Read Morningstar Analysts' latest note on National Grid, in response to an industry regulator ruling, by clicking here.
Fair Value Estimate: 640p
Economic Moat: Narrow
Uncertainty Rating: Medium
Morningstar Credit Rating: BBB+
Thesis (Last updated 18/03/11)
With its $11.8 billion purchase of New York-based Keyspan in August 2007, National Grid (NG.) became one of the world's 15 largest utilities by revenue and reaffirmed its ability to woo regulators on both sides of the Atlantic. Despite heavy regulation that can constrain profits, National Grid continues to create shareholder value. We think yield-hungry investors could appreciate its current dividend yield and growth combination.
National Grid holds an enviable position between energy suppliers and consumers in the United Kingdom and the Northeastern United States. Its dominant position in the U.K. resulted from the government's unbundling of energy generation, transmission, and distribution assets in the 1980s. It now owns or operates nearly every power wire and natural gas pipe in England and Wales and serves 11 million customers through England's largest natural gas distribution network. In 2000, National Grid entered the Northeastern US and now gets about half of its revenue and 40% of its profits from the region. With regulatory returns stronger in the UK than its US regions, we expect revenue and profits to tip more heavily toward the UK in coming years.
National Grid operates in 20 different regulatory regimes, which diversifies regulatory risk but requires substantial negotiating effort. The UK's five-year rate cycles remain the key earnings drivers. Transmission rates, which expire in 2013 after a recent one-year extension to the current regime, allow National Grid to earn a 5% real, aftertax return on assets. The company is actually earning nominal returns on equity above 14% at its transmission business as of late 2010. The initial UK rate framework for 2013 would maintain similar allowed rates of return but place more emphasis on operating performance. We think this is a fair trade-off.
Gas distribution regulation, which expires in 2013, allows a 4.3% real return after tax on its assets. Because gas rates were negotiated during late 2007 when interest rates were falling, they are lower than those for transmission. National Grid has matched or hedged most of its debt based on its regulated allowed returns, so earnings are mostly protected from interest-rate volatility and inflation in the UK.
In the US, federal regulators set transmission rates and state regulators set distribution rates. All rates are based on nominal allowed returns on equity, which currently average about 11% across the company's US operations. However, allowed returns continue to fall given lower interest rates and regulators' reluctance to raise customer bills. This has resulted in earned returns well below allowed returns and a de-emphasis on US investment apart from interstate transmission, which retains favorable rate recovery mechanisms. Management has said repeatedly that it is committed to the US and plans to take steps to improve its financial performance.
National Grid's networks should become more valuable as the UK and Northeastern US implement federal and state policy concerning cleaner-burning power generation and renewable energy. Recent regulatory rulings on both sides of the Atlantic include investment mandates that support its plans to spend £22 billion between 2011 and 2015. If the company can meet this investment goal and avoid punitive regulation, we expect it will continue rewarding shareholders with dividend growth and capital appreciation.
Valuation
We are reaffirming our fair value estimate at 640p per share after reviewing Ofgem's final transmission rate scheme for 2013-21. We previously incorporated the $112.7 million allowed 2011 rate increase at Niagara Mohawk and management's plans for US cost savings. We assume 10% four-year annual operating profit growth based on a fair outcome in the 2013 UK transmission rate regime that maintains current allowed real returns. We believe Ofgem will allow returns on equity near the top end of its final 6.0%-7.2% range, consistent with recent regulatory activity, Ofgem's outlook for £30 billion of infrastructure development needs during the next decade and current allowed returns.
Our forecast incorporates the first four years of National Grid's £22 billion investment programme. We assume most of the returns from those investments produce peak cash flow one to two years after the investments are made, stretching returns from that investment program past our five-year forecast period. We do not incorporate any changes to the depreciable lives of UK transmission assets, as proposed in Ofgem's initial transmission rate review framework.
We assume a long-term currency exchange rate of $1.60 per GBP starting in 2013. In our discounted cash flow valuation, we use a 7.7% cost of capital based on a 10.5% cost of equity and current credit spreads.
Risk
Regulatory risk is the primary factor in our medium fair value uncertainty rating. Regulators seek to keep customer bills low, while the company tries to increase profits. Investor returns depend on the rates regulators set. In the UK, regulators prefer incentive-based rates that require certain investments and efficiency standards. US regulators could punish the company if costs--and, thus, rates--rise too fast. The recent regulatory decision at Niagara Mohawk that granted just 31% of its requested rate hikes demonstrates the uncertainty of utility regulation.
Management & Stewardship
We think National Grid earns high marks for its stewardship. It separates its CEO and chairman roles, requires annual board meetings without management, offers generous employee stock-ownership plans while limiting dilution, keeps fixed executive compensation to less than half of average total compensation, and dutifully returns cash to stockholders through dividends and share buybacks. CEO Steve Holliday, who took over for retired industry veteran Roger Urwin in January 2007, has been with the company since 2001. He proved his negotiating mettle by pushing through the Keyspan acquisition. He now must prove his operational adeptness after several years of acquisition growth. Holliday earned about £2.3 million in total compensation during the fiscal year ending in March 2010, which was in line with comparably-sized companies and roughly the same as he earned in the previous fiscal year. A new finance director, Andrew Bonfield, took over in November 2010. Bonfield is new to the utility industry but has been finance director or CFO most recently for BG Group (BG.), Bristol-Meyers Squibb (BMY) and Cadbury (before its sale to Kraft), so we expect he has experience raising capital to support large growth plans like National Grid is undertaking. Executive director and president of US operations Tom King is an US utility industry veteran but faces the tall task of reinvigorating National Grid's US operations.
Overview
Financial Health: Accounting standards can mask the strength of National Grid's balance sheet and credit profile, which we think is one of the best in the utility sector. Since UK utility regulation allows National Grid to adjust its capital base annually at RPI (plus an additional 200 basis points for transmission assets), we estimate its historical-cost book equity is understated by about £5 billion. Adding back this equity adjustment lowers economic leverage to 66% of total capital, not the 86% reflected on its 2010 fiscal year-end balance sheet. This leverage is in line with its mandated 65% debt-to-capital requirement per UK utility regulation. Interest coverage also is much stronger after adjusting for £1.2 billion of pension-related (noncash) cost included in book interest expense per IFRS accounting standards. We calculate economic EBITDA/interest coverage at 4.5 times and cash flow/interest coverage at 3.0 times for fiscal 2011. More than 50% of its consolidated long-term debt is inflation-linked or floating-rate, matching the UK's inflation-linked regulatory ratemaking mechanism and removing the cash-flow risk of deflation. These both support a strong investment-grade credit profile, and we do not see that changing unless UK regulators cut allowed returns significantly in 2013.
Profile: National Grid is an international utility that provides electricity and gas transmission and distribution in the UK and Northeastern US. Its primary role is to match electricity supply and demand needs across its network and distribute electricity and natural gas to 11 million customers in England and 7.6 million customers in the US. It also operates in power generation, communications infrastructure, metering services, and liquefied natural gas storage.
Bulls Say
-- Aging energy transmission networks and renewable energy requirements in the US and UK will require large capital investments, which drive earnings growth.
-- The regulatory environments in most of National Grid's service areas have favoUrable terms that allow shareholders to participate in upside performance.
-- Management so far has made good on its promise of 8% annual dividend growth through 2012, suggesting an annual dividend for fiscal year 2011 at £36.37 per share.
-- Rates in the UK are set to increase at the inflation rate plus more than 5% annually through 2012, primarily to fund large infrastructure investments.
Bears Say
-- Falling interest rates and a weak economy have led UK and US regulators to cut allowed returns.
-- Despite favoUrable dividend growth, rising bond yields would make National Grid a less appealing investment choice for income-oriented investors.
-- Pushing rate increases and higher allowed returns through regulators in the Northeast US is more difficult with the struggling economy.
-- Tighter credit markets could restrict access to capital the company might need to fund its capital investments.
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