Utilities are generally regarded to be safe investments that pay shareholders growing dividends year after year. And it's for this reason that giants such as SSE(LSE: SSE) and Centrica(LSE: CNA) form the backbone of many dividend portfolios.
However, there's growing concern that these stocks will struggle to maintain payouts as competition in the sector intensifies and weak energy prices depress profits from electricity generation. Looking ahead, they also face increasing regulatory and political pressures to lower prices as consumers battle a real wages squeeze.
With dividend cover for these utilities at historically low levels, there's not a great margin of safety for earnings to fall short of expectations.
Centrica, which delivered annual cost savings of over £300m through its cost efficiency drive, has dividend cover of only 1.4 times. And that's in spite of a 30% cut to its dividend back in 2015 and following efforts to reduce its exposure to global oil price volatility by moving away from upstream.
Meanwhile, SSE has so far managed to keep its dividend growing, despite similar earnings pressure. Things have got back on track lately, with adjusted earnings per share up 5.2% last year and dividend cover at the top of its expected range, at 1.38 times. But cover is forecast to fall back to 1.28 times this year as wholesale electricity prices have resumed their downward trajectory.
With the Bank of England warning about possible interest rate rises in the near future, investors also need to consider its likely impact on the profitability of these two companies. Higher rates increase the cost of borrowing, and utility companies, which typically carry more debt, will understandably feel the effect more strongly than those companies that are less indebted.
And it's not just the impact on dividend sustainability that income investors need to worry about. Rising interest rates won't just hurt the profitability of these utility firms, but their valuation multiples too. That's because as interest rates increase, dividend stocks, including most utilities, become relatively less attractive when alternative income investments such as bonds become cheaper and yield more.
Looking ahead, I reckon any interest rate rise over the next few years will be modest given the prolonged economic and political uncertainty. Still, with current rates at record low levels, the interest rate risk for utility stocks is clearly on the downside.
Although SSE and Centrica face some big earnings risks, I reckon much of this has been fully priced-in. Valuations are undemanding, with shares trading at 12.9 times forward earnings for SSE and 13.1 times for Centrica.
Out of these two stocks, I would prefer SSE. It has one of the highest dividend yields in the sector, at 6.2%, while it also appears to be one of the safest. That's because although its dividend cover is not the highest, its cash flow is more reliable than many in the sector. Roughly half of its underlying earnings come from its steady regulated transmission assets.
Jack Tang has no position in any shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. 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.