Steady as She Goes - Equity Dividends . . .

And a stock for income growth - SSE PLC

 

Inflation ravages savings - one pound in 1975 is worth only 15p today. Index-linked Gilts were once an excellent protection against inflation, but currently their real yield is a negative 1%, compared to the 4% real yield they habitually provided prior to 1996. This reflects the extraordinary increase in the price of all Gilts since the bursting of the Stock Market bubble in 2001. No doubt they will once again be a good protection against inflation. What to do now?

 

The income from equities has grown consistently since 1945, as the following table, from Barclays Capital 2012 Equity Gilt Study, demonstrates:

Equity dividends have grown in every five-year period since 1945, with the exception of 1997-2001 and 1998-2002. Once discounting for inflation, dividend income has doubled in real terms since 1945 and by 81% since 1975. However, although in absolute terms dividend income has grown by 34% since 1996, in after-inflation terms it has lost 14% over this period. 1996 was the peak year for real dividend income since 1945.

 

As companies are loath to reduce dividend payouts, equity income is more stable than equity profits or prices. Over the long term, dividends usually more than keep pace with inflation. Of course, looking forward this depends upon a number of unknowns: will company profits keep pace with economic growth? What will be the future growth of the UK and world economy? Will companies increase dividends in line with profits?

 

Currently, the FTSE All-Share yields an historical 3.5%. This compares well to 10-year gilts (2.0%), investment grade sterling corporate bonds (3.3% yield to maturity for the ishares Exchange Traded Fund SLXX) and cash (2.0%).

 

Some thoughts for the long-term investor:

1. Inflation protection must be a high priority for long-term investors, because, while from year to year the effect may be small, over many years it can destroy the value of savings.

2. Index linked Gilts are a wonderful protection. They provide a guarantee that your savings will not be eroded. But, as they are currently offering a negative yield, they are very expensive.

3. If we take the last 20 years, the current yield on equities, at 3.5%, is somewhat superior to the average yield of 2.8%. However, you have to go back a further 21 years, to 1972, to find a year when the equity dividend yield was so low.

4. As managers commonly charge 1.5% p.a., any managed fund that in practice tracks the market, reduces the equity dividend yield from 3.5 to 2.0% before costs. Exchange traded funds are the better option here. Even better, is to construct your own income-producing portfolio.

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A stock for income growth - SSE PLC

There is no other company in the FTSE 100 that has a stronger commitment to pay out increasing dividends and has consistently raised its dividend by more than inflation over the last 12 years than SSE (formerly Scottish & Southern Energy). The share is on an historic yield of 5.7% at 1419p. It has increased its dividend by a compound 9.6% p.a. since 2001. In its latest statement SSE promises to increase the 2013 dividend by at least 2% over inflation and in the following period to increase it by more than the rate of inflation.

SSE claims to be the only quoted energy company that is fully integrated. It produces, stores, generates and distributes gas and electricity and supplies households and businesses. And SSE invests heavily in renewable energy resources. This requires substantial capital expenditure, which it must recoup through a combination of volume and price increases. Volume is restricted by demand from the UK economy (it also has an Irish business), and the trend is downward, though by investing in generation and distribution SSE does add value. Most prices are set according to a formula agreed with the regulator, Ofgem.

Can the company keep up its pace of increasing dividends, given that prices are mostly regulated and new capital must be found for new plant and installations? Capital expenditure regularly exceeds the company's cash flow, once the dividend payment is deducted.

Looking at the past, the Debt to Equity ratio has increased from 81% in 2001 to 132% in 2012; debt reached its highest point in 2010 (185%), when the company issued new capital to bring it down. Provided SSE continues to invest its new funds as well as in the past (average return on equity is 22% and the average return on new investments for the last 12 years has been 17% - both outstanding for a utility), this is not a worry. Management has made good use of its funds.

SSE says that the dividend cover should not be less than 1.5 times earnings per share (EPS), so its EPS record is of great importance in enabling the company to meet its dividend objectives. While SSE has managed to increase its EPS by a compound 8.9% p.a. since 2001-3, this has not kept up with the increase in dividends. The 2012 dividend cover (using the company's 'adjusted' EPS) is 1.4. But it is also true that 2011/12 was subject to both very mild weather and energy price gyrations that made it atypical. Nevertheless, EPS growth is slowing and the dividend cover is shrinking.

The main risks are:

1. SSE depends on government policy and regulation for pricing. A decision to delay price increases in 2012 reduced profit. The energy companies were under strong pressure from Government to keep their prices down. This pressure looks set to continue.

2. How much of the cost of the government 's energy policy to substitute renewable energy sources for fossil fuels will fall on companies like SSE?

3. UK demand for energy is falling.

4. How much longer can the company afford to increase its dividend by more than the rate of inflation?

 A valuation model for SSE throws up 1330p as a price worth paying for its share. This is an average of three calculations based on a) Earnings (1152p), b) Return on Equity (1305) and c) Equity per share (1532p) for the five years 2012-2016. The assumptions are: 1. EPS growth of 7.5% pa. 2. Return on Equity of 17%. 3. Increase in Equity per Share of 9% p.a. 4. A discount rate of 10.2% (5.2% is SSE's weighted cost of debt plus 5% for profit and safety). 5. An average PE ratio of 12.5. 6. Retained earnings are 24% of profit after tax.

The share price of SSE has fluctuated between 1200p (30 January 2012) and 1470p (24 December 2012)in the last 12 months.

(Note: The CEO today announced he was resigning. He will be replaced by Alistair Phillips-Davies. In the last Annual Report, Mr Phillips-Davies said, "Dividend growth isn't just a financial commitment. It's a management commitment to being disciplined, consistent and long term. That's entirely appropriate in a sector like energy and I think goes to the heart of the type of company SSE is.")