Where next for utility dividends?

Utility stocks live or die by the dividends they pay, especially in a low-interest rate environment. But what are their prospects for maintaining payout rates? Nigel Hawkins looks at the numbers.

For shareholders, dividends – whether in the short-term or in the long-term – are the life-blood of investment. Of course, there are some successful companies that do not pay out regular dividends; instead, they are pure growth stocks and seek to provide longer-term returns. The most spectacularly successful of these is Apple.

Overall, despite all the shenanigans on the political and Brexit fronts, UK dividend levels have been generally increasing each year. Some companies, such as Provident Financial, have hit trouble recently and have suspended dividend payments, while Royal Bank of Scotland – the recipient of £45.5 billion of taxpayers’ largesse almost a decade ago – has not paid a dividend subsequently.

But at least Tesco and Lloyds have recently returned to the dividend-paying list, albeit with relatively modest payouts.

The dividend bell-weather for the market is Shell, whose annual dividend has not fallen since 1945. It remains, by some way, the largest dividend payer in the UK stock market.

For the defensive utilities sector, investors are generally seeking reliable dividend pay-outs, preferably with a real increase each year. This feature, with very few hiccups, has applied to the quoted utilities sector since the late 1980s and early 1990s when the big utility privatisations took place.

The water sector has delivered very impressively on the dividend front, although the increases of recent years have been pared back, as tighter regulation has kicked in. Of the three quoted water stocks, Pennon arguably offers the most exciting real dividend growth, due to its ownership of the Viridor waste business. The latter’s returns are volatile but are very influential in determining Pennon’s annual dividend increase.

Severn Trent’s 2017/18 full-year dividend is projected to be almost 87p, thereby putting it on a prospective yield of 4.1 per cent. During the summer, this latter figure was lower but Severn Trent’s shares have performed poorly in recent weeks, due mainly to market nervousness about the oncoming periodic review announcement.

Similar comments apply to United Utilities, whose dividend growth will probably be a little lower. On a full-year projected dividend of 40p, United Utilities is currently yielding 4.7 per cent.

Previous experience suggests that most water company dividend cuts are implemented at the start of a new regulatory period. Hence, the interim dividend of the 2020/21 financial year may be the first casualty of tougher price regulation.

National Grid, with a market capitalisation of c£32 billion, is the UK’s largest utility and, as such, a key dividend payer. For 2017/18, an RPI-linked increase over the 2016/17 of 44.4p payout is forecast. While its US business is now delivering better returns, National Grid faces various regulatory reviews, of which the UK electricity transmission determination – due to impact in 2021 – is pivotal.

Centrica’s recent dividend profile has been poor. A 17p payout for 2013 compares with an expected 12p payout for 2017 – no dividend growth there, then. The proposed energy cap may depress profits from its core domestic gas business, thereby putting further pressure on its ability to maintain its current dividend payout rate.

While SSE’s exposure to the energy cap is materially diluted by its networks and generation earnings, its dividend cover at just under 1.4x for 2016/17 was thin. For all three of these electricity utilities, there have been periodic concerns that their divided cover is too low.

Looking forward, with the key periodic review for the water sector and various reviews for the energy companies – notwithstanding the unknown impact of the proposed energy cap – future dividend projections are uncertain.

The reality is that for UK utilities, the easy days of dividend growth are long past. Cover ratios are almost universally low, so that a dividend cut – and its negative share price impact – are never far away.

Another issue has manifested itself of late. The Labour party’s antipathy to the utilities sector is well known and its June manifesto promised wider-ranging nationalisation of the electricity, gas and water sectors.

Importantly, though, shadow chancellor John McDonnell has very recently confirmed that parliament would set the terms of any compensation for disenfranchised shareholders. This would be financed by gilt-edged stock issuances. Theoretically, parliament could set an ultra-low compensation figure, although share prices would already have reacted sharply to any incoming Labour government.

To date, utility directors have been virtually silent on this subject, which is pivotal to any utility valuation – and especially if the Labour party looks likely to enter government. In setting their long-term dividend policy, this threat will need to be addressed. In National Grid’s case, it could even decide to demerge its US business to reduce its exposure to an incoming Labour government.

Furthermore, it could be argued that utilities would be better off paying out very high dividends before the next general election if they perceive that a Jeremy Corbyn-led Labour government is a very real scenario.

For utility managements, therefore, there is a lot of food for thought.