When I think of gas and electricity transmission system operator National Grid (LSE: NG) (NYSE: NGG.US), two factors jump out at me as the firm’s greatest weaknesses and top the list of what makes the company less attractive as an investment proposition.
Capital-intensive business
Running huge power lines and gas pipes takes a lot of maintenance to keep things safe. The company deals in pressures and voltages measured in high numbers, where one slip could prove fatal.
The nation depends on reliable energy supplies to keep industry, commerce and domestic arrangements ticking over. Ever-rising fuel costs keep operational efficiency in sharp focus.
Such factors have one thing in common: capital. It takes vast sums of money to upgrade, repair and maintain energy infrastructure, which keeps National Grid constantly investing capital. There’s no skimping; the regulators maintain a tight grip to ensure compliance with their capital investment requirements.
To finance such expenditure, the firm reinvests cash flow, takes on debt, and increases equity by methods such as settling dividend payment in scrip form, which saves cash outflow. Net debt is running at around £25.6 billion, almost seven times the level of last year’s operating profit. There’s no doubt that high debt is a prominent feature with National Grid, justified by the firm’s consistent cash flow. However, it strikes me as debt by necessity rather than by choice; the company’s not financing robust growth with its borrowings, for example.
That said, debt levels have been consistent, swinging between around six and eight times operating profit in recent years:
| Year to March | 2010 | 2011 | 2012 | 2013 | 2014 |
| Net debt (£m) | 24,404 | 22,814 | 22,693 | 27,424 | 25,596 |
| Operating profit (£m) | 3293 | 3745 | 3539 | 3749 | 3735 |
| Debt divided by op. profit | 7.4 | 6.1 | 6.4 | 7.3 | 6.9 |
National Grid’s ability to raise new debt is important, so stable credit ratings from agencies such as Fitch and Moody’s help to ensure debt remains affordable. Debt is, however, a drag on investor returns and does carry with it the risk that National Grid could find re-financing difficult in the future.
Fierce regulation
National Grid runs Britain’s energy transmission systems and four of the country’s eight regional gas distribution networks. The firm also has interests in the north eastern US, where it operates electricity generation, transmission and distribution assets, and gas distribution networks.
All the firm’s activities, both sides of the Atlantic, face fierce scrutiny from regulators who set maximum earnings limits and minimum investment thresholds, to make sure National Grid keeps investing in its assets. Such close monitoring takes the shine of the firm’s monopolistic positioning and keeps a lid on investor returns.
National Grid has to balance capital expenditure, regulatory compliance and interest payments on debt, but still manages to produce steady cash flow, which it uses to keep investor dividend payments growing. The company’s dividend-growth strategy is pedestrian; it tries to mirror the rate of retail-price inflation.
What now?
At a share price of 878p, National Grid’s forward P/E rating is running at just over 15 for 2016. The dividend yield that year should be about 5%, but city analysts following the firm expect earnings to slide 18% in 2015 before recovering by 6% the year after.
The apparent security of the dividend payment will attract many investors but, given the immediate growth outlook, the shares are starting to look pricey. If the shares re-rate down, which they could do, capital attrition could nullify forward income gains from the dividend.
