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Will National Grid be able to maintain its income status?

Two utility groups' plans to sell stakes in their gas distribution businesses are causing some to fear for the sustainability of dividends
September 29, 2016

National Grid (NG.) epitomises what investors want when investing in a utility company: long-dated, sizeable and steady returns and delivering few shocks to the market. However, some fear its ability to continue to pay out generous annual dividends may be under threat if the sale of a majority stake in its UK gas distribution operations goes ahead.

China Resources Gas - part of a state-owned Chinese conglomerate - launched a bid for part of National Grid's UK gas distribution arm just over a week ago, partnering with a consortium including an Australian fund manager and Singapore's electricity distributor, according to reports from the Financial Times. Other potential bidders include a consortium led by Hong Kong's richest man, Li Ka-shing, and one led by the Canada Pension Plan Investment Board, the paper reported. A spokesperson for National Grid said the group would not speculate on the identity of potential bidders.

The energy infrastructure provider announced plans to sell a 51 per cent stake in its UK gas distribution business at the same time as its first-half results last November. The rationale behind the sale is to grow the return it makes on its assets, which will enable management to increase the dividend by at least RPI inflation for the foreseeable future. The lion's share of the proceeds is earmarked for a return to investors. Management expects the sale to complete in early 2017 and is in the process of separating the business from the rest of the group.

The question is whether management will be able to achieve its goal of paying out steadily increasing dividends following the sale. The reason for concern relates to the way the group makes money from ensuring distribution infrastructure is kept updated and efficient. For instance, National Grid is in the middle of a 30-year gas mains replacement programme, which began in 2002. Under Ofgem's current price control framework - which runs until 2021 - National Grid recovers some of the money spent on delivering these upgrades via customer bills. By carrying out long-dated projects the business steadily grows its asset base, plus RPI inflation, generating cash to pay the dividend. Investors should also be aware that energy regulator Ofgem has reminded bidding companies pricing controls post-2021 have not been decided, so if they purchase these businesses at a premium "they will not be compensated for that premium". That, arguably, puts a ceiling on offer prices.

National Grid grew its regulated asset base by 3 per cent to £42bn in the year to March. However, management hopes that by selling a stake in the more mature gas distribution business and investing cash in higher-yielding assets elsewhere, it will be able to grow its overall asset base by 5 per cent a year. Distribution accounted for one-fifth of group operating profit during the 12 months to March.

SSE (SSE) is also planning to sell up to a third of its 50 per cent stake in Scottish and southern England gas distributor SGN, either returning the proceeds to investors or investing them back into the company.