Analysis: National Grid powers ahead

Jitters about Brexit and another recession have had little impact on National Grid’s share price, and another solid set of financial results have made the company a blue-chip favourite.

In recent weeks, several utilities have announced their full-year results, including Severn Trent, Pennon and National Grid, Europe’s most valuable utility. A recurring theme has been outperformance of the regulatory settlement, which has driven their share prices upwards, especially as markets are becoming increasingly nervous about a possible recession.

In National Grid’s case, its shares are close to their record high, having recently breached the £10 barrier. Investors will have been reassured by the operational strength of National Grid, which is strong both in the UK and in the US.

Aside from interconnector sales, National Grid’s EU revenues are modest. Hence, it is far less exposed to Brexit concerns which have depressed the share price ratings of companies such as EasyJet.

In its 2015/16 full-year results, National Grid confirmed that its adjusted operating profit rose by 6 per cent to almost £4.1 billion. The equivalent increase at the pre-tax profit level was an impressive 9 per cent. Earnings per share, boosted by a 6 per cent cut in interest payments, rose sharply to 63.5p per share – a 10 per cent increase over 2014/15.

Central to National Grid’s profits are its regulated UK electricity and gas businesses. Both performed so well in 2015/16 that a group 12.3 per cent return on equity was achieved. The leading UK business, electricity transmission, delivered an operating profit of £1,173 million. A similar result was reported for the two gas businesses: distribution at £878 million and transportation at £486 million respectively.

Of course, these figures are driven primarily by the various price determinations of recent years set by Ofgem. Nonetheless, the degree of outperformance – compared with Ofgem’s projections – has been marked.

Whereas Ofgem’s allowed figures assumed a return on each business of around 10 per cent, the achieved figures in 2015/16 ranged between 12.5 per cent and, for electricity transmission, a stonking 13.9 per cent. Against this background, National Grid has been able to confirm customer benefits in excess of £330 million since the start of the regulatory period in April 2013.

Given that the regulatory settlements were distinctly generous, it is perhaps hardly surprising that Ofgem has decided to implement a mid-term review. Crucially, however, there will be no changes to the key financial parameters, including the pivotal weighted average cost of capital (Wacc) figure – something that National Grid is anxious to trumpet.

For some years, National Grid’s US business has lagged, with some suggestions that it should be sold off entirely or at least partly demerged. The 2015/16 figures disclosed that operating profit from the US businesses was £1,185 million for the period. Currently, various rate case reviews are underway, with National Grid’s activities in New York and Massachusetts being under particular scrutiny.

Various factors benefited National Grid’s other businesses. Particular highlights included operating profits from metering of £162 million, from interconnectors of £123 million and from Grain/LNG of £72 million. Given these formidable numbers, all three of these undertakings are sizeable businesses on a standalone basis.

National Grid’s investment budget amounts to c£4 billion a year, split roughly 50/50 between the UK and the US. In the UK, this translates to an expected £16 billion investment programme over the eight-year RIIO regulatory period. In the US, investment levels are being ramped up, with substantial investment being allocated to the modernisation of some East Coast gas network systems.

Net debt has now reached a formidable £25.3 billion, which – though a vast figure – is not dissimilar from some of National Grid’s leading EU competitors, most of whom have a far lower market value. However, this net debt figure seems set to fall over the next 18 months as National Grid plans to sell a majority stake in its UK gas distribution operations.

The book value of these assets is c£8.7 billion, so that – with the current sales premium over regulatory asset value of a minimum 35 per cent – the actual sale price of these assets should be c£12 billion. While some of the proceeds will presumably be earmarked to reduce net debt, investors will be hoping for either a special dividend payment or a share buyback programme.

With considerable market uncertainty about the sustainability of dividend payments from such blue-chip companies as Shell and Vodafone (along with the troubled bank and mining sectors) National Grid’s shares offer considerable dividend security. But the current level of dividend cover, at 1.5x, is no more than reassuring, although it is less of a concern than that of the UK’s second most valuable quoted utility, SSE. For 2015/16, National Grid’s dividend was raised by a modest 1.1 per cent, equivalent to the increase in RPI; this met expectations.

Looking forward, the most serious threat to National Grid’s share price rating is probably a rise in global interest rates. In such circumstances, the differential between National Grid’s current yield of c4.4 per cent and that of US Treasury bonds/UK gilts would narrow – to the probable detriment of National Grid’s share price.

However, such a scenario may be offset by news about the proposed majority sale of the gas distribution assets, where the achieved premium may surprise on the upside. And, of course, National Grid’s latest results were pretty impressive.