Investor expectations make SSE a buy

Investor expectations can be a gift or a curse. Sometimes they allow investors to buy shares at discounted prices because the market expects a difficult period. Other times, however, they can lead to a disappointing share price performance even if a company records high earnings growth. In such a scenario, if profit growth falls below expectations, share price falls can be on the cards.

One stock which has seen investor expectations deteriorate in recent weeks is SSE (LON:SSE). The general election has prompted a return of the political risk which was present in 2015, when various political leaders made utility companies culpable for a cost of living ‘crisis’. Price caps and the potential for nationalisation have caused the SSE share price to fall 5% since the start of the year.

However, a share price fall means SSE now yields 6.2%. At a time when inflation is moving higher and SSE is aiming to match RPI in dividend growth, it could prove to be a sound long-term buying opportunity.

Risk factors

As discussed in SSE’s recent full year results, its outlook for financial year 2018 is uncertain. The price cap proposed by the Conservative party could affect around 70% of its customers and lead to a fall in earnings over the medium term. While the Conservatives look set to win the upcoming election by a large margin, a Labour government could theoretically be possible. In that situation, an emergency price cap and even a potential nationalisation could occur.


As such, it seems as though the company’s earnings will be hit to at least some extent in the next few years. That’s particularly the case because CPI inflation is now 50 basis points ahead of wage growth. It currently stands at 2.7%, but is forecast to move higher according to the Bank of England. Other forecasters predict a CPI inflation rate of as much as 4% by the end of 2018. In such a scenario, political risk may rise for SSE and its sector peers. The level of a price cap could be lower if real consumer incomes are squeezed, leading to an even greater negative impact on SSE’s earnings.

As well as increased political risk and the potential for lower earnings due to a price cap, SSE faces internal issues. Its wholesale division may have performed well last year, but its retail division continues to experience a loss in customers. Although the rate of loss slowed to its lowest level since 2013, with 210,000 customers lost in financial year 2017, greater competition in the energy market means the trend may continue. It could even be exacerbated by higher inflation, lower wage growth and the ease of switching via online comparison sites.

Income appeal

As mentioned, the SSE share price has fallen of late so that the company now yields 6.2%. In the FTSE 100 there are only three stocks which have higher historic yields. One of them is Pearson, which plans to cut dividends by half this year, and the other two companies are Shell and BP. While they both may offer higher income returns than SSE, their business models are less stable and their dividends are not due to be covered by profit this year. This compares to SSE’s dividend coverage ratio of 1.38.

As well as offering possibly the most attractive income return in the FTSE 100, SSE also intends to raise dividends by at least as much as RPI inflation during the period 2018-2020.

As well as offering possibly the most attractive income return in the FTSE 100, SSE also intends to raise dividends by at least as much as RPI inflation during the period 2018-2020. This is the company’s financial priority and so all of its investment decisions are based upon an assumption that it will meet its goal. It is also working towards the achievement of dividend cover within a range of 1.2x to 1.4x. Although dividend coverage is expected to dip to the bottom end of the range in financial year 2018, it nevertheless represents a relatively healthy coverage ratio.

Investment potential

This mix of a high yield and dividend growth which matches RPI inflation could make SSE a highly desirable stock over the medium term. It has a P/E of 11.7, which is appealing when compared to many of its utility sector peers. For example, Centrica has a P/E of 11.5 and yet is undergoing a major transition which adds additional risk to the company’s outlook. National Grid has a P/E of 16.7, while water services company Severn Trent has a P/E of 22.1. Although they may have greater stability and lower risk than SSE, their potential rewards are also likely to be lower.


There is also scope for an improvement in SSE’s retail performance. As discussed, it is losing customers within the division, but has been able to stem the flow in the last year. In future, its strategy to install smart meters and provide digital services could mean an enhanced customer experience which may improve the performance of the division. Additionally, SSE’s regulatory asset value (RAV) is on track to rise to £9 billion by 2020 from its current level of £7.7 billion. This could act as a positive catalyst on the company’s share price, and encourage a higher valuation.

Outlook

SSE faces an uncertain future. Political risk is high, and this could cause a fall in its earnings in 2018 and potentially in future years. Added to this, the company is facing difficulties in its retail division, although it is taking steps to stem the loss of customers.

Despite its risks, the company offers investment potential because the market seems to have priced in significant future challenges for the business. It has the fourth highest historic yield in the FTSE 100, is forecast to raise dividends by at least as much as RPI over the next three years, and has relatively high dividend coverage. It also has an attractive valuation relative to sector peers and a strategy which includes a sustained rise in RAV.

Therefore, buying SSE may not mean defensive characteristics in the short run. However, in the long run it could mean a relatively high total return.