Investing in UK utilities such as SSE (LSE: SSE) (NASDAQOTH: SSEZY.US) is meant to provide a safe, bond-like income. Yet things can, and do, go wrong, usually as a result of political meddling with pricing and energy policy.
That’s what’s happening in the UK at the moment, prompting SSE to try and regain control of the situation by announcing a package of changes to its business: it will cut investment in renewables, legally separate its wholesale and retail operations, and fix its current priced until at least January 2016.
These changes should strengthen SSE’s business — but do shareholders need to be worried about the safety of the firm’s dividend, which has risen ahead of inflation every year since 1999?
To find out more, I’ve taken a look at three key financial metrics that could highlight potential problems.
1. Operating profit/interest
What we’re looking for here is a ratio of at least 1.5, preferably over 2, to show that SSE’s earnings cover its interest payments with room to spare:
Operating profit / net finance costs
£1,123.6m / £145.9m = 7.7 times cover
SSE’s finance costs appear to be well covered by its earnings, suggesting that its dividend should be fairly safe as long as its profits hold up.
Sustained increases in wholesale gas or electricity costs could cause problems, however, now that SSE has committed not to increase its retail prices until 2016 at the earliest.
2. Debt/equity ratio
Commonly referred to as gearing, this is simply the ratio of debt to shareholder equity, or book value. I tend to use net debt, as companies often maintain large cash balances that can be used to reduce debt if necessary.
UK utilities normally have high gearing, and SSE is no exception. SSE’s latest reported accounts show net debt of £5,974m and equity of £5,307m, giving net gearing of 112%.
3. Operating profit/sales
This ratio is usually known as operating margin and is useful measure of a company’s profitability.
SSE has reported a satisfactory operating margin of 3.7% for the last 12 months. However, I’m concerned that threatened pricing caps could put this profitability at risk. A low margin is only really attractive if it’s safe.
Is SSE a safe buy?
I believe that SSE may be forced to cut its dividend over the next couple of years. However, the firm’s current yield is so high that I’m happy to accept this risk.