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Should Centrica PLC And SSE PLC Shareholders Prepare For A Dividend Cut?

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Stock market investors are often criticised for focusing on the short term, but they aren’t the only ones.

Thanks to pre-election grandstanding, and a refusal to define a clear, long-term energy policy, UK politicians have created a climate of uncertainty for energy utilities that has seen Centrica (LSE: CNA) (NASDAQOTH: CPYYY.US) lose 18% of its value and SSE (LSE: SSE) (NASDAQOTH: SSEZY.US) fall by 12% over the last six months.

As the threat of political action on energy prices grows stronger, I think there’s a serious risk that SSE and Centrica could be forced to cut their dividends over the next eighteen months.

Warning signs?

The high level of SSE’s 6.4% prospective yield provides a clear warning that the firm’s payout might be unsustainable. One problem is SSE’s underlying profitability: the firm’s operating margin has fallen from 7.3% in 2008, to just 2.8% in 2013.

Energy consumption is falling, too. According to SSE, average gas consumption per customer fell by 9.5% during the first nine months of 2013, compared to 2012, while electricity consumption fell by 4.3%. SSE also lost 250,000 customer accounts in the UK and Ireland last year.

SSE’s dividend has only been covered by free cash flow once since 2008, and if the next government decides to cap or freeze energy prices, then in my view, a dividend cut would become very likely.

What about Centrica?

On average, Centrica’s dividend has been covered 1.5 times by free cash flow since 2007, making it one of the strongest in the sector.

However, Centrica has its own problems. Around 35% of its operating profits come from British Gas, which has a 42% market share and profit margins of around 11%. Given that British supermarkets are happy if they can manage a 5% operating margin, these profits seem pretty generous.

If British Gas is forced to reduce its profit margins, then Centrica’s profits would take a big hit, which I suspect would be likely to lead to a cut to Centrica’s dividend.

What happens next?

Our next insight into the future of the energy market is expected sometime in late March, when the initial findings of the Ofgem/OFT competition review of the energy market are expected.

As a SSE shareholder, I’ve accepted the risk of a dividend cut, and will continue to add to my holding; even a 30% cut would still leave me with a dividend yield on cost of more than 4%. 

However, this recipe may not work for you, and whether you rate SSE and Centrica as a buy, is a decision only you can take.

Whatever you decide, I would strongly recommend you take a close look at each firm's dividend for yourself.

One way of spotting at-risk dividends before they are cut is by following the five 'golden dividend rules' detailed in the Motley Fool's latest report, "How To Create Dividends For Life".

The report is completely free and exclusive to Motley Fool readers -- to get your copy, simply click here now.

> Roland owns shares in SSE but does not own shares in Centrica.