How Will SSE Plc Fare In 2014?

For most shares in the FTSE 100, 2013 was a good year and investors have likely enjoyed capital gains and rising dividend income.

That makes me nervous about investing for 2014 and beyond, and I’m going to work hard to adhere to the first tenet of money management: preserve capital.

To help me avoid losses whilst pursuing gains, I’m examining companies from three important angles:

• Prospects;
• Risks;
• Valuation.

Today, I’m looking at electricity and gas utility company SSE (LSE: SSE) (NASDAQOTH: SSEZY.US).

Track record

With the shares at 1339p, SSE’s market cap. is £12,938 million.

This table summarises the firm’s recent financial record:

1) Prospects

The directors of SSE seem determined to remunerate investors with annual above-inflation increases in the dividend. The recent interim results statement revealed a 3.2% dividend uplift, and the firm reckons it has achieved an unbroken record of better-than-inflation dividend-raising stretching back to 1999. That’s a well-engrained tradition that I’m sure no CEO will want to break.

Backing up that dividend is a well-diversified utility business with around 97% of revenue coming from the UK and 3% from Ireland. The firm has electricity distribution operations in the North of Scotland and Southern England; electricity and gas supply contracts; gas production, distribution and storage businesses; and interests in electricity generating assets. Potentially, good financial performance in any one particular business area could help offset poorer performance in another, which could help to support that ongoing progressive dividend policy.

2) Risks

Events recently tested that theory with SSE delivering a 17.4% decline in adjusted earnings per share with the half-time figures. Beneath that headline-number is a mixed operating performance: the energy distribution and transmission operation produced 74% of operating profit with the remaining 26% coming mostly from electricity generation. Meanwhile, retail energy supply delivered an operating loss over the period, and yet the dividend went up.

So, the directors’ determination about the dividend seems robust. I’m more worried about the share price; as ‘defensives’ like SSE tend to move in and out of favour counter-cyclically to economies. When the macro-economic environment seems dire, P/E ratings can expand as investors head for ‘safe’ investments. When general economic circumstances start to look rosy, like now, investors tend to switch to ‘risk-on’ investments, moving away from utilities like SSE, which means the P/E rating often contracts.

The firm reckons trading in the regulated utility sector has been difficult lately. On top of that, the business is highly capital-intensive and relies on debt funding to keep things ticking over. Topping the list of potentially catastrophic outcomes is the possibility of SSE having its credit rating downgraded by the likes of Moodys and Standard & Poors. If that happens, finance could be hard to obtain at an economic price and profits could evaporate altogether, along with the dividend. There’s also a big risk revolving around commodity prices. We’ve already seen how escalating wholesale prices can squeeze the profit from the firm’s retail operation.

3) Valuation

The forward dividend yield for year ending March 2015 is running at about 6.8%, which on the one hand looks good, but on the other hand looks too high: I get nervous when yields approach 7% as such levels often presage a cut.  Analysts following SSE reckon adjusted forward earnings are likely to rise 6%, which means they’ll cover the dividend payout just under 1.4 times.

The forward P/E rating is around 11, which seems to sit well against dividend-yield and earnings-growth expectations.

What now?

I’m one of those investors looking at ‘growthy’ type investments at this point in the cycle so will be unlikely to invest in SSE right now. However, I can see the attraction of the firm’s chunky dividend payout.