Utility companies such as National Grid (NG.) have long been a haven for income investors. Perhaps not the most exciting proposition, but a stable and growing dividend has been underpinned by the predictability of the group’s regulated monopoly position. The enduring challenge is how to balance the high capital investment required to maintain and grow the asset base with the generous dividend payments now expected by shareholders
Capital investment of £4.5bn saw assets grow by 7.2 per cent in 2019 (above the targeted 5-7 per cent range) and is expected to increase to almost £5bn in 2020. But such heavy capital investment means free cash flow has failed to cover the dividend over the past 10 years. True, the ratio of statutory earnings per share (EPS) to the dividend has been historically secure above 1. But, save for an exceptional year in 2018 which benefited from a £1.5bn windfall from US tax cuts, the dividend cover has actually been declining, slipping to 0.94 in 2019. Some £624m in exceptional charges weighing on statutory earnings did make for an atypical year, but the downward trend raises questions about long-term dividend safety – even more so with added uncertainty ahead.
The next 18 months will be critical as the RIIO-2 consultation determines the “fair” return networks can earn from investment in their asset base in the next regulatory period from 2021. Whereas National Grid is advocating an allowed return on equity (RoE) of 5.5 per cent in real terms, Ofgem is proposing an allowed RoE of just 4.3 per cent. Compared with the 7 per cent real RoE permitted under the current price control period, it is clear National Grid’s regulated UK operations will be less profitable moving forward – Societe Generale forecasts a 4.5 per cent drop in underlying EPS for FY2022.
The question is how this will translate to the dividend. Analysts at RBC Capital Markets remain bullish. Seeing the proposed RoE for RIIO-2 as “an aggressive but manageable cut”, they believe the dividend is sustainable. But in the face of squeezed returns, high levels of debt could exacerbate the dividend conundrum. Net debt surged by 15 per cent in 2019 to £26.5bn, while cash generated from continuing operations fell by 5 per cent to £4.46bn. Even with £1.97bn in cash proceeds from selling the remaining stake in Cadent gas, net debt is expected to increase by a further £1bn in 2020. In the face of diminished earnings and climbing debt, if not an outright cut, dividend growth could slow compared with current expectations.
Outside the reach of UK regulators, the US business may help offset the earnings pressure from lower allowed UK returns. Adjusted operating profit increased by 8 per cent in 2019, accounting for 51 per cent of the group total. With a blended allowed return of around 9.5 per cent, RoE for regulated US operations is expected to increase to at least 95 per cent of this threshold in 2020. Similarly, growth potential from the group’s investment in interconnectors could serve as a counterbalance. Including the Nemo Link, which became operational in January, four projects are expected to contribute around £100m of cash profits in FY2022, rising to £250m from FY2025 onwards.
