Tesco's Dividend Safe, For Now

| About: Tesco PLC (TSCDF)

Early this month, Tesco (OTCPK:TSCDF) reported a 10.5 percent drop in group trading profits for the first half of the year, its first decline in 20 years. Sales in its key UK market grew by 0.1% in the second quarter, (only) just halting an 18-month slide in its sales and broadly meeting low expectations, as the group is in the midst of a major UK turnaround plan after making a surprise profit warning in January.

With the exception of Tesco Bank, showing a doubling in trading profits to £94m ($151 million U.S.), profits from all of the group's other major divisions spanning Europe, Asia, the U.S. and the UK went into reverse.

I hope that you were not expecting a quick turn-around message from Tesco this time round, as it has only just embarked upon on its all-important UK recovery strategy, some of which I outlined in an earlier article.

The United Kingdom - initial step(s) to recovery?

While UK like-for-like sales growth has improved since the last update, and with sales growth having outperforming the industry, this has primarily been achieved by more discounting. A rather short-term solution to some of its UK problems. UK sales have "been bought" at the expense of profits, which are down to 12.4 percent in the UK.

In the five months since CEO Clarke launched his "fightback," the group has recruited 8,000 more staff to give customers better service at its 3,000 UK stores, devoted more store space to food, given stores a "warmer look" and revamped food ranges.

The group has spent more on money-off vouchers and marketing that makes use of customer information gleaned from its Clubcard loyalty scheme, and rolled out a new service to let online shoppers collect their orders at the store.

This has resulted in the 0.1 percent rise in underlying sales in the second quarter - an improvement from the 1.5 percent fall in the first quarter - with the company claiming that its (rather) costly plan to bring customers back by adding staff and smartening up its stores was working.

However, Britons have been cutting back on non-essential spending as their incomes suffer the worst squeeze for more than 30 years on the back of soaring food and fuel prices, higher taxes as a result of government austerity measures, and slow wage rises. I gather this is a situation unlikely to change any time soon.

These tough economic times have squeezed mid-market player Tesco from all sides, benefiting heavy discounters like German operators Lidl and Aldi as well as higher-end grocers. With perceived high quality but pricey, Sainsbury (OTCQX:JSAIY) (OTCQX:JSNSF) and Waitrose are both running programs that promise to match Tesco prices on branded goods. And Asda - subsidiary of Wal-Mart (NYSE:WMT) - is "known to everyone" as just "cheap" and cheerful.

But, let's keep things in perspective here ...

Tesco (UK only) made £1.115m ($1.118 million U.S.) on sales of £23.9bn ($38.6 million U.S.), generating a margin of 4.7 percent, and this was only for the first half. Tesco states that it expects similar margin levels in the 2nd half, and these levels already reflect a significant investment in trying to improve store efficiency.

Situation abroad is deteriorating

Tougher economic conditions are now also hurting Tesco's international operations. Tesco now earns nearly 40 percent of its revenue outside Britain, but the extent to which some parts of its international business have deteriorated is in particular worrying.

In Asia, like-for-likes sales fell 1.4 percent and trading profits by 1.7 percent, in particular due to the South Korean government restricting Sunday opening hours for supermarkets. Note: South Korea is Tesco's biggest international market and Sunday is the peak trading day in the country, accounting for more than 20 percent of business. Shorter trading hours is/will clearly hurt future sales, with Tesco already warning it would knock £100 million ($161 million U.S.) off 2012/13 profit.

Not surprisingly, European sales are also declining. The ongoing eurozone crisis impacted negatively on its performance on the continent - in Central Europe the group's trading profit slumped a massive 28 percent as consumer confidence faded away - while profitability in China and the U.S. remained elusive.

Tesco's "Fresh & Easy" U.S. stores delivered a small reduction in losses by just £1m ($1.6 million U.S.) to £72m ($116 million U.S.) with sales performance improving throughout the period while like-for-like sales growth was 5.2 percent for the half, following a stronger performance in the second quarter.

Tesco is not facing serious decline

From the announced results, and our summary interpretation thereof, it is rather obvious that there are some deep-rooted problems at Tesco and that the turnaround in the UK has a long way to go. Thus far there are rather few signs that things will get easier in Tesco's other markets any time soon.

It may well take another year or so before we will see some early and sustained signs of a turnaround in the UK and elsewhere. And let us also not forget: the USA is the only area still making a loss; it was also the only area showing good like-for-like sales increase - 3.6 percent in Quarter 1 and 6.9 per cent in Quarter 2 - going in the right direction.

While Tesco has underperformed in its core UK market, there are already some early signs that the investment in its UK stores is starting to bear some fruit. Existing stores, products and service have all improved. Also, Tesco is cutting back on its investment in new space, with an emphasis on the Tesco Express format, suggesting that the battleground for supermarkets is increasingly moving online.

Management's shift toward online sales and convenience stores and away from massive hypermarkets saved £500 million ($808 million U.S.) in capital expenditure and the sale of some property in Korea and Thailand helped reduce net debt from £7.6 billion ($12.2 billion U.S.) to £7.2 billion ($11.6 billion U.S.).

The future emphasis on fewer new stores and more emphasis on clicks is going to result in less CAPEX and more of the only things that matter to us long-term dividend income investors: more cash, more profits and more dividends.

Dividend statement

The "new" focus on cash flow means the Board was comfortable enough, even with the drop in profitability, to maintain the dividend at 4.63 pence:

The Board has approved a maintained interim dividend of 4.63p per share, demonstrating our confidence in the progress that is being made in implementing the UK Plan, notwithstanding the necessary investment in 'Building a Better Tesco.' The interim dividend will be paid on 21 December 2012 to shareholders on the Register of Members at the close of business on 12 October 2012.

Anything positive?

Kantar Retail, a respected international retailing research and consultancy firm is rather sanguine about these figures. Bryan Roberts, Director of Retail Insights, comments:

Tesco's numbers today tell us that its under-performance in the UK may well have bottomed out. The last couple of years have shown us that even the giants can falter when they take their eye off the shopper; years of underinvestment in stores and people are now being reversed by Philip Clarke and these early signs suggest that his radical investment program is paying off.

Roberts adds:

In the fullness of time, Tesco's recent problems are likely to be seen as an unfortunate blip. Although structural problems remain, such as Tesco's reliance on tricky non-food categories in its Extra stores its leadership in on-line and convenience store retailing augur well for the future. Tesco's pioneering roll-out of Click and Collect grocery, for example, indicates that it is getting back on the front foot. Competitors should be fearing the worst as 2013 is likely to see a resurgent Tesco looking to make up the ground it has lost.

Now, that's more like it!

Disclosure: I am long OTCPK:TSCDF. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Our Dividend Income Portfolio owns a shareholding in Tesco Plc, purchased during 2011 and in early 2012, following the trading profits update. At current levels, Tesco remains historically undervalued as per our valuation methodology.