For years energy networks have been seen as safe and attractive places to invest. Yes, their returns have been regulated but the growth in the size of the networks has allowed many companies to grow their profits and dividends to their shareholders. Now it seems that the energy regulator has said “enough is enough” and that it’s time for customers to save some money. This could be very bad news for shareholders in National Grid (LSE:NG.) and SSE (LSE:SSE).
Last week, OFGEM, the UK’s energy regulator, gave its latest view on how much money gas and electricity transmission and distribution networks could make from their assets between 2021 and 2026. The short answer is a lot less than they are making now.
Along with so many businesses over the last decade, utility networks have benefited from very cheap borrowing costs. They have been able to finance themselves more cheaply than the regulator assumed that they would be able to and have pocketed the difference. OFGEM now wants the benefits to go back to electricity and gas consumers where transmission and distribution charges make up around 20 per cent of a household energy bill.
The best way to understand a transmission company is to think of it like a motorway network. Electricity pylons and wires and pipes can move large quantities of electricity and gas from power stations and gas fields across the country. The distribution companies are like A and B roads which take the electricity and gas off the motorways and into people’s homes. They are a vital part of our national infrastructure and need to be maintained and expanded to meet the changing ways energy is produced and used.
The sheer scale of these networks means that they are natural monopolies. It doesn’t make sense to duplicate them. This means that the amount they can charge customers has to be kept in check and regulated.
The job of the regulator is to make sure that the networks can charge enough – but not too much – to cover their costs while incentivising cost savings and extra investment. If it gets its sums right then the companies concerned will have enough money left over to earn a fair return on the money that they invest. What constitutes a fair return is a matter of opinion. The companies always want to earn more than the regulators think is fair and the two parties argue about what is the right number every five years or so.
Last week, OFGEM gave its view on what the number should be. It thinks 4.3 per cent in real terms (before inflation) on shareholders’ return on equity (RoE) is fair. If it gives customers a little bit extra they could make 4.8 per cent. This compares with the 7-8 per cent they are allowed to earn now.
This, in its view, is enough for an efficient transmission and distribution to fund the cost of running the networks, pay the interest on its borrowings and pay a reasonable return to shareholders. OFGEM, rightly in my view, thinks that moving gas and electricity around the country is a relatively low-risk business that should not command a high rate of interest.
National Grid is not happy and it’s not difficult to see why. It thinks 5.5 per cent before inflation is fair. Regardless, it looks as if the profits of its UK electricity and gas distribution are going to take a big haircut compared with what they are making now. Last year, before inflation its electricity networks' RoE was more than 10 per cent and gas distribution made just under 7 per cent. Its electricity transmission business is expected to make at least 3 per cent more than its allowed return this year. This legitimate outperformance was never going to last but it could fall by a long way.
What does this mean for the sustainability of National Grid’s dividend? It is currently targeting dividend growth in line with retail price index (RPI) inflation – about 3 per cent – for the next few years. Analysts don’t yet seem to think that its dividend will be cut and a forecast yield of 6 per cent reflects that view, but OFGEM is quite clear that it sees what it calls “dividend restraint” as a way for companies to finance their businesses.
The cash cost of this year’s expected 48.8p a share dividend is just under £1.7bn. Assuming that depreciation is a proxy for maintenance investment requirement (it usually understated it in the case of utility assets), then National Grid would have about £2bn of free cash flow before investing in new network assets. Factor in a cut to its allowed returns from electricity and gas transmission and the current dividend gets harder to fund.
The company will hope that OFGEM will be a little more generous when it makes its final decision next year and that its US business can take up the dividend challenge. At the very least, dividend growth rates could slow compared with current expectations.
I’m more bearish on SSE’s dividend prospects. It is already cutting its dividend per share to 80p this year from just over 97p last year. The company has arguably been overpaying for years as its profits have failed to grow and debts have increased. With profits from Networks making up the biggest chunk of its total profits, a reduction in allowed returns is going to hurt.
Excluding working capital and again using depreciation as a proxy for stay-in-business capital expenditure, SSE had just over £600m of steady state free cash flow last year. The cash cost – before scrip dividends are taken into account – of an 80p a share annual dividend is currently £827m. SSE will have to hope that its big investments in offshore wind farms pay off handsomely, otherwise this year’s dividend cut could be followed by another one in a few years’ time.
SSE’s forecast yield of 7.7 per cent – based on a dividend of 80p a share – is in the danger zone, which suggests the market has doubts on its sustainability. I think it is right to.
Can Marks & Spencer and Sainsbury’s be fixed?
Companies like humans go through life cycles. A select few grow up to be big and strong and live strong healthy lives. Many go through the phases of growth, maturity, old age and then die.
For many years, Marks and Spencer (LSE:M&S) and Sainsbury’s (LSE:SBRY) have looked like chronically ill patients that have tried on many occasions to convince their doctors that they can return to full health only to relapse again. Neither are currently at death’s door but I struggle to see how either of them can return to good health.
Both find themselves in a bad place due to one key mistake – they have failed to convince enough people that they offer value for money. Both are guilty of complacency on a big scale. During their days of dominating their patches of the retail market in the heydays of the late 1980s they grew too much by increasing prices while failing to innovate. This alienated their customers and left themselves open to competition that went on to eat their lunch.
Despite grand restructuring plans and promises of a return to the good days both companies are still making the same mistakes. Marks and Spencer likes to think that its food offering is of such superior quality that it can charge ridiculous prices for it. It has relied on the indifference of its elderly and monied customer base to just keep on paying up without grumbling. Unfortunately for it, the game has moved on. Its rivals are selling just as good food for lower prices.
Its clothing range remains uninspiring to many people and is no match for innovative young brands and established rivals such as Next (NXT). It remains the go-to place for underwear and socks but this not the source of a profit recovery.
Its internet business remains well behind its competitors while its decision to buy a 50 per cent stake in Ocado’s UK business has all the hallmarks of an expensive mistake. I think the whole business of food delivery is a very attractive proposition for equity investors for the simple reason that no one seems to be able to make any money from it.
Ocado itself makes little or no money from selling groceries over the internet and delivering then to people’s homes. Yet its business is valued at £8.4bn by the stock market on the belief that other retailers will buy its technology in the hope that they will make decent money from it. At least Ocado has the equivalent of full shopping trolleys to make up its sales, how M&S, which tends to have a much smaller basket size can make money – or more importantly not lose lots of money – is anyone’s guess. A £600m rights issue and a big dividend cut is an expensive price for shareholders to pay to try.
A company can only work with what it has. In M&S’s case, it has a store portfolio that is very old and in the wrong locations to thrive. It can close lots of shops, cut costs and put new shops with better formats in better locations. It has realised that it has to cut its prices but changing perceptions among consumers doesn’t tend to happen overnight.
The real risk for M&S shareholders is that it is now too late to turn the ship around. City analysts are forecasting no growth in trading profits for the next three years. These forecasts may be too optimistic.
Sainsbury’s may find itself in an even worse position. It has propped up its underlying trading profit performance in recent years by wringing costs savings from its acquisition of Argos. Its core UK supermarkets business has continued to struggle against the discounters such as Aldi and Lidl and a resurgent Tesco (LSE:TSCO) and Wm Morrison (LSE:MRW).
It’s not difficult to see why. I used to push a trolley around my local Sainsbury’s for years doing my family’s weekly grocery shop until I got fed up with it about a year ago. I got fed up with the prices of its fresh food, the empty shelves and the fact that it took an age to get through the tills when I’d finished because the company didn’t want to pay people to work on the checkouts. Many others have had a similar experience.
This failure of retailing basics can be put right with good management. What is more difficult is selling enough food profitably to cover the overheads of large superstores. Sainsbury’s tried to fix this problem by merging with Asda and using the benefits of lower buying costs to beef up its margins. Now that this has been blocked, it seems that there is no plan B.
In years gone by, Sainsbury’s would have been seen as a takeover target for private equity buyers. Now, the economics don’t stack up. It would take a very brave buyer to load this company up with debt and do large-scale sale and leasebacks of the store estate and increase its operational gearing in the process. But the main reason it is unlikely to happen is because there is no easy exit route that is all important in securing an acceptable return on investment.
As with M&S, there is next to no underlying growth in Sainsbury’s business. Without it, a sustainable profit and share price recovery looks impossible.
The US bond market is a warning sign for stock market investors
For the last decade low yields on government bonds have been viewed as a free lunch for stock market investors. The higher yields available on shares combined with growing profits and cash flows have seen a tremendous bull market take place. That said, the government bond market – despite its manipulation by central banks – remains a very good barometer for investors that they would be wise to take note of.
At the moment, the US government bond market is telling investors that there may be trouble ahead. This is because the yield curve – which compares the yield to maturity on bonds of different maturities – is inverted.
If you lend money to the US government for three months you will currently get a yield to maturity of 2.35 per cent. If you lend it money for 10 years you will only get 2.32 per cent. This doesn’t usually make sense. Because inflation reduces the buying power of fixed interest coupons from bonds and the repayment of principal, investors usually demand a higher interest rate to lend money for longer periods of time.
When this doesn’t happen and the yield curve is inverted, it’s usually because investors expect interest rates to be lower in the future than they are now. Perhaps because the economy has entered a recession. This message was bang on in 2007, could it be right now?
Stock market investors don’t seem too concerned judging by current share prices. Valuations of very good companies remain very high and those of some-not-so-good ones are beginning to look very low. A recession and a decline in profits or slowdown in growth leaves expensive shares looking very vulnerable.
Given this backdrop, I can’t help but find the current valuations of shares such as Imperial Brands (LSE:IMB) very interesting. I could reel off a whole article as to why people shouldn’t invest in its shares but it’s hard to dispute that its shares now look very cheap.
At just under £20 per share these shares are hated. Imperial trades on a one year forecast rolling PE ratio of just seven times and offers a dividend yield of more than 10 per cent, while profits, free cash flows and dividends are expected to keep on growing for the next three years.
While investors keep ploughing their money into very expensive quality shares, Imperial continues to be shunned. The risks of tobacco shares are well known but I can’t help thinking that Imperial's shares are at least worth a closer look given that a dire outlook looks increasingly priced in.