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These 2 FTSE 100 stocks yield 7%, but are they bargains or value traps?

Utility giants SSE (LSE: SSE) and Centrica (LSE: CNA) are sure to feature high up on any list of the UK’s top dividend stocks. These two FTSE 100 income champions both support dividend yields of around 7% at the time of writing. 

But can you trust this market-beating distribution? That’s the question I want to try and answer today.

Market-beating

Generally speaking, when a dividend yield rises into the high single digits, it’s an indication that the market believes the payout is unsustainable. More often than not, this ominous signal holds true.

I wouldn’t rule out the same happening with SSE and Centrica. Indeed, both companies have already cut their dividends recently, and the UK utility industry is facing growing pressure to lower costs to customers and improve efficiency. At the same time, both SSE and Centrica cannot afford to cut their investment spending on new capital projects, as these are fundamentally crucial to long-term growth. If there’s a choice between maintaining the diffident payout and capital spending, the former will be first to go.

Having said all of the above, these are both very defensive businesses with steady income streams from the supply of energy to consumers and businesses across the United Kingdom. Unlike so many other companies, where demand for products fluctuates, the need for energy is only increasing as the country grows.

SSE and Centrica’s ability to capitalise on this growth depends on whether or not they can keep their customers interested. Unfortunately, they’re both struggling to do so. 

Falling profits 

At the beginning of September, SSE warned that earnings for the first six months of the year would fall by around 50% year-on-year, thanks to high gas prices, a drop in consumption, as well as lower renewables production. 

Meanwhile, Centrica lost 268,000 of its UK customers in the first half of 2018, pulling down operating cash flow by 11% to £1.1bn. Management has stated in the past that the company’s full-year cash flow must fall in a range of £2.1bn to £2.3bn for the dividend to be safe.

These numbers seem to suggest that the enterprises are going to struggle to grow, or even maintain their earnings at current levels required to support dividend payouts to shareholders. City analysts are not expecting Centrica to report any earnings growth for the next two years, so investors will just have to hope that cash flows do not decline further. 

Analysts have a slightly better performance pencilled in for SSE. Earnings per share, after falling in fiscal 2018 and 2019, are expected to return to growth in 2020. But while growth is expected to return in fiscal 2020, analysts believe this will be the year the company reduces its dividend. A cut of 17% is expected.

The bottom line 

So in conclusion, while Centrica and SSE might look attractive as income investments today, I’m not buying them for my portfolio. Both companies are struggling to grow and it could only be a matter of time before politicians place more restrictions on the industry, squeezing profit margins further. With this being the case, I’m happy to look elsewhere for income.

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Rupert Hargreaves owns no share 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.