Why I’d buy the SSE share price and 7% dividend yield

G A Chester explains why he’s attracted by the valuation of SSE plc (LON:SSE) and a mid-cap sector peer.

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I’ve been a big fan of FTSE 100 utility SSE (LSE: SSE) going back to the 1990s, but I took a dim view of its profit warning last year. However, six months on, I’m more optimistic about the business, and the prospects for investors buying the stock today.

As well as discussing my positive view on SSE, I’ll explain why I continue to see good value in FTSE 250 utility Drax (LSE: DRX), which I first tipped as a recovery stock two years ago.

Optimism

In an article last month on another utility (British Gas owner Centrica), I wrote: “The share price is sufficiently low, and the outlook sufficiently improved, to move to rating the stock a ‘buy’.” Part of what I saw as the improved outlook was the benefit to the big players of a spate of failures of smaller energy suppliers. While the market will undoubtedly remain competitive, I think the recent era of suicidal pricing by new entrants is probably over.

My optimism about this has since been bolstered by a recent announcement from regulator Ofgem. It’s bringing in more stringent tests for any company applying for a licence to enter the energy supply market. This makes me happy to reiterate my personal ‘buy’ rating on Centrica, and is also part of the reason why I attach the same rating to SSE.

Undemanding

Late last year, SSE pulled out of a plan to demerge its household energy supply business and combine it with npower in a new independent company. Management still intends to separate the household supply business — a demerger or sale are among the possibilities — but in the meantime it’s an asset held for disposal, and is profitable and cash flow positive.

I like the remaining core SSE’s future as a leading energy infrastructure company in a low carbon world, focused on regulated networks and renewables, complemented by flexible thermal generation and business energy sales. Meanwhile, my concerns about the company’s trading/hedging arm (responsible for a shock profit warning last year) have been allayed by robust changes to ensure trading positions cannot have a material impact in future.

On an undemanding rating of less than 12 times forecast earnings for the year ending March 2020, and with a prospective yield of 7% on a rebased dividend, I see the stock as very buyable.

Growth and income

Drax is another energy company rapidly evolving for a flexible, low-carbon and renewable generation future. It accelerated its strategy with the recent £702m acquisition of Scottish Power’s portfolio of pumped storage, hydro and gas-fired generation assets. This, together with what management calls “attractive investment opportunities throughout our business,” bodes well for future earnings and dividend growth.

City analysts expect earnings to leap 177% this year, putting the shares at less than 13 times earnings. And the multiple falls to around 10 on forecasts of 27% earnings growth in 2020. A prospective dividend yield of 4.3% this year, rising to over 5% next year, adds to the attraction of what has become a compelling growth-and-income story, in my view. As such, this is another stock I rate a ‘buy’

Finally, a word on the Labour Party’s nationalisation plans. As I explained in a recent article on National Grid, I think there are good reasons for believing shareholders would receive full and effective compensation, if it ever came to the expropriation of their assets.

Should you invest, the value of your investment may rise or fall and your capital is at risk. Before investing, your individual circumstances should be considered so you should consider taking independent financial advice.

G A Chester has no position in any of the shares 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.

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