Inflation has been non-existent over the past few years. As recently as 18 months ago, the inflation rate was 0%. But this is all changing and inflation over the past few months has jumped to 2.3%. And it is set to rise further as the weak pound, following the Brexit vote, makes imports more expensive for us to buy.
With inflation returning, now is a good time to start thinking about buying into assets that will protect the value of money as the cost of living increases. Utility companies are a great way to protect against inflation as the prices they charge are regulated and linked to the Retail Price index (CPI). This is the reason why you often see utility companies link their dividends directly to the retail price index or the consumer price index.
What makes SSE unique is the company has a networks unit in addition to the more traditional wholesale and retail devisions. The networks unit is an aspect of the company I really like. Infrastructure assets like pipelines were traditionally seen as reliable but boring asset classes. But in recent years, the ability of infrastructure assets to churn out good cash flows irrespective of economic conditions have made them attractive to investors, particularly when interest rates are close to zero.
I am confident about the enduring appeal of infrastructure assets such as gas pipelines to investors. That is the reason National Grid was able to sell a part of its gas assets for an amount more than most expected.
Why Shares In Utility Companies Are Falling ?
Utility shares have taken a dive over the past week. This is due to the fear that the Tories want to introduce an energy price cap as part of their election manifesto set to be published on 8 May. The conservative business secretary recently stated that energy companies are ‘exploiting’ people and said that the government will act to stope the “flagrant mistreatment” of customers.
An energy price cap is bad news for utility providers as it would mean that they would not be able to increase prices for a set period of time (approx 20 month) and this would in turn hit the bottom line and make it hard for companies to continue to increase their dividends in line with RPI.
The main question from an investors point of view is ‘is the energy price cap legal ?’. As far as my research goes, no one currently knows the answer to this. The big energy companies would almost definitely challenge the ruling in court. But lawyers say it is unclear about whether it is contrary to UK or European law (it still has to apply to EU law until Brexit is formalised). This uncertainty regarding how the policy would be implemented and the legalities of it is causing uncertainties in the industry and as we all know, investors hate uncertainty hence shares in the sector have taken a tumble.
An Energy Price Freeze Could Be Good For The Big 6.
We all know by now that regulation is good for the current incumbents. Go and read my article on the Tobacco industry to see how regulation gave the big players and their investors great returns over the years.
In terms of regulation via price caps in the energy sector, new and smaller companies would be deterred from entering the industry due to uncertainties and lack of profit incentives. The big players such as SSE would be able to withstand a year or two of non-price increase and thus consolidate power in the process. There is a high probability that the big players in the energy space would come out even stronger and have even greater market share after the price freeze.
Is SSE’s dividend safe?
The most important aspect of utility shares is the dividend. This is because the majority of the return I will get from a utility company will come in the form of dividends as opposed to capital growth. Thus it is important to buy shares in boring utility companies when the yield is high and the dividend cover is adequate. With a current yield of 6.6% the SSE dividend is certainly high. But the question is, is the dividend sustainable?
The big 6 energy companies currently face stiff competition for customers from a swathe of new and existing independent energy suppliers. Take SSE for instance, it revealed in January that its customer numbers had dropped to 8.08m from 8.21m at the end of March 2016 – although the customer exodus has halted as of late. New competition is putting profits from the firm’s retail division under pressure.
In a recent trading update, SSE stated that operating profit from its Networks business will be around £100m lower in the year to 31 March 2018 than the previous 12 months. This shortfall is blamed on a number of issues including a lower income from electricity transmission charges and a revenue hit from the sale of its 16.7% equity stake in Scotia Gas Networks Limited.
But the most important part of the update is the company expects dividend cover this
year to be within the expected range of around 1.2-times to 1.4-times. The group finance director stated ‘ we are on course to deliver adjusted earnings per share (EPS) of between 122p and 125p,’implying a 1.3-times cover of the currently predicted
94.1p dividend this year. This is decent margin of safety for a company in a slow and stodgy industry. Based on this guidance, I would say that the SSE dividend is safe at present.
My Purchase of SSE
With the impending election and the uncertainties around the industry, share prices across the board have dropped providing a great opportunities to snap up shares with decent yields.
I bought 65 shares in SSE on Thursday at a price of 1425p a piece. With an expected dividend of 94.1p over the coming year, the dividend yield on my purchase is a decent 6.6%.
I do believe that shares in utility companies will be volatile from now till the election – if the conservatives win, which they should, the volatility should extend to ‘if and when’ any price caps are introduced. So for those who want a greater margin of safety on their purchase, they could wait to see if share prices drift much lower. I on the other hand bought shares this past week as I believe the price I paid is fair for a company like SSE. Sure I could be patient and wait for a lower entry price but I am not in the trade of timing the markets. I have waited on certain shares to go ‘just that little bit lower’ before and have missed out on buying some solid investments in the process. I have learned that it is better to buy a stock when it hits your price target as opposed to waiting and seeing how much longer it can fall. Sure SSE could fall further in price from here but with a 6.6% yield, I am not going to complain.
My purchase in SSE has pushed my total ISA dividend income to £1489. I have included my April monthly purchases of GSK, Associated British Foods, Sage, Informa and PZ Cussons in this figure. I will be writing an April stock purchase article real soon so check back to read it.