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SSE - On track to meet guidance

Equity research team | 31 January 2017 | A A A
SSE - On track to meet guidance

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No news or research item is a personal recommendation to deal. All investments can fall as well as rise in value so you could get back less than you invest.

SSE plc Ord 50p

Sell: 1,790.50 | Buy: 1,791.50 | Change 14.50 (0.82%)
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Shares in SSE were broadly flat after the group announced that it remains on target to deliver adjusted earnings per share of at least 120p (2016: 119.5p ).

Our View:

SSE's dividend has grown every year since 1992, at a compound annual rate of almost 10% per annum, against that background the prospective yield of 6.3% is an undeniable attraction. However, in order to sustain dividend growth in the long run, we feel the group's profits and cash flows must improve.

Dividend growth has slowed in recent years. SSE now aims to grow the payout at least in-line with RPI inflation, replacing the previous target of above-inflation increases. Dividend cover has dropped below the group's long run target of 1.5x. In FY16, SSE's free cash flow (cash available after interest costs and capital expenditure, but before disposals) didn't come anywhere close to covering the dividend, yet again.

Over the last six years SSE has spent well over £9bn on capital expenditure, with 2016/17 expected to represent an all-time high, yet net cash from operations has gone broadly nowhere. The dividend has been propped up by proceeds from asset disposals, debt, and share issuance. This can't go on indefinitely, especially given that the disposal programme is now largely complete; and net debt/EBITDA stands at 2.7 x.

In order to improve free cash flows, capital expenditure would have to be cut back and/or the operating cash flows the business generates would have to improve. The former does not look likely in the short to medium term, given that SSE has committed to spending in the region of £6bn by March 2020.

Around half of this expenditure will be directed towards the Networks division (electricity and gas distribution), where returns are set by the regulator. In theory this investment should lead to steady and reliable growth in cash flows. However, it is the other 50% of spending on the more volatile Wholesale and Retail operations where returns look less certain, particularly given a backdrop of low wholesale power prices and falling customer numbers in the Retail business.

The Networks division is the jewel in SSE's crown and the steady cash flows this generates do support the dividend. But it only accounts for around half of group profits. The big question is whether the long term investments SSE is making in the other two divisions will lead to significantly higher cash flows in the future, in order to sustain the generous dividend policy.

Q3 Trading Update:

Within wholesale, SSE has secured agreements to provide 3,239MW of de-rated electricity generation capacity from October 2020 to September 2021 at a price of £22.5/kW. SSE has prequalified 5,908MW of its electricity generation portfolio, including all of its thermal power stations, ahead of the supplementary Capacity Market Auction for delivery in 2017/18 (which started on the 31st January).

Revenues from the group's regulated networks division, which provides transmission services to National Grid, is expected to decline by £40m in 2017/18, returning to 2016/17 levels thereafter. Regulated asset values are expected to grow, increasing by £300m in 2017/18 alone. Energy customer numbers continued to decline in the retail division, down from 8.21m to 8.08m over the three months to 31 December 2016. The group has held energy prices steady this winter, and will do so until at least April 2017, despite upwards pressure in the cost of supplying households.

Although average temperatures remained similar to those seen in 2015, cooler weather in the last three months of the year resulted in higher average energy consumption. However, dryer and less windy conditions resulted in renewable output around 20% lower than in a normal year.

Capital expenditure for the year is now expected to be £1.75bn (previously £1.85bn ).

SSE has completed £87m of the £500m share buyback programme announced at the half year stage and continues to expect the full year dividend to increase by at least RPI. Dividend cover is expected to remain within the 1.2-1.4 times range.

Unless otherwise stated, all estimated figures, including prospective dividend yields, are taken from a consensus of analyst forecasts compiled by Thomson Reuters. These estimates should not be taken as a reliable indicator of future performance.

This article is not advice or a recommendation to buy, sell or hold any investment. No view is given on the present or future value or price of any investment, and investors should form their own view on any proposed investment. This article has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is considered a marketing communication. Non-independent research is not subject to FCA rules prohibiting dealing ahead of research, however HL has put controls in place (including dealing restrictions, physical and information barriers) to manage potential conflicts of interest presented by such dealing. Please see our full non-independent research for more information.

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