SSE – a lesson in dividend safety

The company’s problems have taken a heavy toll on its share price. Even with a heavy dividend cut expected next year, it is by no means certain that the worst is over for SSE. Political and regulatory threats hover over it, but given the depressed share price it’s not unreasonable to ask whether these have been overdone. It’s also fair to question whether the shares are a classic value trap.

The business

The root of SSE’s current problems rest with the mix of its business and the effect on its overall profitability. In short, the reliability provided by its networks business is currently being offset by a very volatile wholesale business.

SSE operating profit by division (£m)

Source: Company reports

The networks business has been the most dependable part of SSE and has underpinned its ability to pay a dividend and increase it over the years due to the predictability of the cash flows it generates. It consists of an electricity transmission business in the north of Scotland (it's part of the national electricity grid), electricity distribution networks in the south of England and north of Scotland, which distribute electricity from local substations to homes and businesses, and a share in gas distribution businesses in the same areas.

The prices the networks can charge electricity and gas suppliers are regulated by Ofgem. SSE makes money by efficiently investing in its transmission and distribution assets, which can increase its regulatory asset value (RAV). Providing it meets its financial and operational targets, SSE is allowed to earn a reasonable return (a rate of interest set by the regulator) on its RAV. If it performs better than the regulator expects then it can earn a higher interest rate on its RAV and make more money for shareholders.

Generally speaking, a growing RAV is a positive development and this can come from upgrading networks and growing the size of it by connecting more homes and businesses to it. The growth in renewable energy and the need to upgrade networks for things such as electric vehicles suggests that growth in the RAV is possible in the future. The danger is that the regulator cuts the rate of interest SSE can earn on its RAV – more on this later.

SSE sells electricity and gas to retail and business customers in the UK and Ireland. This business has been under pressure in recent years due to competition, lower demand from customers and a price cap introduced by the government. SSE wants to get rid of this business and tried unsuccessfully to merge it with npower’s last year.

The wholesale business has created lots of problems for SSE. The days when electricity generators could make very large profits are long gone. The shift to clean energy and the growth of renewables has made it very hard for SSE’s remaining coal and gas power stations to make money. This is why it is investing huge amounts of money in onshore and offshore wind farms.

Wind farms can make good money when the wind is blowing and nothing if it doesn't. SSE’s gas and coal power stations are therefore needed to keep the lights on and can be very profitable when they are called on to generate electricity. This means that the profits that SSE can make from generating electricity can be very volatile as they are dependent on the weather and the prevailing power price.

Where SSE’s wholesale energy business has got into trouble has been with its energy trading business. SSE has to enter into contracts to buy and sell electricity, gas, carbon, coal and oil. Controlling the exposure to commodity prices is not easy, and if not enough price risk is hedged it can create big losses. SSE is expected to lose £300m in 2018-19 from its energy portfolio management business and could still be losing £100m in 2019-20, although it hopes it can get to a position of break-even by better hedging.

Gas storage used to be a nice business when cheap gas could be bought and stored in the summer and sold when prices increased in the winter. This is no longer the case and SSE is struggling to make any money from this business. Making money from producing gas is also difficult. SSE has stakes in 15 gasfields in the North Sea, but the business is not consistent with its strategy of decarbonising its business and will probably be sold in the next few years.

SSE’s problem in numbers – an increasingly unaffordable dividend payout

Sources: Company Reports/my calculations

It is clear from looking at the trend in some of SSE’s key financial performance numbers over the past decade that its dividend has been on borrowed time. Since 2008, SSE has invested nearly £9bn more in its businesses, but its operating profits have only increased by just over £300m – an incremental return on investment of just 3.7 per cent. Free cash generation has been weak as a result and net debt has soared to nearly £10bn. The dividend is barely covered by profits and is certainly not by cash flow.

The intended merging of its retail business – which is no longer happening – has already led SSE to announce that its full-year dividend will be cut from just over 97p in 2018-19 to 80p in 2019-20. But unless profits pick up, the dividend cover still looks as though it will be very thin, making this lower dividend vulnerable to any further fall in profits.

How sustainable is SSE’s revised dividend policy?

An annual dividend of 80p a share will cost SSE £821m based on its current share count, and assuming no scrip dividend. This is much higher than the amount of free cash flow (FCF) being generated by the business after all its investment in networks and wind farms is taken into account. If depreciation is taken as a proxy for maintenance investment requirements (not always the case with regulated utilities) then there is likely to be enough money to pay this dividend according to current analysts’ forecasts.

SSE is aiming to increase its dividend by the rate of inflation (as measured by RPI) between 2020 and 2023. This would increase its cost to over £900m by then, based on an assumption of 2.5 per cent inflation.

How realistic is this?

The networks business remains the key to the dividend. SSE is pinning its hopes on RAV growing from just over £8bn in 2018 to over £10bn in 2023. If it makes a return of 4-5 per cent after inflation and tax on these assets then operating profits are expected to average around £800m out to 2023 – not much higher than they are now.

SSE could make higher profits if big investment projects are accepted by the regulator. There are around £700m of additional projects in its Scottish transmission business and a further massive £1.5bn to connect wind farms to the islands of Shetland, Orkney and the Western Isles.

The danger is that Ofgem will cut the allowed rate of return on the networks’ RAV. New price limits for electricity transmission and gas distribution will come into force from 2021 with new prices for electricity distribution from 2023. In December 2018, Ofgem proposed an after-tax real return for National Grid's (NG.) transmission assets of just 4 per cent. Applying that to SSE’s networks business might see it make lower profits than it currently expects.

The big hope is that SSE’s renewable energy business of wind farms, hydro electric and pumped storage will make a growing contribution to profits and cash flows. If all goes to plan, SSE expects to have 4.2 gigawatts of renewables capacity by 2020, which it hopes can generate FCF (after maintenance capex) of £775m based on achieving a power price plus subsidy of £95 per megawatt hour.

Wind farms’ profits will always be subject to variable weather patterns, but going forward the government’s contracts for difference (CFD) scheme has taken some of the risk out of renewables by guaranteeing a power price relative to the prevailing market price. Renewables will earn a strike price based on the costs of investing in wind farms that is expected to be higher than current market prices most of the time. If the market price is higher than the strike price, then the renewables business owner will have to pay the additional money back so that customers get a good deal.

SSE intends to create a separate renewables business so that investors have more visibility on how it is performing. This is a welcome development.

SSE still has 4.7GW of gas-fired power stations with capacity obligations out to September 2022 to generate electricity when renewables and nuclear cannot keep the lights on. The flexibility offered by gas should give SSE the opportunity to make an additional source of profits to pay its dividend.

It may be that SSE could be able to make enough money to meet its revised dividend targets, even if Ofgem is really tough on prices. But it looks to be a close call at the moment. SSE’s debt is too high for my liking and any improvement in FCF or money raised from selling assets would be put to good use in reducing it

While it has a retail business that it clearly doesn’t want to own, it is likely to be a source of some profits and cash flow as well while it stays under SSE’s roof. A lot also depends on the ability to cut down the big losses currently being made in its energy portfolio management business, which is a worry.

How much bad news is priced into SSE’s share price?

My view is a lot. Taking the current share price at the time of writing of 1,123p, the prospective dividend yield is 7.1 per cent based on a 2019-20 dividend per share (DPS) of 80p. If that dividend can grow by 2.5 per cent a year to 2024 – one year longer than SSE’s current dividend target – and then stay unchanged forever then assuming a 7 per cent required return by investors, a dividend valuation model values SSE’s shares at 1,243p. An 8 per cent return would reduce this valuation to 1,086p.

Many investors worry about the threat of nationalisation if a Jeremy Corbyn-led Labour government comes to power in the UK. You can make up your own mind on the likelihood of this happening, but the one thing that is rarely discussed is what price the utilities would be renationalised at. It’s by no means certain that it could be done at a big discount to the current market prices and would surely be contested in the courts.

The company clearly faces a lot of threats, but its investment is now being targeted towards assets that should produce less volatile returns than its past spending. This might make the shares worth considering for adventurous income investors.