Are they soaring in a sense of “peak Corbyn”, that the risk of re-nationalisations is ebbing as Labour struggles to gain on the accident-prone Tories? Has a posse of hedge funds been short the sector, now re-purchasing stock in a sense, fears got overdone and utilities’ strength of cash flows supports attractive dividend yields at current prices?
Or is this just a rally in a long-term bear market, an inevitable twitch after extensive falls but doesn’t really alter the market’s sceptical mood?
No genuine shorting amid political twists
SSE (SSE), the FTSE 100 (UKX)-listed supplier of electricity and gas, is a good example, trading sideways over 2015-16, then a 17% drop mainly in H2 2017 that appeared to climax with a further 12% plunge to 1,180p early last February, then a rebound to test 1,400p currently.
Last October, Theresa May reinforced the Tories’ manifesto pledge to set a cap on poor value “standard” energy tariffs, which probably impacted sentiment, though the actual legislation in late February 2018 has coincided with utility stocks rising.
- Stockwatch: A 9% yield for contrarians
If there’s a link then it was an over-reaction in the months leading up to reality (of a cap).
The pattern looks very much like short-selling on the political news, then buying back that has lately created a squeeze, but historic data for SSE shows only a minor 0.5% stock on loan last year and it vanished in June.
It has also taken until the early May local elections for Labour to be seen as needing to do better – mid the electoral term – if it wants to form the next government.
So if “peak Corbyn” is a factor, then it’s only just becoming apparent. Meanwhile, the EU frets about a Corbyn government giving British industry unfair subsidies, and opinion polls show the UK as divided for Labour/Tory support like it is for Leave/Remain the EU.
Source: interactive investor Past performance is not a guide to future performance
With a general election not required for another four years, it would take a constitutional crisis over Brexit to undermine the government, an opportunity Labour has latched onto, so if Tory rebels continue to side with HM Opposition then, indeed, the government’s credibility will go to the wire in months ahead.
The Tories’ chief risk as “owners of Brexit”, however, is it possibly coinciding with cyclical slowdown and interest rate rises in the next two years. Meanwhile, Labour is likely occasionally to keep mooting renationalisation of utilities but the surprise effect is diluting.
“Beast from the East” triggered re-appraisal of yield?
Share price recovery in February 2018, then especially from late March, links with cold weather snaps which may have prompted a de-risking of SSE’s fat dividend yield – likewise on other energy utilities.
At about 1,200p the prospective yield was entertaining 8%, currently just shy of 7% and would appear supported by SSE’s strong cash flow profile (see table where the trend in cash flow per share significantly exceeds earnings per share), although capital expenditure on renewables makes it hard to be sure exactly what free cash leeway the board has for payouts.
SSE has also spent £500 million buying back shares since end-2016, so if the board wants to prioritise genuine returns of capital then it likely could.
Similarly, Centrica (CNA) has risen about 25% off its February lows. I have several times drawn attention to the shares since December 2017, where a prospective yield over 8% has made the stock sensitive to any decent news.
Yet BT (BT.A) is also attempting to join the party, jumping nearly 15%, as if sentiment towards utilities is improving.
SSE – financial summary Consensus estimates year ended 31 Mar 2013 2014 2015 2016 2017 2018 2019 Turnover (£ million) 28,305 30,585 31,654 28,781 29,038 IFRS3 pre-tax profit (£m) 571 592 735 593 1,777 Normalised pre-tax profit (£m) 954 1,250 1,410 1,229 1,864 1,447 1,598 Operating margin (%) 2.7 4.5 4.6 3.3 5.6 IFRS3 earnings/share (p) 42.2 33.3 55.2 46.0 158 Normalised earnings/share (p) 80.1 94.9 122 105 163.0 117 124 Earnings per share growth (%) 10.3 18.5 28.8 -13.8 55.1 -28.2 5.9 Price/earnings multiple (x) 8.5 11.9 11.2 Historic annual average P/E (x) 15.7 13.6 13.8 0.2 9.5 Cash flow/share (p) 208 238 199 216 256 Capex/share (p) 170 178 138 163 146 Dividend per share (p) 81.3 85.0 87.3 88.7 89.9 94.5 97.0 Dividend yield (%) 6.4 7.1 7.3 Covered by earnings (x) 1.1 1.5 2.0 1.4 2.3 1.2 Net tangible assets per share (p) -480 434 535 430 546
Source: Company REFS Past performance is not a guide to future performance
A mixed narrative in SSE’s updates
The last trading update at end-January preceded a share price drop, yet its message was resilient:
“Effective delivery of day-to-day operations during the first nine months of this financial year, together with returns from its long-term investment programme, mean SSE now expects to deliver adjusted earnings per share in a 116p to 120p range for 2017/18, plus a full-year dividend increase that at least keeps pace with RPI inflation.”
As if attuned to the need to keep income-seekers sweet, “at least RPI inflation” is included also in the current year’s dividend growth target. Mind the flip-side of attention to dividends is a lack of underlying growth appeal, with upside/downside in the stock hinging on what yield is considered appropriate for shifting risks.
Buybacks have cancelled nearly 35 million shares, implicitly 3.3% of the issued capital and, with the stock down 200p since the programme began, you take your view whether it mitigated the drop, helped support earnings per share (EPS), or was a false “return” of capital.
Interims for the six months to 30 September 2017 were uninspiring: even “adjusted” profit figures were down 8% to 14%, with adjusted earnings per share down 8.8% to 31.2p although the interim dividend rose 3.6% to 28.4p – possibly helped by slightly lower investment and capital spending.
SSE still expects to invest some £1.7 billion in its asset base, two-thirds of which represent electricity networks and renewable, in order to substantially raise renewable capacity.
That’s significant relative to a market capitalisation just over £14 billion, i.e. investment that could be seen as vital for the business to adapt to modern needs, than leverage revenues.
Ongoing capex is likely a reason why long-term growth investors steer clear of stocks like this: SSE’s five-year table shows revenue/profit trending volatile-sideways, a definitive break-out as yet elusive.
More positively, the table shows the operating margin improving from 2.7% to 5.6% over four years, a factor to watch when SSE reports prelims on Friday 25 May.
Balance sheet is good in parts
Last September there was some £13 billion property/plant versus £1 billion goodwill/intangibles; nearly £1.2 billion cash in support of capex/dividend budgets; albeit over £8.5 billion debt (principally longer-term) thus net assets of £6.1 billion with net tangible assets per share near 550p.
Debt has appealed to fairly predictable firms such as utilities in the post-2009 era of very low interest rates, however, its cost is set to increase in due course with inevitable rate rises.
The Bank of England might defer one this week as economic data softens for the Western economies, although some extent of normalising interest rates will happen – say to 3% – in the next two years.
Meanwhile, SSE’s income statement shows a £216 million net interest charge shearing 12.5% of operating profit. Concern about impending rate rises may have contributed to SSE’s fall in the last year, as speculation gathered about an upturn in rates and the Bank of England changed its guidance to “more and sooner than expected”, although inflation/growth will be its guide.
Eyes on prelims and the evolving risk/reward profile
While their broad outcome has already been set, the context of rising utility stocks means traders will seek fresh signs, momentum can continue.
SSE will need to explain how it can judiciously cope with a cap on its standard tariff, without compromising its dividend growth policy.
But with fears ebbing over Labour, a re-assertion of SSE’s cash flow strengths could continue the rally to 1,500p which would still imply a near 6.5% yield that might be judged appropriate for the risks. Accumulate.
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