What should investors in National Grid (LSE: NG.) be worried about?
With its extensive gas and electric grids in the UK, and millions of direct customers buying gas and electricity from it in the north-eastern United States, National Grid (LSE: NG) (NYSE: NGG.US) is a business with very definite attractions. A £26bn FTSE 100 (UKX) constituent, last year the company earned a pre-tax profit of £2.3bn on revenues of £14bn.
And no wonder this defensively positioned business is popular with many investors: with its shares changing hands today at 709p, the company is rated on a prospective price-to-earnings (P/E) ratio of 13, and offers income investors a very tempting forecast dividend yield of 6.1%.
But how safe is that share price? And -- of vital importance to income investors -- how safe is that dividend? In short, how could an investment in National Grid adversely impact investors' wealth?
In this series, I set out to answer just these questions. My starting point: National Grid's latest annual report, where the company's directors are obliged to address the issue of risk.
One immediate thing that I'm looking for is an acknowledgement that risks do exist, and that they need managing.
The good news? As you'd expect from a business of National Grid's size and calibre, the company has in place a risk management policy, a system of regular reviews, and a number of high-level committees tasked with monitoring the risks that the business has identified.
But what, precisely, are those risks that the company faces?
Read the small print, and National Grid identifies no fewer than 11 risks as having a significant prospective impact on the company's financial performance. They range from environmental hazards to IT system failure, and from regulatory changes to counter-party risk.
So let's take a look at three of the biggest.
As National Grid explains, its business is financed through cash generated from ongoing operations, bank-lending facilities and the capital markets -- particularly the long-term debt capital markets. But the fact remains that its infrastructure is expensive and capital-intensive, consuming hefty chunks of expenditure.
And, as the company points out, recent years have highlighted how financial markets can be subject to periods of volatility and shortages of liquidity. Or, as the company puts it:
"Maintenance and growth of our business requires access to capital markets at commercially acceptable interest rates. If we were unable to access the capital markets or other sources of finance at competitive rates for a prolonged period, our cost of financing may increase, the discretionary and uncommitted elements of our proposed capital investment programme may need to be reconsidered and the manner in which we implement our strategy may need to be reassessed. The occurrence of any such events could have a material adverse impact on our business, results of operations, and prospects."
How real is the danger? Look no further than National Grid's surprise rights issue in 2010, which tapped shareholders for £3.2bn, in order to embark on a £22bn capital investment programme while maintaining the company's single 'A' rating.
That said, National Grid explains that it regularly undertakes cash flow long-term projections, and continually monitors liquidity, taking into account regulatory requirements that restrict its ability to pay dividends from some of its operating businesses.
The business of moving large volumes of gas and high-voltage electricity about the country is inherently risky. Electricity generation brings further environmental impacts, and there are additional risks by way of historic legacy operations and potential adverse effects from things that are presently considered relatively risk-free, such as the effects of electric and magnetic fields. As the company puts it:
"Aspects of our activities are potentially hazardous or could damage the environment. We are subject to laws and regulations relating to pollution, the protection of the environment, and the use and disposal of hazardous substances and waste materials. These expose us to costs and liabilities relating to our operations and properties whether current, including those inherited from predecessor bodies, or formerly owned by us, and sites used for the disposal of our waste."
Any business operating in the United States needs look no further than the very public travails of BP (LSE: BP) (NYSE: BP.US) to see the catastrophic effects of slipshod approaches to environmental hazards and safety -- from the Texas City oil refinery explosion to the more recent Gulf of Mexico disaster.
That said, National Grid insists that it has robust investigation and remediation programmes to clean up wastes, together with engineered controls in place to minimise or mitigate releases to the environment during remediation activities, including containment, alarms, spill response contracts and equipment.
Additionally, company-wide initiatives are supplemented with regional specific safety programmes aimed at addressing specific areas to ensure safety is at the forefront of every employee's mind.
Last month's Hurricane Sandy devastated large parts of the United States' north-eastern coast, second only to Hurricane Katrina in its devastating impact. Damage has been estimated at $50bn. Are two such deadly storms, so close together, evidence of climate change? Who knows? But National Grid is well aware of the risks posed by extreme weather. As the company puts it:
"We may be affected by potential events that are largely outside our control such as the impact of weather, including as a result of climate change. Weather conditions can affect financial performance and severe weather that causes outages or damages infrastructure will materially adversely affect operational and potentially business performance and our reputation."
How are these risks dealt with? First, says National Grid, robust demand forecasting processes and scenario analysis are supplemented by routine maintenance supported by a risk-based asset replacement strategy.
Second, in the United States, where the company's networks are more susceptible to damage from storms, measures in place to address interruptions include robust emergency response plans with training and annual drills; mutual aid agreements with other utilities; communication with regulators on restoration progress and costs; formalised annual business continuity plans and tactical drills; and the cross-training of personnel on various aspects of emergency response.
Risk vs reward
Two superstar investors who are well-used to weighing risks are Neil Woodford and Warren Buffett.
On a dividend reinvested basis over the 15 years to 31 December 2011, Neil Woodford delivered a return of 347%, versus the FTSE All-Share's distinctly more modest 42% performance. Warren Buffett, for his part, has delivered returns of over 20% per annum since 1965, transforming himself into the world's third-wealthiest person.
Each, as it happens, are the subject of two special reports prepared by Motley Fool analysts. And they're yours to freely download, without any obligation.
So click here to download this free special report profiling the investment logic behind eight of Mr Woodford's largest and most successful current picks.
And click here to discover which beaten-down British share Warren Buffett has been buying of late -- and why he bought it, and the price he paid.
> Malcolm owns shares in BP, but not in any other company mentioned here.