Stockwatch: 6% yield should aid re-rating

FTSE 100-listed electricity supplier SSE is worth considering with the shares currently low in their latest trading range, at just over 1,500p. The five-year chart is quite volatile but trends overall upwards in line with the £16 billion group's financial profile (see table).

Recent years have shown quite stable growth, projected to increase particularly in the 2016/17 financial year - despite the energy supply side expected to show a near-term decline in operating profit, relative to profits growth in generation and energy portfolio management.

Further good signs are cash flow per share substantially exceeding earnings per share and earnings cover for the dividend kept significantly over one. Admittedly, the group has high capital expenditure needs, but the dividend looks secure - implying a 6% prospective yield which ought both to attract income investors and help the stock rise over time as the yield becomes priced more competitively. Indeed, when I drew attention near 1,400p in February 2014 the prospective yield was 6.6% - high enough to appear unrealistic or very risky, yet it was still covered over 1.3 times by projected earnings.

SSE has shown it can deliver, and the stock's trading up to 1,680p by end-2014 and near 1,700p during 2015, indicates the market does respond to the high yield when the price is down. It has recently retreated again amid a volatile trend and just gone ex-dividend to the effect of 61.8p. A fat yield implies high risks, so the clearest way to assess this stock is to confront what they may be:

Competition and Markets Authority investigation

It has been mooted since March 2014 that, the energy sector will be subject to significant political and regulatory scrutiny. Earlier this month, the Competition and Markets Authority (CMA) published its provisional findings and possible remedies, to which SSE responded, saying it will "continue to work constructively with the CMA [towards] an enduring outcome that gives customers confidence, allows regulators to regulate, and encourages investors to invest..."

While the CMA's conclusions won't be published until the end of this year, it already looks like piecemeal initiatives such as helping customers switch suppliers more easily, and the use of smart meters, will be the thrust - than genuinely radical action such as breaking up "the big six" oligopoly of suppliers. The idea of a price cap has already been dismissed by 10 Downing Street and a Conservative majority government appears is most unlikely to take an ideological swipe at business - as was feared of Labour.

Otherwise weather fluctuations - their effect on energy demand and weather-related damage of the electricity networks - constitute the main risk. This links in to the nagging issue of capital expenditure constraining freedom for greater returns of capital, say if this had to increase after bouts of extreme weather.

All this doesn't really amount to enough risk to price an energy stock for a 6% yield; it may also reflect a major utility offering less excitement for growth-oriented investors, i.e. the market prices SSE where it does in order to attract income seekers. Yet the five-year chart shows the stock in a broad uptrend and the earnings targets are attractive. Such a major business is always liable to see some variation of performance within its segments, but overall the earnings trend is up and the board has a clear sense of growing the dividend with responsible earnings cover. The current price of 1,520p therefore offers another opportunity to lock in an attractive yield, with a 90p/share dividend representing a base for the future.

Management targets ahead of consensus

The latest trading statement affirms SSE's plan to invest about £1.75 billion during the current financial year and it being on track for normalised earnings per share of at least 115p. There'll also be a dividend rise at least in line with inflation. This compares with an overall cautious City consensus looking for 112p and implies a forward P/E of 13.2 times - pretty much in line with the anticipated trend in earnings per share, if no premium to it.

SSE shares closed down around 80p in response to the update, slightly more than the 61.8p implied by going ex- the final dividend. That may have reflected reports that over-emphasised a slowing in profits growth on the energy supply side. Waffle by the chief executive didn't help either: "The early months of this new financial year have again demonstrated the breadth and depth of the issues that need to be managed as we aim to fulfil our core purpose of providing the energy people need in a reliable and sustainable way" - which could be interpreted as being a bit challenged.

Yet like-for-like operating figures appear overall good: on the wholesale side of the business, total electricity output from gas- and oil-fired power stations rose from 2.19 to 2.42 terawatt hours (TWh), despite coal-fired output slumping from 1.79 to 0.41TWh. Total electricity from renewables rose from 1.62 to 2.20Twh and gas production assets were marginally ahead. The retail side has slipped slightly, with accounts down from 8.58 to 8.49 million over the latest quarter, so switching suppliers is having some effect - but SSE has lately made efforts to improve its pricing structure and website .

A new generator is virtually complete at Ferrybridge in West Yorkshire; eight onshore wind farms are under construction; the Scottish Beauly-to-Denny replacement transmission line is complete; and smart meters are being installed for retail customers (in anticipation of the CMA). These examples show the need for substantial ongoing investment, expected to total about £5.5 billion (net of about £1 billion disposals) over four years to March 2018. It is a factor that can deter investors who prefer exposure to firms with stronger net cash flow - i.e. potential for shareholder returns - however it looks well-discounted in the share price already.

A comforting tuck-away

While SSE may not excite, its combination of attractive yield and undemanding P/E make it useful as a portfolio building-block - the business enjoying a robust financial profile, supplying essential needs. It should be resilient against major current risks in the financial system, such as a rise in US interest rates, Chinese wobbles or further trouble in the eurozone.

For more information visit: sse.co.uk.