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Is SSE a buy for its 7% dividend yield?

With a dividend yield of 7%, shares in ‘Big Six’ energy company SSE (LSE: SSE) look pretty tempting to income-hungry investors. Everyone loves high income, but just how safe is the dividend?

Forward guidance

Encouragingly, the company has set out its dividend plans for the next five years, ahead of the planned spin-off of its household energy supply and services business. Following a 3.7% increase in its dividend to 94.7p per share for the 2017/18 financial year, SSE expects to raise it again this year, by 3% to 97.5p, representing dividend growth which is broadly in line with expectations for RPI inflation.

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And following the planned merger of its retail supply business with Npower and its subsequent spin-off, SSE plans to re-base its dividend payout to 80p per share in 2019/20, before returning to dividend growth which will keep pace with RPI inflation in the three following years to March 2023.

Clarity on the dividend should give investors a great deal of certainty about its medium-term income outlook, but its longer-term prospects needs to be viewed in context of the challenging trading conditions in the sector.

Challenges remain

There’s still a great deal of political and regulatory uncertainty which is holding back a re-rating in its shares, and earnings will likely come under pressure from the impending introduction of the government’s energy price cap and ongoing competitive pressures in the industry.

What’s more, there are growing concerns about the capital expenditure needed for its regulated energy networks business. For some time now, SSE has struggled to generate sufficient free cash flow after dividends to fully cover the investment needs for the regulated parts of the group, but going forward, that could become even harder following the spin-off of its cash-generative retail supply business.

Still, SSE is not in any imminent danger. The company maintains a solid investment-grade credit rating and expects net debt and hybrid capital to peak at around £10bn, before falling back towards £9bn by 2023. With this in mind, SSE should have enough financial flexibility to weather the challenges without great concern.

Different strategy

Meanwhile, smaller rival Telecom Plus (LSE: TEP) has adopted a different strategy to deal with the competitive pressures in the retail energy market. It’s looking at cross-selling opportunities to bundle together various products and services, in a similar way to the so-called quad-play packages that are becoming more prevalent in the telecommunications market.

Together with supplying energy, phone and broadband to households, the company is expanding into the home insurance and replacement boilers market. It recently acquired a 75% stake in Glow Green, a fast-growing supplier and installer of domestic gas boilers and warranty and care plans.

Competitive edge

With a growing product offering, Telecom Plus is a unique integrated multi-utility which seeks to gain an edge in an increasingly competitive market. The one-stop shop approach has been shown to be an effective tool to increase sales and reduce churn rates in the telecommunications market, so this strategy could deliver significant growth in the long term.

In the nearer-term, things look upbeat too, with the group expected to deliver continued growth in customer and service numbers. City analysts expect the dividend to increase to 50.3p this year, giving the stock a forward dividend yield of 4.8%.

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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.