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One undervalued dividend stock I’d buy over Centrica plc

Photo: Magnascan (pixabay). License: CC0 Public Domain.

At first glance, Centrica (LSE: CNA) looks to be a top dividend stock. The utility company is highly defensive, and the shares support a dividend yield of 6.9%. The payout is covered 1.3 times by earnings per share, so it does not look as if management will be forced to cut it any time soon. 

However, while Centrica might look attractive at first glance, I’m avoiding this high-yield play in favour of another dividend champion. 

Risky business

The supply and distribution of gas and electricity shouldn’t be a risky business. The amount of power the world is consuming is growing every day, and it takes an enormous amount of financial firepower to set up new power generation facilities, giving the industry high barriers to entry. 

Unfortunately, politicians are now starting to interfere in the market and these actions have dramatically increased the risks of operating in the sector. Energy price cap threats have sent shares in Centrica down by almost 50% over the past five years, and the company has already been forced to cut its dividend. 

It’s impossible to tell what the future holds for the energy industry, but it’s unlikely the operating environment is going to get any easier. With this being the case, I believe Centrica’s dividend is under threat once again. Dividend cover of 1.3 is not enough of a cushion to protect against a further deterioration in earnings.  

As well as political issues, Centrica is also struggling to attract customers. During the first half, the group lost 387,000 account holders, but a 12.5% increase in domestic energy prices helped cushion a decline in earnings. Adjusted group earnings fell 11% for the period, and the operating margin of the UK Home division slipped from 12.7% last time to 11%. 

Price hikes are one way of offsetting customer exits, but the company’s use of this tactic will be limited. If prices continue to rise, customers will only exit faster, and higher prices will embolden policymakers to clamp down. Put simply, the firm is stuck between a rock and a hard place. 

Upward trajectory 

Compared to Centrica, Man Group (LSE: EMG) looks to me to be a much better buy. The company’s potential is not being constricted by politics and demand for its services is growing not shrinking.

In a trading update published today, Man announced that funds under management had increased to $103.5bn at 30 September, up 28% year to date. Net inflows of $2.8bn, investment gains of $3.3bn and FX movements all helped contribute to the positive performance. 

Off the back of these gains, City analysts are expecting the company to report earnings per share growth of 45% for 2017, followed by growth of 26% for 2018. Following this increase, analysts have pencilled in a dividend of 7.5p per share for this year, and 8.5p for 2018 — growth of 25% in two years. Based on these projections, the shares support a dividend yield of 4.4%, and the payout is covered 1.6 times by earnings per share. 

As well as the annual dividend, Man’s management has put a share repurchase plan in place. A $100m repurchase has been given the green light, and the group has around $275m in excess capital (excluding the buyback), which could also be distrubuted. 

Overall, I believe Man’s growing earnings, dividend and buybacks show that the group is a much better income buy than Centrica. 

Research is key 

Dividend stocks are portfolio essentials over the long term, but you really need to do your research to make sure you're buying the best income stocks. Companies with a high dividend yield like Centrica might look attractive at first glance, but there's more to a good dividend stock than just a high yield. 

With this being the case, to help you find the market's best dividend champions for yourself, the Motley Fool has put together this free report, which is designed to help you improve your investment returns in just 10 easy steps

Click here to download the report for free today.

Rupert Hargreaves owns no share mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.