Shares in energy utility company SSE (LSE: SSE) are trading close to 20% lower than they did in the summer of 2016. The stock looks like it has been caught up in the apparent rotation of investors out of defensives and into cheap-looking cyclicals.
Yet today’s trading update suggests the fundamentals of the underlying business remain sound. Chief executive Alistair Phillips-Davies said the firm plans an increase in the full-year dividend for the current trading year and next year “that is at least in line with RPI inflation.”
I think we can gauge the outlook of a business quite well by examining the directors’ decisions concerning the dividend, and this one says ‘business as usual’ to me.
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Evolving to meet challenges
That’s not to say that earning a living supplying and distributing gas and electricity is easy. In the update, Mr Phillips-Davies emphasised that point. It’s well known that the sector is capital-intensive, requiring great chunks of money to constantly maintain, upgrade and install infrastructure. The figures are large. SSE expects its investment and capital expenditure to be around £6bn over the four-year period to March 2020. Such commitments often lead to high borrowings, and the directors of firms such as SSE have to perform a fine balancing act between using incoming cash flow to service debts and to reward shareholders with the dividend.
On top of that, the regulatory environment can be demanding, and the constant threat from political changes hangs over the sector – perhaps there could even be a programme of nationalisation in Britain. In an example of how regulation can drive a business such as SSE’s, £5bn of the firm’s £6bn planned capital expenditure is going to “economically-regulated electricity networks and government-mandated renewable energy projects.”
Mr Phillips-Davies said he expects SSE to “evolve significantly between now and the end of the next financial year.” The company aims to focus more on creating value from its assets and infrastructure, and to “contribute to the creation of a new energy supply market model that combines the resources and experience of two established players with the focus and agility of an independent supplier.”
Still defensive and attractive
SSE is adapting to the changing economic and political landscape, and I reckon there’s a good chance that the firm will muddle through in the future without drastic financial consequences for investors. We investors have long prized firms like SSE for their defensive qualities, but they do tend to suffer from cyclical valuations. In times of uncertainty investors often pile in and drive the shares up only to desert the defensives when value looks better elsewhere.
But just as valuations and share prices of defensive companies can fall, as we’ve seen lately, they can also stabilise and even go back up again as long as the underlying business fundamentals remain intact. So to me, the trick is to buy good value, and SSE has a tempting showing on quality and value metrics right now. The only missing pillar of support is positive momentum in the shares – but that could be about to change. If evidence of basing and a turnaround in the trend develops on the share price chart, I’ll be interested in looking closely at the investment opportunity with a view to buying some of SSE’s shares.
