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National Grid (NG) is one of the most geographically diversified international power transmission groups. It owns and operates the electricity transmission network in England and Wales, the gas transmission network in Great Britain, and electricity transmission and gas distribution assets in the East Coast of the US. The near 50/50 split of operating profit between the UK and the US provides a strong hedge against headwinds in unfavourable changes in regulation, interest rate increases and currency risks. NG’s regulated monopoly status provides a Warren Buffett style ‘moat’ that protects it from any competition and guarantees a certain level of income for the business – and dividends for shareholders.
Strong and stable financial performance
NG is a stable utility business, with limited growth but with a high and stable dividend yield, currently around 5.3%. NG generated comfortable free cash flows in the past three years of between GBP 1-1.5 billion per annum, allowing it to acquire treasury shares of more than GBP 1 billion, and to increase dividends in line with inflation. Dividend payouts are less than 30% of operating cash flows, and have been almost fully covered by free cash flow in the past three years. Net financial debt to operating cash flow has been increasing to reach around 6.3x but interest coverage was comfortably above 4x, earning NG a comfortable credit rating of BBB+. The margin of operating cash flow to sales was at 30%, one of the highest in the sector, and net profit to sales reached a comfortable 10%. NG’s current valuation parameters could be more attractive, but are still reasonable for a company with such strong financial metrics; market capitalisation to operating cash flow is 7.2x while market cap to book value is at 1.6x – reasonable levels although not particularly cheap. Return on equity has been a stable 11-12% over the past three years.
Recent results published for the year ending 31 March 2020 were uneventful, as they missed the bulk of the lockdown period. Underlying operating profits were up by 1% to GBP 3.5bn, COVID-19 impact on earnings was primarily driven by a GBP 117m increased provision for US bad debts. Group RoE of 11.7% was only 0.1% lower than that of the previous year. Full year dividend was up by 2.6%. National Grid’s total returns — dividends plus shares — over the past year are close to 11% – a handsome return, given the low underlying risk of the business.
For comparison reasons, PPL Corporation (PPL), which manages fully regulated generation, transmission and distribution assets in the US and UK, has net financial debt to operating cash flow of close to 10x. This significantly high level of leverage leaves PPL with no room for additional debt accretion, and thus putting pressure on its ability to maintaining capital expenditures commitments, not to mention its ability to pay out dividends. PPL has an EBITDA margin of 32%, and return on equity of 11% – similar to NG. PPL generated no free cash flow for the past 3 years, versus annual free cash flow of around GBP 1 billion generated by NG in each of the last 3 years. PPL has a similar current dividend yield to NG, but the difference is that PPL has been funding dividend payments over the past 5 years almost entirely debt – raising clear doubts about sustainability, not to mention future increases.
COVID-19 impact significant over the short-term, should even out medium-term
COVID-19 is expected to have a more significant impact in the financial year ending 2021, with underlying operating profits expected to decrease by approximately GBP 400m, and with a potential negative impact of up to GBP 1 billion on cash flow by the end of this financial year. However, these amounts are expected to be recovered eventually rather being a permanent loss of income and cash.
As well as potential lower US customer revenue collection affecting cashflow in 2020/21, NG assume additional revenue shortfall in the UK and US due to COVID-19 that will impact both headline earnings and cash flow. These impacts come from areas where NG have (or will have) regulatory mechanisms in place, thereby classified as timing impacts, such as, (1) lower demand in the UK and US, and (2) customer assistance programmes in the UK.Lower levels of energy usage due to COVID-19 may impact NG’s revenue collection within year, and therefore headline earnings, although this should even out longer term as almost all revenues are decoupled from demand across the UK and US. This means that any under-collection is primarily a timing one and NG expect to recover revenues through existing regulatory mechanisms in the medium term.
Similarly, in the UK, NG is participating in a scheme that has been set up to help some of the smaller energy supply customers. This involves the relaxation of network charge payment terms for suppliers and shippers who are facing cash flow challenges as a result of COVID-19. An open letter from Ofgem proposed that all network charges are repayable in the current financial and allows NG to recover any unsettled amounts in the 2021/22 financial year.
Regulation is the main risk: The main investment risk for NG, as with other regulated utilities, is the cost of equity return that the regulator sets for each regulatory period. Last December, National Grid submitted its final business plans to Ofgem – the UK regulator – for its UK electricity and gas transmission businesses for the 2021-2026 regulatory period RIIO-2 (RIIO 2 [Revenue = Incentives + Innovation + Outputs]). RIIO-2 will be the next price control for UK companies running the gas and electricity transmission networks and will start on 1 April 2021, replacing RIIO-1, which began on 1 April 2013. In RIIO 2, NG plans to spend of ‘Totex’ (capex plus opex) GBP 7.1bn on electricity transmission and GBP 2.8bn on gas transmission. The baseline spend would see consumer bills reduced slightly in real terms for both electricity and gas transmission – seeking to please Ofgem and to extract a high cost of equity as possible. NG is proposing an allowed cost of equity of 6.5%, within the range of 6-7% for RIIO 1. Ofgem mandated consultants recommended 3-5% as a better range, and in early July consultations Ofgem has set a baseline return on regulatory equity of 3.95% between 2021 and 2026 — nearly half the rate set seven years ago. Companies and other transmission operators were hoping for nearer 5%. The tug of war will continue between Ofgem and regulated companies until a final decision takes place in November 2020, and investors should monitor closely that outcome before taking big positions in NG.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.