Dividend policy: National Grid pays dividends biannually, with a policy to grow payments in line with retail price inflation for the foreseeable future
Payment: Twice a year, in sterling with scrip alternative, occasional special dividends
Yield: 5.5 per cent
Last cut: No cut since the company began paying out in 1996, after accounting for rebasing following a rights issue in June 2010
The challenge for National Grid (NG.), alongside many other utility companies, is balancing the need for high capital expenditure in order to maintain and grow the asset base (the UK’s energy network, in National Grid’s case) with the generous dividend payments expected of publicly listed utilities. However, that’s meant free cash flow has failed to cover dividends over the past 10 years. This should not concern investors too much as adjusted EPS cover was 1.3 times at the last full-year results and the dividend payout ratio has only exceeded 75 per cent of net income once since 2003, according to Capital IQ data (see chart).
Some investors have argued that over-reliance on dividend payments by asset-intensive businesses – as a means of keeping shareholders happy – can lead to a lack of focus on innovation that could move the business forward.
Such arguments are especially pertinent to energy utilities as renewable forms of energy gather steam, making distributed generation more accessible than ever before. There is, the argument goes, little point in owning an energy network if nobody is relying on electricity transmitted from large power plants anymore.
To combat this, National Grid established National Grid Ventures in April 2017, facilitating investments in growth areas outside of the core regulated business, including emerging technologies. By March this year this division already accounted for 6 per cent of operating profit, with investments in interconnectors, liquefied natural gas storage and smart metering.
Another potential threat to earnings is energy regulator Ofgem’s RIIO-2 review, which will determine price controls from 2021. Brokerage RBC Capital Markets estimates the mid-case cost of equity permitted by the review would be largely in line with National Grid’s retained cash flow to net debt ratio of 9 per cent, needed to maintain its credit ratings. It’s risky to rely on an estimate, but RBC reckons the group could improve its ratio comfortably with only modest cost-cutting or improvement in cash flows.
Last year National Grid spent £4bn on a special dividend and share buyback following the sale of a 61 per cent stake in its UK gas distribution business. While it has now agreed an option for the sale of the remaining stake, shareholders will not be seeing another payout. Instead, the £2bn the group expects to generate will be retained for investment in the business. While this may disappoint shareholders in the short term, it allows for further investment in the US business or National Grid Ventures, two divisions that have been performing well and will not fall under the scope of RIIO-2, and the limits on returns, creating the potential for capital returns.
Much has been made of the possible re-nationalisation of utilities and, while it cannot be ruled out, we think it is unlikely. Leaving aside the challenges of a programme of renationalisation making it through parliament, bringing the energy companies back into the government would probably be by far the single most expensive of the formerly public industries, with estimated costs ranging from £55bn to £185bn, according to the Centre for Policy Studies. This makes sectors such as rail – which could be brought into public ownership for virtually no cost as franchises end – far more likely targets.
National Grid is not standing still. The group has demonstrated an impressive ability to scale both its US division and its venture arm. At 856p, the potential dividend yield this year is well above 5 per cent, and with the increased earnings potential following the sale of the gas distribution business, we think the shares are a solid income buy.
Last IC View: Buy, 888p, 24 May 2018