Tesco's Dividend at a Crossroads: Can Margin Pressures Be Managed?

Tesco (TSCO), the UK’s leading grocery retailer, has long been a dividend stalwart for income-focused investors. However, recent financial signals suggest its payout could face its toughest test in years. While the company recently raised its dividend by 13.2% to 13.70p per share, a host of financial and operational challenges loom over its ability to sustain this yield. Let’s dissect the risks and opportunities ahead.

The Dividend’s Strong Start Masks Underlying Weakness

Tesco’s fiscal year 2025 (ending Feb. 2025) delivered solid top-line growth, with sales up 4% to £63.6bn. The company also launched a £1.45bn share buyback, signaling confidence in its balance sheet. However, profitability took a hit: net income fell 9.1% to £1.6bn, with margins compressing to 2.3%—a worrying drop from 2.6% the prior year. The dividend payout ratio now sits at 61%, a manageable level, but risks rising if profits falter further.

Key Risks to the Dividend

1. Margin Squeeze from Cost Spirals

Tesco’s FY2026 guidance projects operating profit between £2.7bn and £3.0bn—a range below the £3.13bn achieved in FY2025. The primary culprit? Soaring costs. A 5.2% pay rise for store workers, a £235m rise in social security payments, and a new plastic packaging tax will collectively drain £415m from profits. If these expenses outpace revenue growth, margins could contract further, squeezing the cash flow needed to support the 4.3% dividend yield—already above its 3.6% ten-year average.

2. The Grocery Price War Intensifies

Tesco’s cautious outlook explicitly cites “heightened competitive intensity.” Rival Asda’s aggressive price cuts and Aldi’s relentless expansion are forcing Tesco to defend its market share. While its price-matching initiative and Clubcard loyalty program have slowed customer attrition, sustained price wars could erode profitability. In 2024, Tesco’s UK market share dipped to 27.9%, though it rebounded to 28.3% by early 2025. The question remains: Can it maintain this without sacrificing margins?

3. A History of Dividend Volatility

Despite the recent boost, Tesco’s dividend has trended downward over the past decade. From £0.187 per share in 2015 to £0.137 today, the payout has averaged a 3.1% annual decline. This inconsistent track record raises doubts about management’s commitment to sustaining the current level, particularly as profit headwinds mount.

4. Debt and Liquidity Pressures

Tesco’s net debt rose to £9.5bn in FY2025, up from £9.3bn the prior year. While its £1.4bn–£1.8bn medium-term free cash flow guidance remains robust, higher debt levels could limit flexibility during a downturn. A further £500m in cost savings targeted for FY2026 will be critical to offsetting these pressures.

Countervailing Strengths

Despite these risks, Tesco’s position as the UK’s largest grocer—accounting for nearly a third of the market—provides a buffer. Its premium “Tesco Finest” line and efficient supply chain have bolstered customer loyalty, while the Booker acquisition (its convenience store division) continues to generate steady cash flow, even as tobacco sales decline.

Analysts also highlight that projected earnings per share (EPS) growth of 31% for the next year could reduce the payout ratio to a sustainable 48%, if margins stabilize.

Conclusion: A Delicate Balancing Act

Tesco’s dividend remains at risk, but its fate hinges on execution. The company must:
- Control costs: Achieve the £500m savings target for FY2026 to offset rising expenses.
- Win the price war: Maintain market share without sacrificing margins through disciplined pricing and loyalty programs.
- Stabilize earnings: Ensure FY2026 profits stay within the guided range, ideally closer to the upper end.

Investors should monitor two key metrics:
1. Free cash flow: If it dips below £1.5bn, dividend sustainability becomes questionable.
2. Competitor actions: Any further price cuts by Asda or Aldi could force Tesco into defensive moves that strain profitability.

While the dividend is far from guaranteed, Tesco’s scale and cash flow resilience suggest it can survive—but not thrive—unless management delivers on its cost and growth plans. For now, income investors should treat TSCO as a “hold,” with a wary eye on the next fiscal year’s results.

In the grocery sector’s brutal battleground, survival demands more than dividends—it requires margins. And on that front, the stakes have never been higher.