Analysis: Dividends – the quest for growth

In recent months, the stock market has performed erratically, as various bear factors have prevailed over a growing economy. Indeed, unless the oil price rallies, it seems that the uncertainty over Brexit will dominate market trading during the late spring and summer.

For managers of income funds, there has been an added worry, namely the risk of dividend cuts. After all, solid dividend growth is pivotal to their financial models.

In particular, the impact of the compounding element should not be overlooked.

Over a 10-year period, for example, a 20p dividend growing at 5 per cent is worth immeasurably more – especially via a discounted cash flow model – than a 20p dividend, which is halved in year 2, and then grows at say 6 per cent a year.

By year 10, the former is worth 31.0p in current money compared with just 15.9p for the latter.

Over the last two years, many leading FTSE-100 members have unceremoniously cut their dividends.

In the banking sector, lower dividends date right back to the 2008 financial crisis. Even today, the prospects of RBS paying a decent dividend to its minority private sector shareholders are hardly bright, whilst the current Lloyd’s dividend is modest.

More recently, the UK’s biggest dividend payer, the oil sector, continues to face massive challenges from falling oil prices, which have plunged from c$115 per barrel in June 2014 to c$40 today.

Although Shell has increased its dividend every year since 1945, on-going weak oil and gas prices will exert tight cash flow pressures. BP, too, faces a similar struggle.

Major mining companies, Billiton and Rio Tinto, have both cut their dividends. And, in the groceries sector, Tesco, Sainsbury and Morrisons have all reduced their dividends as competition increases and margins decline.

Not surprisingly, discerning income fund managers will continue to focus on the utilities sector, although the three quoted water companies, Severn Trent, United Utilities and Pennon, boast a combined market capitalisation of just c£15 billion.

The equivalent value for the three FTSE-100 energy companies, National Grid, SSE and Centrica, is over four times higher at c£65 billion.

National Grid’s shares continue to be much-sought after, to such an extent that they recently breached the £10 level, their highest-ever.

Whilst minor exposure to the impact of Brexit is one explanation, National Grid’s reassuring RPI+ dividend growth policy is an obvious share price driver.

Moreover, it benefits from the on-going low interest rate environment, both in terms of reducing its own interest rate bill and also in maintaining a healthy yield gap between 10-year bonds and its equity rating.

With its key UK regulatory price settlement expected to endure until 2021, National Grid offers a solid defensive earnings profile, underpinned by real dividend growth prospects.

SSE’s earnings profile is more volatile. Whilst its earnings are almost entirely UK-based, they accrue from all aspects of the energy sector, ranging from electricity generation in industrial Yorkshire to energy supply to remote Scottish islands.

Various scenarios can be devised showing that its dividend growth policy – of a minimum RPI – is eminently deliverable. Less optimistic scenarios, though, indicate that a dividend cut is certainly possible, especially if generation prices remain weak and renewable subsidies are sharply cut back.

Nonetheless, investors have generally done very well out of SSE, despite all the trials and tribulations of falling generation prices, the last General Election, the Scottish referendum and ongoing doubts about renewable subsidies.

Investors in Centrica have suffered more directly from the plunge in oil and gas prices. During the boom days of oil, prior to mid-2014, Centrica went long on oil and gas production – and are now caught short. Furthermore, generation returns from its gas-fired plants have been dire of late.

In February 2015, Centrica’s dividend was re-based, a decision described by incoming chief executive, Iain Conn, as “very difficult”.

Whilst the 30 per cent final dividend cut was hardly a shock – the lowly market rating in the lead-up to the 2014 full-year results had telegraphed it – funds holding Centrica shares undoubtedly suffered.

In the water sector, both Severn Trent – essentially the same Midlands-based water and sewerage business as it was at privatisation in 1989 – and United Utilities continue to offer decent dividend growth, although the former trimmed its dividend pay-out by 5 per cent following the last periodic review.

With the periodic review due to last until 2020, income investors should benefit from solid and more predictable returns, compared with most other sectors.

Ironically, the nearest true utility performer amongst the FTSE-100 stocks remains BT, a company that does not regard itself in that light.

Yet, for years, despite all the hype, its broadband initiatives and its TV deals, BT has performed like a utility with its underlying Earnings before Interest, Tax and Depreciation (EBITDA) seemingly stuck at c£6 billion per year.

And BT pays a decent dividend.

Inevitably, the quest for dividend growth is bound to focus on the utilities sector, especially as other sectors have seen major dividend down-grades.

For those who sold utility privatisation to City institutions – and to the public – in the late 1980s on their ability to deliver ‘progressive dividend growth’, they have been vindicated.