK turnaround plan, Building A Better Tesco. Could this threaten the supermarket's dividend growth record?

Is Tesco's dividend safe?
Tesco's cash flow has been quite badly stretched over the last five years, but I think that by disposing of its U.S. business and focusing on improving its existing U.K. stores, Tesco should be able to reverse the decline in its UK sales and improve its cash flow. I'm also quite keen on the growing income from Tesco Bank; personal finance products tend to provide much higher profit margins than food, and Tesco reported an operating margin of 18.3% for Tesco Bank in its most recent interim results, compared to 5.2% for its U.K. supermarket operations. I think that Tesco will manage to avoid cutting its dividend, but any dividend growth is likely to be pretty minimal for the next couple of years, while the company's turnaround plans work through the system and start to deliver results.

Top income tips
One man who really understands how to assess the quality of a company's dividends is legendary City fund manager Neil Woodford, whose High Income fund grew by 342% over the fifteen years to October 2012, during which time the FTSE All-Share index managed a gain of only 125%. Woodford selects stocks that he believes are undervalued and likely to deliver strong dividend growth. His record is one of the best in the City and at the end of October 2012, he had 21 billion pounds of private investors' funds under management -- more than any other City fund manager. You can learn about eight of Neil Woodford's largest holdings and how he generates such fantastic returns in this exclusive Motley Fool report. It's completely free, but is available for a limited time only. I strongly suggest you click here and download the report today to avoid missing out.

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