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The Stock Picker’s Guide To SSE PLC

Successful investors use a disciplined approach to picking stocks, and checklists can be a great way to make sure you’ve covered all the bases.

In this series I’m subjecting companies to scrutiny under five headings: prospects, performance, management, safety and valuation.How does SSE (LSE: SSE) measure up?

1. Prospects

SSE has a vertically integrated business model combining:

  • Electricity generation, which is unregulated;
  • Electricity and gas transmission and distribution, which is economically-regulated;
  • Retail electricity and gas distribution, which is subject to legislation, e.g. it was fined recently for unfair doorstep-selling.

Vertical integration mitigates the impact of energy prices on the company, whilst the mix of regulated and non-regulated activities balances certainty of returns and bigger opportunities to grow profits.

SSE is a big player in (subsidised) renewable energy such as wind generation. Currently 25% of generating capacity comes from renewables, including hydro, and it plans to increase that to 40% by 2025.

2. Performance

SSE places great emphasis on its dividend track record as the principal measure of its performance. The dividend has increased by more than inflation every year since 1999, though at the expense of occasionally allowing dividend cover of less than one. Over the past eight years it has averaged 1.5, its medium term target.

Return on capital, which has generally been in the high teens and above, was around 10% in the last two years, coinciding with increased capital spend.

3. Management

After 10 years as CEO Ian Marchant recently stepped down in favour of his deputy Alistair Phillips-Davies. That’s unlikely to usher in much change, though Mr Marchant was a prominent figure in an industry which has a high profile with consumers and government.

4. Safety

Including a £0.7bn pension deficit SSE’s net gearing is close to 100%, but that’s not unreasonable for a stable and part economically-regulated business. Interest is covered 3.7 times, and the debt matures at various dates stretching to 2056.

In recent years capital expenditure has run at about £1.5bn a year, over twice the rate of depreciation. That’s been funded by increased borrowings and a £1bn issue of hybrid capital. Thus strictly speaking SSE’s free cash flow hasn’t covered the dividend.

However half the capex has been spent on the regulated networks, increasing the regulated asset base and thus the returns SSE is allowed to make, and half on the wholesale segment, especially renewable generation, that should produce increased revenues.

5. Valuation

SSE’s continuing commitment to increasing its dividend above inflation underpins its share price. The prospective yield is 5.5%, on a P/E of 13.2.

Conclusion

SSE remains an attractive stock for income investors. Though some concerns have been voiced over whether its free cash flow can sustain the rising dividend, this should really be seen as a modest increase in financial risk as the company gears up to invest in productive assets.

SSE is one of the top six highest-yielding stocks in the FTSE 100. In that number is another utility, which is the Motley Fool’s top income pick for 2013. To learn more about that company, you can download an exclusive report straight to your inbox.  Just click here — it’s free.

> Tony owns shares in SSE.