Where Next for the SSE 5.9% Dividend?

LONDON -- Many investors focus on earnings per share when judging a company's performance. However, earnings can be manipulated and adjusted in all sorts of ways, meaning they don't tell you a lot about how much spare cash a company has generated. Similarly, since dividend cover is calculated using earnings, a good level of dividend cover doesn't necessarily mean the payout is actually being funded from a company's profits.

A company's cash flow can tell you a lot about a company's financial health. Is the company burning up its cash reserves on interest payments and operating expenses, or does it generate spare cash that can fund dividends or be retained for future investment? If a dividend isn't funded by cash flow, then there is a greater chance the payout will become unaffordable and be cut, which is bad news for shareholders like you and me.

In this series, I'm going to take a look at the cash flow statements of some of the biggest names in the FTSE 100, to see whether their dividends are being funded in a sustainable way, from genuine spare cash.

Today, I'm looking at dividend legend�SSE� (LSE: SSE  ) (NASDAQOTH: SSEZY  ) , one of just five FTSE 100 companies to have increased its dividend every year since 1999. Can it maintain this impressive record?

Does SSE have enough cash?
As private investors, we want to back businesses that are able to pay their dividends out of free cash flow each year. I define free cash flow as the cash that's left over after capital expenditure, interest payments and tax deductions. With that in mind, let's look at SSE's cash flow from the last five years:

Metric	2008	2009	2010	2011	2012
Free Cash Flow (millions of pounds)	(329.8)	(1,244.1)	288.4	0.7	(223.3)
Dividend Payments (millions of pounds)	502.8	551.9	618.5	513.7	628.7
Free Cash Flow/Dividend*	(0.7)	(2.3)	0.5	0.0	(0.4)

Source: SSE annual reports.
*A value of >1 means the dividend was covered by free cash flow.

Although SSE's dividend is covered by earnings per share -- in 2012, the dividend cover was 1.41 -- the dividend has not covered by SSE's free cash flow for at least the past five years. That means SSE is using borrowed money to fund its dividends each year, which would normally suggest that a dividend cut is likely at some point in the near future.

However, while a sustained track record of debt-funded dividends might suggest trouble for regular companies, for a utility, the risk is much lower.

First, utilities benefit from a regulated income and a captive customer base -- none of us is going to stop buying electricity and gas. This means that they have unusually high levels of future cash flow visibility, which helps them secure their second great advantage -- they can borrow extremely cheaply. Utilities' substantial infrastructure assets and regulated incomes make them a low credit risk and provide them with access to plentiful cheap funding on the bond markets.

It's also worth noting that SSE is by no means unusual -- most of the other listed U.K. utilities also have high debt and pay dividends that aren't covered by free cash flow. Investors are beginning to question how long this state of affairs can continue, especially given the potential for changes to the energy market environment that could stem from the U,K. government's Energy Bill, which is currently winding its way through the houses of parliament but is not expected to be finalized until late 2014.

Is SSE's dividend safe?
On its website, SSE proudly boasts that it has "just one strategic priority: sustained real dividend growth." It has maintained a policy of providing dividend increases above the level of the Retail Price Index (RPI) measure of inflation for some years -- but there is no doubt this payout policy is coming under increasing pressure and may have to be revised. The use of RPI in particular could become difficult, as the government's preferred CPI measure, which is usually around 1% lower, becomes more and more dominant.

What's more, revenue growth has slowed at SSE over the last couple of years, as has EPS growth. All of these factors could combine to put SSE's dividend growth policy under pressure over the next few years. Although I believe SSE's dividend is safe and unlikely to be cut, I do expect to see the dividend growth rate slow over the next two or three years.

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