With a dividend yield around 8.4%, shares in British Gas owner Centrica (LSE: CNA) look pretty attractive to yield-starved investors. But before buying into a stock because of its headline yield, it’s crucial to examine whether the company is likely to sustain such high dividend payout levels in the long term.
And here’s the thing to remember about Centrica and other energy suppliers: the sector is battling against the looming price cap on energy tariffs and faces fierce competition from smaller rivals. With dividend cover for many utility companies at historically low levels, further profitability pressures could undermine the sustainability of their dividends.
No imminent danger
Still, Centrica is not in any imminent danger. Despite a 17% decline in adjusted operating profits for 2017, the company maintained its full-year dividend at 12p per share. It also expects to maintain the current dividend level, subject to it generating annual adjusted operating cash flow within its target range of £2.1bn-£2.3bn and net debt remaining within £2.25bn-£3.25bn.
The company’s financial flexibility is underpinned by its sector-leading balance sheet, which has been bolstered by recent disposals in its upstream and power generation assets. Centrica is also in the midst of a major strategic repositioning, with plans to double down on its customer-facing businesses.
Its leading position in the UK energy supply and services market gives the company a competitive advantage over its rivals. There’s a huge growth opportunity to be seized in the market for smart home devices, which should expand and deepen relationships with households.
Nevertheless, its turnaround prospects needs to be viewed in the context of the challenging trading conditions in the sector. My guess is that the combination of political and regulatory uncertainty will keep the firm’s valuation pegged low in the future, with limited opportunity for the company to deliver any significant earnings growth in the medium term.
What’s more, Centrica’s very high yield of 8.4% tells us that investors are worried about the safety of its dividend. There’s certainly a lot to gain if its turnaround is properly implemented, but the road ahead will likely be a rocky one for investors.
A better buy?
Investors looking for safer dividends should instead consider power generation firm Drax Group (LSE: DRX).
The company seems further along in its transformation plan to shift its focus away from dirty coal towards greener sources of power, such as biomass and gas. Its financial performance in 2017 showed a marked improvement versus the prior year, with all areas of the business contributing to positive EBITDA for the first time.
Drax has also worked hard to shift its reliance on power generation, through an expansion in its business energy supply ops and the on-boarding of Opus Energy. Looking ahead, it intends to play a vital role in helping change the way energy is supplied, with plans to build 200MW of battery storage at the Drax Power Station.
Near fivefold increase in its dividends
Already, Drax’s turnaround is delivering growing cash flows and its rapidly increasing dividends look enticing to me. Following a near fivefold increase in its full-year dividends per share to 12.3p, shares in the group look set to yield 4.6%.
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Jack Tang has no position in any 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.