FTSE 100 income stalwart National Grid (NG.), which manages the UK’s electricity and gas infrastructure, has been downgraded by Morningstar equity analysts.
We have reduced our fair value estimate to 990p a share from £10.50 due to higher capital expenditure estimates and lower earnings estimates for the US regulated activities because of higher operating costs. The stock, which boasts a dividend yield of over 5%, is currently trading at 919p. National Grid is rated as a four-star stock, which means that it is undervalued relative to its peer group.
If National Grid achieves no cost efficiencies, it would cut our cash flow estimate by 6% and reduce our fair value estimate by 30p a share.
We downgraded our moat rating – which indicates that the company has a slender competitive advantage - from narrow to none on our lack of confidence that National Grid can consistently realise returns on capital greater than its cost of capital. The historical rate-setting structures – which determine how much utilities can charge customers - in the US are a key drag on return on invested capital (ROIC) going forward, especially as National Grid invests heavily in the US during the next three to four years. In the US, National Grid has struggled to keep pace with its allowed returns and regularly earns 2-to-3% less than its UK operations.
We assume that the new regulatory regime for gas and electricity transmission in the UK from 2022 will be roughly in line with the current one albeit with less generous incentives.
National Grid's aggressive investment plan during the next decade should not jeopardise its investment-grade rating, given the favourable regulation in place, particularly in the United Kingdom. Still, we expect cash from operations to be too low to fund the rest of the capital spending programme so the group will have to issue new debt.
It introduced a scrip dividend – where investors receive new shares instead of a dividend - in 2013 but plans to repurchase shares in line with the take-up. National Grid’s most recent regulatory filing suggests the company has repurchased about £280 million of shares, or about two thirds of its minimum plan for 2017. The company has an agreement to spend £425 million on repurchases by the end of December, but management might ramp up its pace to meet its goal of returning all of the capital by the end of its March 2018 fiscal year.
National Grid has lowered its cost of debt to an average 3.7% from 5.2% since 2014. We forecast an average £1.2 billion of new debt issues based on management's investment plan.
