Utilities have traditionally been regarded as safe investments, generating stable dividends that grow faster than inflation. Historically, though, dividends have actually been cut many times, and the rate of dividend growth appears to be slowing across the sector.
Gas and Electricity Companies: SSE & Centrica
SSE (LSE: SSE) promises that dividend increases will at least keep up with RPI inflation. Because of weak earnings, the company expects its dividend cover will fall to 1.2x in the coming year, from 1.4x. This falls short of its long-term target of 1.5x. Unless earnings growth catches up with its growth in dividends, its dividend policy would be unsustainable in the long term. Although the company intends to cut costs and dispose underperforming assets to improve earnings, uncertainties remain with market conditions and public policy. With a forward dividend yield of 5.5%, SSE has the highest dividend yield in the sector.
Centrica (LSE: CNA) rebased its dividend 30% lower in 2014, as falling oil prices reduced its upstream profitability. To make matters worse, retail margins have fallen and customer numbers are lower. Low oil prices and competitive market conditions are likely to persist in the medium term. Centrica’s forward dividend yield is expected to be 4.3%, with earnings coverage of 1.5x.
Water Companies: Severn Trent, United Utilities & Pennon Group
Severn Trent (LSE: SVT) announced in January that it would cut its dividend by 5% this year. This is not the first time the company has cut its dividend, and it probably won’t be its last. Back in 2011, Severn Trent and United Utilities (LSE: UU) cut their dividends, following demands from the regulator to cut prices for consumers. Water utilities are heavily regulated, with their pricing set by regulators every five years.
Severn Trent now promises to increase its dividend by at least the RPI for each year until 2020. This is less generous than its previous pledge to increase dividends by RPI +3%, which expired in March 2015.
If the company can’t deliver the stable income that investors desire, then investors deserve a sizeable risk premium to compensate for the risk in investing in the company. With an adjusted forward P/E ratio of 22, the utility’s shares do seem expensive. It’s forward dividend yield is expected to be 3.7%, with earnings coverage of 1.0x.
Water utilities are often seen as alternative investments to Index-linked Gilts, inflation-protected government bonds, which have been negative yielding for a few years now. So, water companies actually pay a yield of more than 4 percentage points higher, which represents their risk premium. The sector’s pricey valuation is caused by the limited availability of inflation protected investments and the strong demand from pension funds and other asset managers. It is also down to takeover interest from private equity and foreign pension funds for ‘stable’ income generating assets.
United Utilities is similarly targeting dividend growth of at least RPI for each year until 2020. The company’s previous target was for dividends to grow at RPI +2%. Its forward dividend yield is 3.8%, with a coverage ratio of 1.1x.
Pennon Group (LSE: PNN) promises a higher level of dividend growth: RPI +4% until 2020. The company’s ownership of Viridor, a waste management business, may explain for its lower valuation multiples and higher dividend yield. Its forward dividend yield is 4.0%, with a coverage ratio of 1.1x.
The dividends for these water companies seem secure for the coming five years; but after that, there is much uncertainty with the next round of negotiations with the regulator. And, five years time is not really that far from now.
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Jack Tang has no position in any shares mentioned. The Motley Fool UK has recommended Centrica. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.