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Income and regulation fears for SSE

SSE is facing a potentially beefed-up regulatory regime at a time when the group's ability to support its current dividend policy is far from certain.
October 16, 2014

Since the start of the year SSE's (SSE) share price is up almost 9 per cent. However, the strong showing ignores the raft of risks faced by the energy group: an important pricing determination that could squeeze profits is due from Ofgem next month; the initial findings of a Competition & Markets Authority (CMA) investigation is expected early next year; and the industry could face the prospect of an antagonistic Labour government following next May's general election. And while some investors may be happy to overlook these major risks for the chance to bag a near-6 per cent forecast yield, dividend cover is expected to become increasingly thin in coming years. We think it's time to sell.

IC TIP: Sell at 1524p
Tip style
Sell
Risk rating
Medium
Timescale
Long Term
Bull points
  • High-yielding stock
  • Defensive play
Bear points
  • Labour pledge on energy prices
  • CMA interim update
  • Dividend cover pressure
  • Ofgem price controls

Next month, the UK power suppliers will find out if they will be forced to operate within a far more stringent regulatory environment. Ofgem is set to publish new electricity distribution price controls that will come into force for an eight-year period from 1 April 2015. Based on Ofgem's earlier draft proposal to cut the allowed return on equity from 6.7 per cent to 6 per cent, broker JPMorgan reckons SSE could take an £80m operating profit hit, wiping 6 per cent off EPS. It also believes that consensus forecasts are currently assuming a more benign final outcome, suggesting potential downside if Ofgem sticks to its guns next month.

 

 

And there are bigger uncertainties on the horizon. The CMA is expected to release its interim update on its investigation into the sector in January or February next year. Ofgem's initial assessment of competition in the retail energy market, which was released last March, found that "competition isn't working as well as it should for consumers". The matter was duly referred to the CMA as it possesses the requisite legal clout to address any structural barriers to competition. It's conceivable that the CMA could conclude that the existing integrated structure of power suppliers isn't working in consumers' best interests, and an enforced separation of power companies' generating units from their supply businesses could follow.

And the 'big six' energy suppliers could face even bigger changes if a Labour government is elected next May. The party has already pledged to freeze gas and electricity prices until 2017 if it prevails in next year's election while it works on plans to reform the industry. This could have some very negative consequences for the big players and uncertainty is likely to build as campaigning for the election intensifies.

Even ignoring the big uncertainties, not everything is clear-cut from an income perspective. There are certainly no guarantees that, even with an ongoing divestment programme in progress, SSE will be able to increase the dividend pay rate in line with recent years. JPMorgan describes SSE's existing dividend policy as potentially "unsustainable". SSE recognises that earnings growth is subject to greater risk in 2016-17, which could potentially take dividend cover well below the 1.5 times target rate. Indeed, cover could well drop to just 1.2 times. Relatively high debt levels make the prospect of falling cover a bigger threat to the payout.

 

SSE (SSE)
ORD PRICE:1,524pMARKET VALUE:£15bn
TOUCH:1,523-1,524p12M HIGH / LOW:1,601pLOW: 1,297p
FORWARD DIVIDEND YIELD:6.0%FORWARD PE RATIO:15
NET ASSET VALUE:297p *NET DEBT:114%

Year to 31 MarTurnover (£bn)Pre-tax profit (£bn)Earnings per share (p)Dividend per share (p)
201231.70.32180.1
201328.30.64284.2
201430.60.63486.7
2015**35.61.610388.8
2016**35.71.610091.8
% change0.4-2-3+3

Normal market size:1,500

Matched bargain trading

Beta:0.51

*Includes intangible assets of £889m, or a 90p share.

**JPMorgan Cazenove forecasts