European utilities with the best yields

If there's one sector of the stock market that looks tempting for income-seekers at the moment, it's European utilities. A number of the continent's biggest electricity and gas companies are currently offering blockbuster dividend yields.

Given that most of us need to use electricity and gas, why are yields so high and share prices so low? Do they represent bargains and a secure source of income? Or is the market right in saying that the high dividends on offer just can't last, given the economic problems in many of the eurozone's countries?

There are reasons to be concerned, no doubt about it. Some utility companies are not as resilient as many people assume. The weakness in some European economies has depressed demand for electricity and gas especially from business users. On top of that, electricity prices have fallen sharply in some markets too. Profits at some companies have come under pressure and with this the ability to keep paying generous dividends.

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That's why the share prices of these companies have gone down and their dividend yields (that is, the dividend per share DPS divided by the share price) have gone up.

The market thinks that these dividends perhaps can't grow or even worse are going to be cut. But is all the bad news out there? In some cases, it might just be. We've scoured the market to see what's on offer. We've taken European utility shares with dividend yields of around 6% or more. Then we've had a look at what analysts' profit forecasts are for each company (earnings per share, EPS), then calculated the dividend cover (EPS/DPS) to get an idea of how safe the dividends might be.

As you can see in the table below, companies such as Spain's Acciona and France's GDF-Suez have no, or very thin, dividend cover. If you want to invest in this sector for income, it might be prudent to insist on dividend cover of at least 1.5 times. It might also be sensible to avoid companies that make most of their money from generating electricity. The profits of these firms look vulnerable to a further downturn in the eurozone.

Instead, we prefer the electricity and gas grid companies the groups that transmit and distribute rather than generate energy. The income of these companies is much more dependent on their asset bases than the price of gas and electricity and the amount they can sell.

Do bear in mind, however, that these businesses are regulated and changes here can have a material impact on profits and dividends. Also, cash-strapped governments may be tempted to squeeze these sectors given the chance, although that could be said for firms in most parts of the world today.

Red Electrica is our top pick

Despite Spain's economic problems, we think that Red Electrica (MCD:REE), the owner and operator of Spain's national electricity grid, gives a good trade-off between high dividend income and safety. It is investing €800m a year until 2015 in maintaining and growing the grid.

With a dividend yield of 6.7% and dividend cover of 1.5 times, profits are expected to grow by 12% a year until 2015, with dividends growing in line with profits. There is a small risk that Spain's national infrastructure plan could reduce the amount of money invested in the grid. But Spain has lots of wind turbines that need connecting, so any decrease probably wouldn't stop profits growing.

A medium-risk investment

We still like Electricite de France (Paris: EDF) for its cheap valuation and well-covered 7% yield. While it makes a lot of money from electricity generation it is exposed to more favourable markets in France and places such as Britain, where overcapacity isn't a major problem. It also has an electricity networks business. We think the political risk and nuclear safety issues are overblown, creating a good long-term income opportunity.

A higher-risk play for the bold

Enel (Milan: ENEL) is Italy's largest power company with big businesses in Spain and Latin America. Its huge debts have seen it slash dividend payments and investment spending. Its projected 6.7% yield now looks very well covered compared with some of its European peers. That said, Italian power prices could fall in a weak economy. Its Latin American businesses are doing quite well, but following state asset grabs from foreign companies in Argentina and Bolivia, these assets are high risk.

Currency risks and withholding taxes

As well as business risk, investing in this sector exposes you to currency risk. If the euro ceases to exist in the future then a possible appreciation of the pound against reinstated national currencies could see you incur currency losses when the value of your investment is turned back to pounds.

The other thing to bear in mind is withholding or non-resident taxes on foreign company dividends. These are deducted before you receive your dividend income. In France, Spain and Italy the rate is currently 15% for British shareholders. Hold foreign stocks in an Isa or Sipp and there will be no further tax to pay.