National Grid on solid ground

A sound regulatory regime and an eight-year price review period have ensured National Grid continues to find favour with investors, even as the economy recovers, says Nigel Hawkins.

In the UK utilities sector, National Grid is by some way the biggest player, with a current market capitalisation around twice that of its nearest quoted contemporaries, Centrica and SSE.

National Grid is in 20th position in the FTSE-100 Index, with a value of almost £32 billion, sandwiched between Unilever and British Telecom.

In recent months, its share price performance has remained resilient, although the sudden burst of economic growth in the UK economy has encouraged investors to look more favourably on cyclical stocks, such as housebuilders. Furthermore, some sectors, such as pharmaceuticals, have been boosted by corporate activity. Hence, National Grid’s share price, though rallying from the late spring, has not exactly sparkled, despite May’s solid 2013/14 full-year results.

In overall terms, its full-year figures met market expectations, with operating profit at £3.7 billion, pre-tax profit at £2.6 billion and underlying earnings per share at 54p. This latter figure compares with 51.4p per share in 2012/13.

For National Grid, returns from its core four divisions are crucial.

First, its UK electricity transmission returns, based on a regulatory asset value (Rav) of £10.9 billion, have provided the core of overall profit for decades. Last year, operating profit was £1.1 billion, around 30 per cent of the total. Crucially, this figure was achieved in the first year of the pivotal eight-year regulatory period. Hence it provides a solid base for future projections, which will take account of expected revenue growth and cost savings.

At the revenue line, some uncertainties remain, notably future load growth levels, which will depend to a significant extent on future generation investment. However, National Grid is focusing on its controllable costs. It is already reporting material savings on its total expenditure (totex) projections. Furthermore, it expects additional savings from its “re-negotiating, re-organizing and re-engineering” initiatives.

The UK electricity transmission business is now earning an equity return of over 12 per cent, which is a decent return for a safe business with low regulatory risk.

Second, UK gas transmission, with a Rav of £0.4 billion, also reported solid progress – unlike the recent figures from gas-fired generation. Last year, its return on equity approached 13 per cent.

Third, UK gas distribution – with a Rav of £8.5 billion – performed well, with savings in controllable costs to the fore. Its overall operating profit was £0.9 billion.

Fourth, trading at National Grid’s US operations, with a Rav of just below £10 billion, was better than previously. In the past, there have been serious concerns about this business.

Importantly, regulatory rulings for utilities in the US are generally more short-term so that negotiating such returns is an ongoing process, unlike the eight-year transmission review window in the UK. And as National Grid has found to its cost previously, they sometimes come with a sting in the tail.

While the overall figures were rather flattered by the lack of storms in the US last year compared with 2012/13, an operating profit of £1.1 billion was reported. However, National Grid did flag up that some additional costs have been incurred as it seeks to improve its operational performance on the East Coast.

US equity return was a more modest 9 per cent, but National Grid drew attention to its recent success in driving forward profitability from its Niagara Mohawk business, where the average returns were up by around 50 per cent on 2011/12.

For investors, the inflation-linked dividend increase was a solid, if unexciting, 2.9 per cent. Low dividend cover precludes major real dividend increases.

Nonetheless, National Grid is now trading on a projected yield of around 5 per cent, which seems a healthy return on a stock with relatively low regulatory risk. The broadly equivalent ten-year gilt yield is around 2.8 per cent.

Unlike most cyclical companies with more volatile returns, National Grid can bear rather higher net debt, which at March 2014 was £21.2 billion. The average financing rate is just below 5 per cent.

Looking forward, managing National Grid’s capital expenditure programme will be a high priority. It is expected to cost around £3.5 billion per year. Much of this investment will be undertaken in the UK. Clearly, with major changes due on the generation front, the outlook is far from certain.

In particular, the construction of new wind plants, both onshore and offshore, gives rise to substantial electricity transmission expenditure. Furthermore, the current level of generation investment is low, a scenario that may well change after next May’s general election.

Even so, many financial uncertainties remain despite the passing into law of the Energy Act 2013, which centres on Electricity Market Reform (EMR). Forecasting both load growth and capacity margins is complex. Inevitably, National Grid has to manage a number of mid-term and long-term generation investment scenarios.

Heavy investment will also take place in National Grid’s US operations. Within New York State, including Long Island, the company remains keen both to modernise and to expand its gas network there.

For many UK utilities, notably SSE, the next 12 months will be crucial, especially on the election front. For National Grid, however, despite its status as the UK’s leading utility, such concerns are comparatively minor. Unlike Centrica, it is not consumer-facing. Instead, it operates below the radar.

More importantly still, its tenaciously fought eight-year UK regulatory price settlement until 2021 is regarded by investors as inviolable – even if a majority Labour government enters office.

National Grid’s next financial news is expected on 28 July via its interim management statement – little of consequence is expected, although National Grid will be keen to highlight its efforts to reduce its cost base. On the same day, the AGM, attracting a few private investors, will take place in Birmingham.

In the lead-up to May’s general election, utility share prices may well prove volatile, as was the case in the summer of 1992 when the latest opinion poll was the key share price determinant.

For National Grid, however, volatility is less likely. Its far-reaching UK regulation settlement and its recovering US returns have been more important drivers.

Nigel Hawkins is a director of Nigel Hawkins Associates, which undertakes investment and policy research