Dave Lewis certainly knows how to arrive with a splash. Taking up the reins as the new boss of Tesco this week, his first move at the embattled retailer was to slash the dividend.
Tesco cut its half-year payout by 75%, vowing to spend the money on taking the fight to the new breed of low-cost rivals that has eaten into its market share.
Investors will hope it’s a one-off, and that Tesco will restore its payout as Lewis nurtures the chain back to health. The trouble is, it may be just the start of a trend. Dividends have grown at an extraordinary rate over the last decade, as companies have pushed up profit margins and, in turn, dividend payouts.
But those margins, as Tesco discovered, may well be unsustainable. If so, Tesco will be far from the only big company that has to slash its dividend over the next few years – and that is very bad news for stocks.
There are many reasons for Tesco’s current woes. Like many big companies, after a long, very successful run, it started to believe its own hype. It built too many drab out-of-town sheds at a time when shoppers were increasingly turning to the internet to buy TVs and dishwashers, and it expanded into overseas markets that it knew too little about.
It had so many plans for world domination, from attacking the Far East and the US, to taking over the banking industry, that it lost its focus on selling cheap milk and sausages to the average British shopper. So far, it is a very familiar story.
But there is another factor that is often overlooked. It allowed its profit margins to drift too high. Tesco is currently running an operating margin of 3.8%. It may not sound a lot, but in the fiercely competitive grocery market, it is actually pretty high.
France’s Carrefour makes 3.4%. America’s Walmart is on 3.13%. Amazon hardly makes anything. By global standards, Tesco was putting a more than generous mark-up on all the stuff it shipped out of its stores.
It wasn’t alone – its main rivals did the same thing. So what happened? Foreign companies such as Lidl and Aldi saw the opportunity to come into the UK, run on far lower profit margins, and undercut the established players. As a result, Tesco has been forced to respond with price cuts of its own, and the slashed dividend is the consequence.
In effect, that high payout to shareholders was financed by charging too much in the stores – and now that competition has ended that, the dividend has to come down.
The worrying point is that it may not be alone. The other UK supermarkets may be just as vulnerable. Sainsbury’s and Morrisons may have to cut their prices as well to match Tesco and the discounters.
Food is the only really successful part of M&S’s business, but there is no reason to imagine it is invulnerable to the same pressures – even its well-heeled customers can be tempted away by cheaper prices. And it doesn’t necessarily stop there.
In fact, across wide swathes of British business, margins are generous by global standards. The traditional airlines were taken apart by low-cost rivals, such as easyJet and Ryanair.
Now, the retailers are seeing the same pressures. And it would not be surprising if financial services, utilities, transport, food manufacturers and leisure operators all found themselves in the same situation over the next few years.
Dividends have grown at a remarkable rate recently. According to share registrar Capita, British quoted companies paid out £63bn in dividends in 2007. By last year, that had grown to £80bn, and is expected to top £100bn this year.
Unfortunately, the global economy – let alone the UK economy – is not much bigger than in 2007. So this pay out has grown substantially in an economy that has hardly grown at all. In effect, it means shareholders are taking a bigger and bigger slice of a pie that has remained roughly the same size.
That is great for them, and dividend growth is one reason why the stockmarket has been so strong over the past few years. But if dividends have been paid for by companies pushing up prices too aggressively, and letting their margins grow too fat, then they won’t
Whenever a company starts making excessive profits, it is always vulnerable to attack. It does not necessarily happen right away. In most industries, there are substantial barriers to entry. It isn’t easy to build enough shops to dent Tesco, as Aldi and Lidl discovered – but over time it can be done.
Likewise, it won’t be easy to create lower-cost banks, or insurers, or cinema chains, or restaurants. But that doesn’t mean it can’t be done. If the opportunity is there, someone will seize it.
So, don’t bet that Tesco’s dividend cut is a one-off, special case – the fact that dividends have grown far faster than the economy suggests that many quoted companies have been pushing prices up too rapidly. Sooner or later, those dividends will have to come down – and when they do, they will take the stock market down too.