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UTILITY WEEK | 29TH APRIL - 5TH MAY 2016 | 17 Finance & Investment Analysis I n recent months, the stock market has performed erratically, as various bear factors have prevailed over a growing economy. Indeed, unless the oil price ral- lies, it seems that the uncertainty over Brexit will dominate market trading during the late spring and summer. For managers of income funds, there has been an added worry, namely the risk of divi- dend cuts. Aer all, solid dividend growth is pivotal to their financial models. In particular, the impact of the com- pounding element should not be overlooked. Over a ten-year period, for example, a 20p dividend growing at 5 per cent is worth more – especially via a discounted cashflow model – than a 20p dividend that is halved in year two and then grows at say 6 per cent a year. By year ten, the former is worth 31.0p compared with just 15.9p for the latter. Over the past two years, many leading FTSE 100 members have unceremoniously cut their dividends. In the banking sector, lower dividends date back to the 2008 financial crisis. Even today, the prospects of RBS paying a decent dividend to its minority private sector share- holders are hardly bright, while the current Lloyd's dividend is modest. More recently, the UK's biggest dividend payer, the oil sector, continues to face mas- sive challenges from falling oil prices, which have plunged from about $115 per barrel in June 2014 to about $40 today. Although Shell has increased its dividend every year since 1945, ongoing weak oil and gas prices will exert tight cashflow pressures. BP faces a similar struggle. Major mining companies Billiton and Rio Tinto have both cut their dividends. And in the groceries sector, Tesco, Sainsbury's and Morrisons have all reduced their divi- dends as competition increases and margins decline. Not surprisingly, discerning income fund managers will continue to focus on the utili- ties sector, although the three quoted water companies – Severn Trent, United Utilities and Pennon – only boast a combined market capitalisation of about £15 billion. The equivalent value of the three FTSE 100 energy companies – National Grid, SSE and Centrica – is more than four times higher at about £65 billion. National Grid's shares continue to be sought aer, to such an extent that they recently breached £10 – their highest ever. While minor exposure to the impact of Brexit is one explanation, National Grid's reassuring RPI+ dividend growth policy is an obvious share price driver. Moreover, it benefits from the ongoing low interest rates, both in terms of reducing its own interest bill and also in maintaining a healthy yield gap between ten-year bonds and its equity rating. With its key UK regulatory price settle- ment expected to endure until 2021, National Grid offers a solid defensive earnings pro- file, underpinned by real dividend growth prospects. SSE's earnings profile is more volatile. While its earnings are almost entirely UK- based, they accrue from all aspects of the energy sector, ranging from electricity gener- ation in industrial Yorkshire to energy supply to remote Scottish islands. Various scenarios can be devised showing that its dividend growth policy – of a mini- mum RPI – is eminently deliverable. Less optimistic scenarios, though, indicate that a dividend cut is certainly possible, especially if generation prices remain weak. Nonetheless, investors have generally done very well out of SSE, despite all the trials and tribulations of falling generation prices, the last general election, the Scot- tish referendum and ongoing doubts about renewable subsidies. Investors in Centrica have suffered more directly from the plunge in oil and gas prices. During the boom days of oil, prior to mid-2014, Centrica went long on oil and gas production – and is now caught short. Fur- thermore, generation returns from its gas- fired plants have been dire of late. In February 2015, Centrica's dividend was re-based, a decision described by incoming chief executive Iain Conn as "very difficult". While the 30 per cent final dividend cut was hardly a shock – the lowly market rat- ing in the lead-up to the 2014 full-year results had telegraphed it – funds holding Centrica shares undoubtedly suffered. In the water sector, both Severn Trent – essentially the same Midlands-based water and sewerage business it was at privatisation in 1989 – and United Utilities continue to offer decent dividend growth, although the former trimmed its dividend payout by 5 per cent following the last periodic review. With the periodic review due to last until 2020, income investors should benefit from solid and more predictable returns compared with most other sectors. Ironically, the nearest true utility per- former among the FTSE 100 stocks remains BT, a company that does not regard itself in that light. Yet for years, despite all the hype, its broadband initiatives and its TV deals, BT has performed like a utility with its under- lying earnings before interest, tax, depre- ciation and amortisation (Ebitda) seemingly stuck at about £6 billion per year. And BT pays a decent dividend. Inevitably, the quest for dividend growth is bound to focus on the utilities sector, especially as other sectors have seen major dividend downgrades. Those who sold utility privatisation to City institutions – and to the public – in the late 1980s on their ability to deliver "progres- sive dividend growth" have been vindicated. Nigel Hawkins, director, Nigel Hawkins Associates Quest for dividend growth As other sectors see major dividend downgrades, the quest for dividend growth will focus on utilities – vindicating those who sold utility privatisation to the City and the public, says Nigel Hawkins. NATIONAL GRID SHARE PRICE, ONE YEAR 1,050 1,000 950 900 850 800 Jul 2015 pence Oct 2015 Jan 2016 Apr 2016