Can SSE plc and Centrica plc afford to pay 6%+ dividends?

When picking a stock for its dividend, it’s important to examine whether the company can actually afford to pay its dividend. That way, you’ll minimise the chances of experiencing the dreaded ‘dividend cut’. Today, I’m looking at two FTSE 100 stocks that have dividend yields in excess of 6%. Can these companies afford to pay those dividends?

SSE

SSE (LSE: SSE) is a popular dividend stock among UK investors. The utility giant has a fantastic record of increasing its dividend over time, and last year paid each shareholder dividends of 91.3p per share. That’s a yield of 6.3%. Is that level sustainable?

SSE places a strong focus on rewarding shareholders. In the recent past the company has aimed to increase the payout each year in line with RPI inflation, and it plans to do the same this year. City analysts currently forecast a FY2018 dividend of 94.2p per share. So will earnings cover that payment?

Looking at today’s half-year results, SSE has stated that it is expecting to report full-year earnings per share at a level which is at least in line with the current consensus earnings estimates of 116p.

Dividing the expected earnings figure of 116p by the expected dividend of 94.2p, we get a coverage ratio of 1.23. Generally speaking, a ratio of under 1.5 is considered to be risky, as it doesn’t leave a significant margin of safety. If earnings fall, the company may not be able to afford its dividend. A ratio of 2 or more is considered more healthy. While SSE’s current ratio is not a level to panic about, investors should be aware that coverage is not strong.

The company has stated today that it plans to increase its dividend by at least RPI inflation this year and next. However, after that the dividend “will reflect the quality and nature of its assets and operations, the earnings derived from them and the longer-term financial outlook.”

So SSE’s dividend looks safe for now and is likely to grow this year and next. However, with a low coverage ratio and an operating environment that features “significant political and regulatory intervention,” the longer-term outlook is certainly not risk-free, in my view.

Centrica

Centrica (LSE: CNA) is another FTSE 100 company that has a very high dividend yield. Last year, the company paid out 12p per share in dividends to shareholders, a yield of 7.1% at the current share price. While that yield obviously sounds attractive, I’m not convinced Centrica is a great income stock.

Looking at the company’s history, Centrica cut its dividend in recent years, with the payout falling from 13.5p per share in FY2014 to 12p per share in FY2015. Last year, the payout was frozen at 12p. That’s not what dividend investors want to see.

While City analysts currently expect a small dividend rise this year, with a payout of 12.2p pencilled in, earnings of only 15.2p are expected, which gives a coverage ratio of 1.25. As with SSE, this doesn’t leave a considerable margin of safety.

With competition within the sector increasing, the threat of political intervention lingering, and the share price locked in a long-term downtrend, I won’t be buying Centrica for its dividend right now.