Here’s Why I’m Reluctant To Hold National Grid Plc, SSE Plc and Centrica Plc

Despite recent market turbulence and the still elevated possibility of further upset during the months ahead, I will be steering clear of Centrica (LSE: CNA), National Grid (LSE:NG) and SSE (LSE: SSE), some of the FTSE 100’s most renowned defensive stocks. Here’s why.

Twin threats: regulation & high leverage

Lower energy prices aside, one of the biggest threats to the UK utility sector at present is the ongoing Competition and Markets Authority (CMA) inquiry into energy costs and pricing practices across the industry.

If the CMA eventually finds against the incumbents then this will probably result in enforcement action, which could take the form of either an industry breakup or, at the very least, tighter regulation of the prices charged to consumers.

This places a significant question mark over the future stability of earnings at Centrica, National Grid and SSE, which in turn has its own implications for trio’s growth prospects over the medium term.

However, regulation is not the only issue facing the sector as high leverage is also an impending problem that will eventually need to be dealt with, particularly in light of the impact that rising interest rates could have upon financing costs and, therefore, the bottom line in the current low-price environment.

This point is illustrated by a brief look at the balance sheets — debt/equity are at 2.2x and 2.1x for Centrica and National Grid, respectively, while gearing also comes in at 66% for both companies.

The outlier in the selection is SSE, which boasts a debt/equity ratio of 1x and gearing of 47%. However, concerns over the group’s dividend will probably continue to outweigh the benefits of a best in class balance sheet for at least the foreseeable future.

Dodgy dividend cover

On balance, Centrica and SSE are the most exposed to current regulatory scrutiny, although if the CMA were to more actively regulate prices then it would only be a matter of time before this downward pressure feeds through to the bottom line at transmission-focused companies like National Grid.

In addition, leverage remains too high at all three companies, while the dividend outlook has also deteriorated during recent quarters, which calls into question the standing commitment of all three businesses to maintain a progressive dividend policy.

If we look at dividend cover levels across the board, ignoring adjusted earnings figures in favour of the IFRS (International Financial Reporting Standard) eligible numbers found in the financial statements, it soon becomes apparent that Centrica, SSE and National Grid are all sailing very close to the wind when it comes to covering their existing payouts.

In detail, the above analysis returns dividend cover ratios of 1.24x for National Grid and 0.67x for SSE, while for Centrica dividend cover remains frightfully low even after last year’s re-basement.

Taking into account 2014’s losses, if you apply the consensus estimate for EPS in the current year to last year’s re-based payout, it suggests that future cover will probably be in the region of 1.3x.

Neither of these ratios are even remotely encouraging and, in addition to rendering the current low valuations across the sector completely irrelevant, they are among the key issues that make me believe that the dividend question will probably be among the largest detractors from returns for the all three companies during the next 12 – 18 months.

As a result, I’ll be observing price action at each of these companies from a safe distance throughout the coming quarters.

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James Skinner 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.