Labour leader Ed Miliband’s pledge to freeze energy bills for 20 months threw a cloud of uncertainty over the future of SSE (LSE: SSE) and Centrica (LSE: CNA).
But now the Tories are back in power, this uncertainty has disappeared.
However, investors should consider their options carefully before jumping back into the sector.
Facing problems
The promise of a price freeze under a Labour government was just one of the many major issues facing Centrica. Indeed, the company has been floundering for some years, ever since its international expansion plan fell off the rails.
Earlier this year the group revealed a net loss of £1bn for fiscal 2014 and slashed its lofty dividend payout by 30%, catching many analysts and investors by surprise.
Utility companies are supposed to be defensive investments, offering stable and predictable dividend payouts. So, it’s no surprise that Centrica’s shares crashed by around 9% on the day the dividend cut was announced.
What’s more, the group’s debt-to-equity ratio has spiralled out of control over the past 12 months. Centrica’s net-debt-to-equity ratio jumped from 1.1 at the end of fiscal 2013, to 2.3 at the end of fiscal 2014.
It is common for utilities to have high levels of debt, although a debt-to-equity ratio of 2.3 is concerning. SSE’s net-debt-to-equity ratio stands at around 1.3.
Falling oil price
One of Centrica’s biggest problems is now the weak oil price environment. You see, Centrica’s upstream business is North Sea focused, and the North Sea is one of the most expensive places to produce oil & gas in the world.
For example, during 2013 it cost Centrica around £23.80 to extract each barrel of oil from its fields in the region. That’s around $38 per barrel. If you include other costs, such as tax and interest payments on debt, there’s not much room for error with the price of oil trading at around $65/bbl.
As a result, Centrica was forced to take a £1.4bn write-down on its oil & gas assets earlier this year. Moreover, the company is planning to slash capital spending by 40% next year after a similar cut this year.
Slow and steady
Compared to Centrica, SSE is a stronger business. The group has a lower debt ratio, no exposure to the volatile oil industry, and management has stated its commitment to the company’s dividend payout for the next three years.
SSE’s dividend yield currently stands at 5.3% and the payout is covered one-and-a-half times by earnings per share. The payout is set rise in line with inflation, at around 2% to 3% per annum, over the next three years.
And now, the threat of a price freeze has disappeared, this payout seems secure. SSE trades at a forward P/E of 13.5. Earnings are set to fall by around 12% over the next three years.
Analysts believe that Centrica will support a dividend yield of 4.3% this year.
Foolish summary
All in all, the Tory win has removed the cloud of uncertainty hanging over the UK utility industry. However, not all utility providers are created equal. Centrica is still struggling with a high debt pile and volatile earnings from its upstream oil & gas arm, but SSE is powering ahead.
So, now the Tories are back in power, it could be time to buy SSE for income, although it might be wise to stay away from Centrica.
