Why the Conservatives power cap pledge may not short circuit the FTSE

Confirmation from the Conservative Party that its manifesto will feature a commitment to cap certain power tariffs charged by the Big Six energy providers means that FTSE 100 Centrica and SSE are both among the list of the 10 worst performers in the FTSE 100 over the past week and the past month, while both are also in the bottom 15 on a three-, six- and 12-month view for good measure.

But even if their earnings and dividend-paying potential may be crimped the overall effect on the income investment case for the UK market is limited, even if concerns linger that dividend cover for the FTSE 100 in particular is thinner than ideal.

Manifesto mauling

Centrica and SSE continue to languish following assertions from the Conservative Party that it will require the regulator Ofgem to cap how much power suppliers can charge according to so-called standard variable tariffs, the most popular package used by British consumers, should the Government be re-elected on 8 June.

Centrica and SSE are adding to a dismal run of performance

Source: Digital Look, Thomson Reuters Datastream

Further details of the clampdown will only become known upon publication of the party manifesto on 8 May but the market is already taking evasive action, amid fears of what the policy may mean for power utilities profits and therefore dividends.

This will be of some concern to income investors in particular, as SSE is the fifth highest yielding stock in the FTSE 100 and Centrica the eleventh highest.

National Grid ranks 27th (before the planned payment of a special dividend this year), according to consensus analysts’ forecasts and is also the 10th biggest individual dividend payer, based on 2017 consensus analysts’ forecasts.

However, its shares should be far less flustered today, owing to the big contribution to its profits made by its US operations and its lack of direct exposure to retail consumers of power.

Utilities offer prospect of fat yields but their overall contribution to aggregate FTSE 100 payments is relatively small

Source: Digital Look, Thomson Reuters Datastream

However, the overall impact on the income attractions of the UK market may not be too severely diminished. Based on an aggregate of current analysts’ consensus forecasts the FTSE 100 offers a dividend yield north of 4%, a figure which way outstrips anything that can be obtained from cash in the bank or Government bonds.

The power and water utilities between them are forecast to generate just 3% of total FTSE 100 profits in 2017 and 5% of total dividend payments, with this year’s earnings already expected to fall 1% and cash returns to shareholders to grow by just 1%:

Utilities overall offer only a modest

Source: Digital Look, consensus analysts’ forecasts

Dividend growth dynamic

The proposed regulatory shift may help to explain why only one of the five FTSE 100 utilities – SSE – has managed to increase its dividend every year for the last decade and why it has been the worst performer in share price terms of the 26 companies to have achieved that feat, serving up a 5% share price drop between April 2007 and April 2017.

That return compares to a 13% advance in the FTSE 100 and an average 232% capital gain from the 26 firms to have a spotless ten-year dividend growth record.

SSE has been the worst performer in capital terms of the 26 FTSE 100 firms with a spotless 10-year dividend growth record

Source: Digital Look, consensus analysts’ forecasts

It also shows how hard it is for companies to sustainably grow profits and dividends. Even firms which generate extremely high margins, and therefore returns on capital employed and cash flow, must constantly wrestle with a number of powerful forces which mean they can never be complacent:

• If their returns on capital are sufficiently high, then fresh capital is likely to be drawn to the sector in search of a piece of the attraction and new competitors will seek to take market share
  
• If this fails to dampen returns, then consumers may eventually baulk at the prices charged and seek substitutes or simply go without
  
• And if that fails, then the final challenge is the likely intervention of the Government in the form of the regulator

It is very, very hard for a company to be able to resist all three forces for long, although the 25 other companies (aside from SSE) who have increased their dividend every time for the last 10 years and outperformed the FTSE 100 in capital terms prove it can be done (and even SSE has outperformed in total return terms).

What is required is the combination of a strong business model, sound finances and a competent management team, with the power of the model being capable of compensating for any deficiencies in the other two, and the company will look to draw on a strong brand, lofty market share, technological edge or an installed base of kit and repeat business to develop and then defend their position.

Russ Mould, AJ Bell Investment Director