A New UK Utility for the Future

10/31/2011 10:00 am EST

Focus: GLOBAL

Josh Peters

Editor, Morningstar DividendInvestor

The dominant UK utilities have gone from their island nation to global success, and this one has all the earmarks of that trajectory, says Josh Peters of Morningstar DividendInvestor.

Dividend increases have been scarce of late across the market, which I regard as a seasonal factor—too many corporate directors have been at the beach. The only hike announced last month came from Verizon Communications (VZ), which raised its dole 2.6% to an even $2 per share on an annualized basis.

While Verizon has largely been spared the spotlight during AT&T’s (T) pursuit of T-Mobile USA, and a lack of drama always counts as a plus in my book, I still regard AT&T as the better pick right now. Even with the small bump to Verizon’s dividend, AT&T offers:

  • an extra 0.5 percentage point of yield;
  • a lower payout ratio (72% for AT&T, 89% for Verizon);
  • and a more attractive P/E multiple on next year’s analyst consensus earnings estimates (11.1 versus 13.7).

It isn’t as if these two businesses are dramatically different in terms of financial strength (both earn Morningstar credit ratings of A-) or future growth potential, so valuation gives Ma Bell an edge.

But even if I don’t have many dividend increases to report, the market hasn’t lost interest in the topic. Many investors seem to be wondering why Microsoft (MSFT) doesn’t double or triple its dividend, and when Apple (AAPL) will ever start parting with some of its massive cash reserves.

Microsoft has a history of raising its dividend at this time of year, but I wouldn’t bet on a massive step-change. As far as Apple goes, who knows where that cash will eventually go?

True Devotees of Dividends
For most publicly traded companies, dividends often seem like an afterthought. It amazes me how often I find that transcripts from management conference calls and analyst meetings refer to dividends only in passing (if at all!), even for companies that pay out billions of dollars a year.

In my experience, only a small handful of businesses give dividends the attention they deserve—Realty Income (O) being the best example, with Genuine Parts (GPC) another notable case.

Even among these prime candidates, talking the talk is not necessarily enough. But when I run across an enterprise whose message to the world places dividends front and center, I figure I’ve found something worth keeping an eye on.

Scottish & Southern Energy (SSE) certainly seems to qualify on this count. Its entire financial strategy revolves around sustainable dividend growth in excess of inflation, and the operation of its business (power generation and distribution in the UK and Ireland) flows from this priority. The company’s annual report for 2011 devotes two full, densely packed pages just to explaining how it seeks to raise shareholders’ pay.

Here’s but one phrase worth quoting: “SSE does not have the goal of maximizing profit in any single year. It takes a longer-term view and believes that profit is a means to an end: sustained real growth in the dividend, the delivery of which is its first financial responsibility to shareholders.”

Unlike National Grid (NGG), which is a pure-play collection of transmission and distribution assets, Scottish & Southern owns power-generation facilities as well—which exposes the firm to commodity-related risks.

National Grid is no slouch when it comes to dividends, either, and I’m not sure I would want to own large stakes in both companies. Still, Scottish & Southern is worth watching.

Formed by the merger of Scottish Hydro Electric and Southern Electric in 1998, Scottish & Southern has weathered the ups and downs of electric deregulation in the UK while maintaining its integrated structure. Its flagship units are the nonregulated generation and retail supply segments, which together account for about 60% of operating profits.

While we are not especially fond of the current generation mix, the company is exploring additional natural-gas capacity and potential nuclear development in the UK.

The generation business is paired with a nonregulated retail electric- and gas-supply business that can serve to offset weaker generation margins when market power prices fall without corresponding falls in fuel costs. However, a government inquiry into alleged unfair pricing practices could force some margin compression on this side of the business. It’s still too early to tell where the inquiry could lead.

SSE’s other primary businesses are its economically regulated electric and gas distribution networks, which operate under a high-quality regulatory regime that approves rates and investment plans over long review cycles. Asset growth in this area could come from plans to bid for transmission projects connecting substantial new wind farms as well as required upgrades to its existing systems.

While reported profits are muddled by hedge accounting under International Accounting Standards, SSE’s payout ratio of 67% on an adjusted basis provides decent coverage for the dividend. Heavy capital spending has swelled the firm’s debt burden, but we still think leverage is reasonable relative to its regulatory asset base.

With long-term debt roughly equal to equity, SSE is still somewhat underleveraged relative to its European peers, and our projected cashflow coverage ratios are relatively strong for a utility.

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