National Grid has long been a favourite for income investors, offering a stable and growing dividend supported by its regulated-monopoly position as owner and operator of the UK’s energy network. In recent years its US-based business has grown to rival its domestic operations, but we feel nagging concerns about political interference mean investors are ignoring the potential for growth.
US and new-technology growth opportunities
Strong dividend
Freeing up cash for investment
Increased rates certainty in the US
Regulatory uncertainty in UK
Nationalisation threat
The key draw for investors in National Grid is the dividend, which management aims to grow at least in line with the retail prices index (RPI) for the foreseeable future. While consistent investment in the asset base means free cash flow has not covered dividend payouts over the last 10 years (see graph), comfort comes from the solid earnings cover, which came in at 1.3 times last year. What's more, the company's retained-cash-flow (RCF)/adjusted-net-debt ratio (a key measure of balance sheet health) of 10.3 per cent is comfortably above the 9 per cent level needed to maintain its important A- credit rating with S&P and A3 with Moody's.
However, over the last few years the shares have fallen back as fears have grown about regulatory change, which includes a recent announcement that Ofgem is investigating electricity transmission demand forecasting. Of more significant concern, though, is the RIIO-2 review process which will soon get under way to agree UK price controls from 2021. Broker RBC Capital Markets calculates that its mid-range expectation for the outcome could push RCF/adjusted net debt below the 9 per cent threshold needed to maintain the credit raging, which would be a worry for income investors. However, the broker also highlights that the savings needed to make up any shortfall, and thereby underpin the sustainability of the dividend, should prove well within National Grid's grasp.
Regulatory concerns may have led investors to ignore the potential for growing assets (the profit engine of National Grid's capital-intensive business). Indeed, in the year to the end of March, fueled by a 14 per cent constant-currency increase in capital expenditure to £4.3m, assets grew by 6 per cent compared with 5 per cent the previous year. What's more, near-term asset growth is expected to come in a 7 per cent with medium-term growth now earmarked to be towards the top end of the 5 to 7 per cent range.
An important source of growth is the US business, where a recent round of regulatory rate setting is close to completion, providing a more certain backdrop against which National Grid can invest. At constant currencies, US capital expenditure was up 15 per cent last year to £2.4bn and management plans to invest $10bn (£7.4bn) over the next three years. Encouragingly, US return on equity came in at 95 per cent of the regulator's allowed rate last year.
The growth of renewable power and the potential electrification of road transport is also expected to be the source of future opportunities. National Grid is working closely with the UK government and has even set up a Silicon Valley team to assess the possible impact of new technologies. Meanwhile, the group's investment in interconnectors through its NG Ventures business is providing a further source of growth.
The funding of the company's investment plans should be helped by the expected £1.2bn sale of National Grid's remaining stake in Cadent Gas, previously called National Grid Gas Distribution, some time between March and October next year. While this will have an impact on revenues, the decision to focus on areas offering higher growth look sensible to us.
There is a nebulous fear of nationalisation should Jeremy Corbyn’s Labour Party win the next election. Many see National Grid as a prime target as the operator of the gas transmission system in the UK and the electricity transmission system in England and Wales. However, we believe any fears of a swingeing deal for shareholders (many of which are large pension funds) are probably overblown in this case. What's more, the cost of nationalisation may reduce its likelihood. The Centre for Policy Studies estimated the cost of nationalising the UK’s energy sector at anywhere between £55bn-£185bn, far higher at the top end than the cost of the water sector, Royal Mail, PFI contracts or any of the other sectors Labour would likely target.
NATIONAL GRID (NG.) | ||||
ORD PRICE: | 888p | MARKET VALUE: | £29.8bn | |
TOUCH: | 887.3-887.5p | 12-MONTH HIGH: | 1,097p | LOW: 733p |
FORWARD DIVIDEND YIELD: | 5.5% | FORWARD PE RATIO: | 14 | |
NET ASSET VALUE: | 561p* | NET DEBT: | 122% |
Year to 31 Mar | Turnover (£bn) | Pre-tax profit (£bn)** | Earnings per share (p)** | Dividend per share (p) |
2016 | 15.1 | 3.14 | 63.5 | 43.3 |
2017 (restated) | 15.0 | 2.81 | 56.9 | 44.3 |
2018 | 15.3 | 2.65 | 59.5 | 45.9 |
2019** | 14.4 | 2.35 | 56.7 | 47.4 |
2020** | 14.8 | 2.67 | 64.7 | 48.7 |
% change | +2 | +14 | +14 | +3 |
Normal market size: | 2,000 | |||
Matched bargain trading | ||||
Beta: | 0.92 | |||
*Includes intangible assets of £6.34bn, or 189p a share **RBC Capital Markets forecasts, adjusted PTP and EPS figures |