The Risks Of Investing In National Grid plc

Today I am highlighting what you need to know before investing in National Grid (LSE: NG) (NYSE: NGG.US).nationalgrid1

Extreme weather patterns on the rise

As one would expect, National Grid is required to fork out vast sums of money in order to keep its infrastructure in both the UK and US up and running. Fortunately the firm’s focus on ‘value engineering’ — not to mention the requirements of RIIO price controls to rein in excessive spending — means that the business has a firm handle on the costs of expanding its asset base.

Still, the effect of severe weather conditions is something that cannot be legislated for, and is something which could potentially have a devastating effect on National Grid’s total expenditure. In its key home markets the severity and number of flooding instances appears to be on the rise, while on the US Eastern Seaboard an environment of worsening snowstorms and sweltering heatwaves is seemingly worsening.

And due to the effects of climate change, the vast sums required to fix the network problems associated with these conditions — and subsequent impact on earnings — is likely to increase in the coming years.

Dividend growth under pressure?

And should the implications of heavy capex flows crimp earnings growth, National Grid’s reputation as a go-to dividend stock could come under threat.

The impact of a rights issue in fiscal 2011 caused the annual payout to slip, but since then the power play has got its progressive dividend policy back on track and payments have risen at a compound annual growth rate of 4.9% since then.

Still, I believe that income hunters should be concerned by the ultra-low dividend coverage protecting payments through to the end of next year. City analysts expect the company to lift the payment to 43.4p and 44.7p per share for the years concluding March 2015 and 2016 correspondingly, in turn creating chunky dividend yields of 4.9% and 5%.

Earnings are expected to drop 17% this year to 54.9p, however, producing miserly dividend coverage of just 1.3 times — any reading below 2 times is generally considered dangerous. And cover remains around this level in fiscal 2016 despite an anticipated 5% earnings improvement, to 57.6p.

Relatively low dividend yields have historically not been a problem for National Grid as its large debt pile has enabled it to finance dividends. But with liabilities continuing to tick higher — net debt rose 5% last year to £21.2bn — questions abound over how sustainable such a strategy is.

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Royston does not own shares in National Grid.