No respite for energy suppliers

Just six months later, SSE is freezing household energy prices until at least January 2016, and it is rumoured that British Gas owner Centrica will follow suit - we'll hear more in an update on 12 May. But why the change of heart, and what does it really mean for profits and ultimately the dividends that shareholders have come to rely upon?

Well, SSE claims its unexpected price freeze was due in no small part to government pledges to remove social and environmental charges from energy bills. Cost-cutting and efforts to secure energy supplies in wholesale markets helped, too. The group did, however, warn that there would be a financial hit, saying that "profit margin from supplying customers with electricity and gas will be lower than it has been previously".

SSE reported a 6.4 per cent pre-tax profit margin from its UK household electricity and gas supply business in 2013, and has obviously decided it can take a short-term hit in return for some easing up in the intense political pressure put on the sector in recent months. Having run the numbers, it estimates that earnings will be flat to slightly up in the year to 31 March 2014, but subject to "greater risks" in the next two years.

"The price for the potential reduction in political pressure is stalled or reduced earnings per share over the next three years," says Angelos Anastasiou, utilities analyst at Whitman Howard. He adds that if Labour does win the next general election and carries out its price freeze promise, this would push SSE's price freeze out for a further year, which would eat deeper into margin and could put the group's A- credit rating at risk.

This pressure on earnings could also mean that dividend cover falls below the group's target range of 1.5 times to just 1.2 times. SSE admitted as much. Of course, that's not ideal, but it is manageable. However, if the group reaches a point where it is unable to fund the dividend out of current year earnings, instead having to dig into retained profits, difficult questions would be asked about the sustainability of the payout.

Prospects for dividends beyond the next couple of years very much depend on the outcome of the recent referral of the energy supply market by regulator Ofgem to the Competition and Markets Authority (CMA). Ofgem says that the investigation is an attempt to "clear the air" following a loss of trust in the big six energy suppliers, and to decide "once and for all" if there are, indeed, barriers to competition.

The basic sticking point is the persistently high market share of the six largest energy companies - British Gas, EDF, E.ON, npower, Scottish Power and SSE. Although the presence of half a dozen players could be seen as a relatively competitive market, they together account for around 95 per cent of UK energy supply, and independent suppliers are struggling to make inroads. This has led to suspicion that barriers to entry for the independents are too high, leading to excess profits for the incumbent suppliers.

Ofgem points out that average profits for the big six for supply and generation have increased from £3bn in 2009 to £3.7bn in 2012. Energy secretary Ed Davey went further in his open letter to Ofgem earlier this year. He said there was evidence that British Gas, the company with the largest share of the domestic gas supply market, has tended to charge one of the highest prices over the past three years, and has been on average the most profitable.

The CMA investigation will take time - possibly as long as two years. When it does report back it could call for a separation of generation and supply business to level the playing field for the smaller energy suppliers who do not have generating assets, or even a break-up of companies which it feels have too tight a grip on the market.

If, as the big six claim, the energy market is already competitive, then the CMA investigation should pose a limited threat. But as SSE's u-turn over the price freeze has demonstrated, a market can always be more competitive. Whatever the outcome, the CMA investigation dragging on in the background undoubtedly leaves a cloud of uncertainty over prospects for the big six.

In the near term, though, the greatest risk could be from moves by Ofgem to speed up the time it takes to switch energy suppliers. The fact that currently takes as long as six weeks to swap supplier could be one reason behind those stubbornly high market shares. Cut switching times to as little as one day, as some claim they can be, and independent suppliers could pose a real threat to the big guys. A multitude of small energy providers could benefit - the largest, privately-owned First Utility, guarantees to beat the big six standard tariffs

IC VIEW:

The only small energy provider that is listed at present is renewable energy supplier Good Energy Group (GOOD), which reported a 32 per cent increase in customer numbers and an 85 per cent increase in cash profits last year. The earnings outlook for Centrica and SSE, meanwhile, looks tough as they face an environment hostile to price increases and potentially stalled or declining customer numbers if switching activity increases.

Both Centrica's and SSE's shares have enjoyed a bit of a bounce in recent months as government action to remove environmental and social costs from energy bills took the heat out of the energy price debate. But with the CMA investigation hanging over the pair and a general election looming, these are not stocks to chase for capital gains.

Nevertheless, they are still both decent income plays. Historically, they have had high dividend yields and a policy of dividend increases at least in line with inflation. All the signs are that abandoning the policy of real dividend increases would be a last resort. SSE has said that it will continue to increase dividends at least in line with inflation despite its earnings-denting price freeze. In doing so, SSE appears to have decided that lower dividend cover is a lesser evil than a dividend cut. The City reckons SSE will raise its dividend by 5 per cent for the year to March 2014, giving a forward dividend yield of 5.7 per cent. It's 4 per cent and 5.4 per cent, respectively, for Centrica.

FAVOURITES:

We rate both Centrica and SSE a hold, but forced to choose between the two, we would plump for SSE right now as it carries the chunkier dividend yield and is potentially less exposed to political risk given its lower market share and pre-emptive price freeze. But our preferred large-cap income play in the utilities sector at present is National Grid (NG.) - a 5 per cent dividend yield and lower political risk than that facing the energy supply companies keep us buyers.

Utilitywise (UTW), one of Investors Chronicle's Tips of the Year (Buy, 244p, 2 Jan 2014), is an interesting play on the energy price theme. It helps companies find the best tariff from energy suppliers and reducing energy costs is much in demand, and earnings are growing fast. Buy.

OUTSIDERS:

Shares in power generator Drax (DRX) have fallen 16 per cent since we turned seller in February at 802p. The valuation looked demanding given uncertainty over the subsidy regime for its shift to biomass from coal generation, and we continue to steer clear.

THE BROKERS VIEW:

SSE - the second largest UK energy supplier with around 16 per cent market share - has frozen its residential prices until at least January 2016. While Centrica has not made a similar pledge and has stated that it wants to retain flexibility (for example given the turmoil in the Ukraine) we think Centrica will have to follow suit.

We forecast British Gas residential supply margins to fall to around 3.9 per cent (versus around 6.5 per cent previously), meaning the lowest operating margin in nine years. We assume that despite the 'price freeze' ending January 2016, it will take the industry two years to restore margins to around 6.4 per cent. Our long-term estimates - from 2017 and beyond - are less impacted by the energy price freeze. We believe margins can be restored to around 6 per cent in the long-run, not least because competitors would be at breakeven if British Gas margins fall to around 4 per cent.

Note that our central assumption is the Competition and Markets Authority (CMA) does not regulate or adjust down margins. A CMA investigation will unlikely yield results before the second half of 2015, leaving uncertainty on long-run margins.

Centrica trades on around 13.3 times 2015 forecast earnings, falling to around 12 times in 2016. This is the top-half of the historical range (the price-earnings ratio has gone below 9 times in the past). The 2015 expected dividend yield is around 5.5 per cent, growing at around 3 per cent per annum on our forecasts.

We prefer SSE (around 6.1 per cent yield) and National Grid (around 5.3 per cent yield), both of which have similar dividend growth.

Centrica is rated Neutral with a 310p price target. National Grid is rated Outperform with an 800p price target. And SSE is rated Outperform with 1,600p price target.

Mark Freshney is a utilities analyst at Credit Suisse