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- Prospects;
- Risks;
- Valuation.
Today, I’m looking at gas and electricity transmission system operator National Grid (LSE: NG) (NYSE: NGG.US).
Track record
With the shares at 790p, National Grid’s market cap. is £29,469 million.
This table summarises the firm’s recent financial record:
| Year to March | 2009 | 2010 | 2011 | 2012 | 2013 |
|---|---|---|---|---|---|
| Revenue (£m) | 15,624 | 14,007 | 14,343 | 13,832 | 14,359 |
| Net cash from operations (£m) | 3,413 | 4,516 | 4,858 | 4,228 | 3,750 |
| Adjusted earnings per share | 50.2p | 55.05p | 50.9p | 50p | 56.1p |
| Dividend per share | 35.64p | 38.49p | 36.37p | 39.28p | 40.85p |
1) Prospects
As operator of Britain’s gas and electricity transmission systems, National Grid seems to own a toll-bridge style business: energy suppliers have to transport energy using the firm’s system, and there’s little prospect of a competitor’s transmission system eroding National Grid’s market share. In a free market, that scenario would provide the company with supreme pricing power to assure profitability.
Of course, it’s not quite like that as, thankfully, fierce regulation crimps the firm’s activities, so we can all keep warm and still sleep at night without worrying about the clatter of the letterbox and the thump on the doormat at the end of each quarter. Nevertheless, National Grid’s turnover is consistent and the resulting steady cash flow makes the firm’s dividend attractive.
Last year, the company earned around 44% of its operating profits through Britain’s transmission networks. A further 22% came from operating four of the country’s eight regional gas distribution networks and 34% came from the company’s interests in the north eastern US, where its regulated business includes electricity generation, transmission and distribution assets, and gas distribution networks.
National Grid reckons that a regulatory price control plan governs the majority of revenues it collects each year. If the firm takes more than this allowed level of revenue, it must return the money to customers in subsequent years, and if it collects less than this level of revenue, it may recover the balance from customers in later years as well.
So, by balancing capital expenditure, regulatory compliance and interest payments on debt, National Grid has the opportunity to maintain a steady cash flow, which it can use to remunerate shareholders. The firm aims to grow the dividend at least in line with the rate of retail-price inflation each year.
2) Risks
National Grid needs to keep investing capital to increase operating efficiency, ensure regulatory compliance and to further investor returns. To finance such expenditure, the firm reinvests cash flow, takes on debt and increases equity by, for example, settling dividend payment in scrip form, thus saving on cash outflow. Net debt is running at around £21.4billion, or just under six times the level of last year’s operating profit, with the firm expecting to add about £1 billion of new debt during its current financial year. Success seems to depend on National Grid’s ability to raise new debt. As such, stable credit ratings from agencies such as Fitch and Moody’s are very important if debt is to remain affordable.
Overall, regulation and debt-dependency are perhaps the two main risks that could threaten the profitability of the business and therefore returns for National-Grid investors. Both factors are beyond the immediate control of the directors and therefore serve to take some of the shine off National Grid’s otherwise attractive market position.
3) Valuation
Forward earnings cover the forward dividend just less than 1.3 times for 2015. At today’s share-price level, that implies a yield of around 5.5%.
City analysts are expecting earnings to rebound by 5% in 2015 after dipping by about 7% this year. Meanwhile, the forward P/E rating is running at about 14, which looks a little generous to me, even after considering National Grid’s potentially stable cash flow.
