Hunting for yield at any price is an extremely risky sport. Everyone likes to receive dividends, but no one likes to be on the receiving end of a dividend cut, which usually ends up costing you more in capital losses than you ever received in dividend income. This is why dividend due diligence is key.
It is critical to find dividends that are both above the market average and well covered by earnings per share with room for manoeuvre if things don't go to plan for the company if you don't want to find yourself suffering a dividend cut hangover.
Unfortunately, two of the FTSE 100's top dividend stocks have the hallmarks of companies that may be forced to cut their dividends in the near future. The companies in question are SSE(LSE: SSE) and Centrica(LSE: CNA).
Not as stable as they seem
As two of the UK's top utilities, SSE and Centrica are considered to be some of the most defensive stocks trading in London today. However, these companies are almost constantly under pressure from regulators, the government and consumers to lower prices. At the same time, costs are only increasing. Wage growth, inflation and sterling's devaluation are just three factors pushing their costs onto a collision course with consumer and regulatory demands.
And as well as cost pressures, these companies have to invest for growth. Energy generation is an extremely capital-intensive business and trying to invest for the future, as well as returning cash to investors in an increasingly hostile business environment is a delicate balancing act.
For example, for the past five years, SSE has generated an average of £2.2bn in cash from operations every year. Over the same period, the company has also had to invest an average of £1.8bn per annum in its operations. These figures imply the group has had an average of £400m per annum available to return to investors. The problem is, since 2012 the company has consistently returned more than this via dividends with an average of £630m distributed every year. The spending gap has been funded with debt. Between 2015 and 2016 the group's gross debt rose from £6.1bn to £7.2bn.
Unlike SSE, Centrica's debt has been falling, but this is only because the group has cut capital spending to the bone. Total debt fell from £6.6bn in 2015 to £6.4bn in 2016. Capital expenditures have fallen from £2.4bn in 2012 to £830m for 2016. How such an aggressive reduction in capital spending will impact long-term growth is unknown for now, but it is generally believed that to ensure sustainable growth over time, a company has to maintain investment spending.
At the time of writing, shares in SSE support a dividend yield of 6.2% and shares in Centrica yield 5.7%. While these dividends may seem attractive compared to the market average of around 3.5%, their future potential is questionable. It may pay dividends for investors to hunt for income elsewhere.
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Rupert Hargreaves has no position in any shares mentioned. The Motley Fool UK has recommended Centrica. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.