Utility minus utility

But that was in the days when utilities suppliers seemed to offer limitless potential to gung-ho acquirers. They dealt out near-certain returns slightly higher than the cost of capital, which just cried out to be leveraged up as far as the imagination and recklessness could take them. Yet as the future folded into the present, the performance of utilities became depressingly mundane, compromised in particular by political imperatives to assuage unhappy consumers and to save the planet.

Thus it is that the income fund’s other utilities holding – vertically integrated energy group SSE (SSE) – has performed much more sedately. Actually, its performance in the past 10 years has been poor. SSE’s shares, which the fund bought for 634p each in early 2003, peaked at £16.96 early in 2008 but are now just £13.33. Still, if you think that’s bad, spare a thought for the sad souls who own shares in Germany’s giant energy companies. Take the second largest, RWE (Ger:RWE) – its share price peaked at almost €101 (£90) at about the same time as SSE’s, but now stands just below €22. That equates to about £43bn of value destroyed by the perversities of Germany’s energy policies; or three SSEs reduced to nothing.

In times of despair, company bosses tend to rearrange the deck chairs at a hyperactive rate – and throw a few overboard. And, sure enough, RWE and SSE want to rearrange their seating plans. In particular, RWE’s Innogy subsidiary, whose roots lie with the UK’s National Power, has been squeezed, chopped and moulded relentlessly in the past few years and the latest move is to merge its UK energy supplier, Npower, with the energy-supply side of SSE, in the process splitting SSE into two companies. So SSE’s shareholders will own a slightly smaller version of their existing company and most of something that SSE’s City advisers nattily label MergeCo; it will get a formal – and probably silly – name in due course.

SSE’s shareholders have approved the plan, although – judging by the response of SSE’s share price – with little enthusiasm. Since it was announced in November, SSE’s shares have fallen 8 per cent relative to the All-Share index, which has nudged up over that period. Their wariness is understandable since there is every chance that the complete package entails a cut in their dividends.

It is not in doubt that the dividend to be paid by the ‘new’ SSE – basically, the generation and transmission arms of the existing group – will be cut. SSE’s bosses make that clear. In the current year SSE plans to pay 97.5p per share, 3 per cent up on the previous year. Then in 2019-20 – the first full year after the de-merger – the payout will be cut to 80p. After that – hopefully – it will rise in line with inflation.

So the key question is whether that income shortfall – 17.5p per share, or 18 per cent – can be made good by dividends from MergeCo? We will know more early next year when MergeCo releases its prospectus, but – despite management’s hyperbolic enthusiasm for their plan – it would be a big ask. The new bosses of MergeCo will have two large obstacles to overcome. The first is that consistently profitable SSE Energy Services is being merged with a serial loss-maker. In each of the three years to 2017 Npower made operational losses and – pro forma – MergeCo made a £185m pre-tax profit in 2017-18 compared with £278m of profit made by standalone SSE Energy Services.

The second is that MergeCo’s dividends will have to be shared out among more shares. That’s because Innogy – soon to be passed on to E.ON (Ger:EOAN), Germany’s biggest energy supplier – will own 34 per cent of MergeCo. Those extra shares mean that making good the 17.5p dividend shortfall will cost £273m for MergeCo. Paying that looks beyond its means, judging by 2017-18’s pro-forma profit.

That said, there is a bright spot – the synergies that should emerge from combining two major UK energy suppliers that, together, have about 11.8m accounts and approaching 20 per cent of the UK market. True, the UK’s competition regulator, the Competition and Markets Authority, could yet have something to say about that, although it’s unlikely given the high rates of customer churn in the market for energy supply; almost one-in-five customers changed supplier in 2017.

Assuming the deal goes through, SSE’s bosses reckon that MergeCo will generate synergies of £175m a year by 2023. In crude terms, take that figure, tax it and discount it to present value and it would be worth about £120m. Add it to an approximation of MergeCo’s underlying earnings power and we have a business capable of making about £270m a year net of tax and in today’s money values. By a wonderful coincidence that’s about the cost of bridging that 17.5p dividend gap. But there is barely a slim chance that all of it would be distributed to shareholders and, besides, it actually has to materialise, easier said than done given the bitterly competitive market for energy supply.

The long and the short of it, therefore, is that SSE’s shareholders have a dividend cut to look forward to. Of course, we won’t have a counterfactual and the dividend cut might have happened anyway. After all, not once in the past five years has SSE come close to generating the free cash to cover its dividend payments and, even for a utility, there is a limit to how far it can pile up debt – in the five years to March 2018, net debt rose 53 per cent to £8.9bn.

As to what I’ll do with the income fund’s holding in SSE, most likely I’ll keep the high-yield SSE shares and ditch those in lowish-yielding MergeCo. I don’t have to decide yet – the deal won’t complete until next spring at the earliest. Meanwhile, I can earmark the capital tied up in SSE – about 8 per cent of the portfolio’s total – as funds ready to be deployed should a great opportunity arise. The trouble is, in today’s world of income investing, ‘great opportunity’ is almost an oxymoron.

■ Meanwhile – and continuing a theme begun last week – I must focus on Brexit-free earnings for the income fund. The fact that overseas companies seem to be under less pressure to pay dividends than UK companies – and especially to pay them twice a year – complicates that task, at the very least tending to make the flow of income received lumpier.

For example, Belgian wire-products maker Bekaert (Be: BEKB) – best known in the UK as the owner of wire rope maker Bridon, which was London-listed until the late 1990s – pays a dividend once a year in May. So if I were to buy its shares now it would be 10 months before the fund got a payout, albeit a fat one. Exactly the same applies to lighting equipment maker Signify NV (NL: LIGHT), which, until earlier this year, was Philips Lighting. Both companies reported first-half results for 2018 last week and, in both cases, the figures made dull reading, even though the companies had signalled that.

Yet as the table shows, shares in Bekaert and Signify trade well below my guesstimate of underlying value, which – in crude terms – is arrived at by capitalising average profits for the past five years at an estimated cost of capital. Of course, that prompts the question whether the future will be much like the recent past? In Bekaert’s case, the years 2012-17 show a company getting its act together, in the process driving up profits margins from 3.4 per cent in 2012 to a peak 8.3 per cent in 2016. Other financial ratios improved similarly, but 2018 will see a sharp reverse. Against a backdrop of global growth in the group’s main markets – automotive and industrial steel wire – that’s miserable. Management blames an agglomeration of one-off factors, but now there is the concern that these will unwind (assuming they do) just as economic growth slows, leaving Bekaert no better off.

Signify is in a similar position – and it has to be said that both companies have been hurt by the euro’s recent strength – although it also battles within markets that are either contracting (conventional lighting) or whose growth is decelerating from a hectic pace (LEDs). Its return on equity (RoE) – averaged over the past five years in the table – also indicates a company that may struggle to be truly profitable over an economic cycle, although the average over the past three is a much more acceptable 8.8 per cent. The same applies to Bekaert, where the RoE is 8.5 per cent over the past three. If the three-year returns are a better indicator of the future, we have companies capable of creating value for their shareholders.

Besides, both are significant players in markets that are hardly going to disappear; both generate lots of recurring revenues by selling low-cost, must-have items for which there is a base level of demand. In that sense – and this particularly applies to Bekaert – each has a business model quite like that of Vesuvius (VSVS), which supplies consumables to foundries and whose shares are currently one of the income fund’s best performers. Both also look capable of maintaining their dividend even in poor years because free cash flow usually exceeds the cost of the payout comfortably. True, that does depend on their capital spending (capex) staying below the charge for writing down fixed assets and Bekaert’s capex is currently blipping upwards.

So – as I say often enough – we have here companies whose shares look as if they could do a job in an income fund, although they won’t set the world alight. Next week I’ll see what’s available in the land of Donald Trump.