At first glance, FTSE 100 stalwart National Grid (LSE: NG) looks like a great addition to any portfolio.
Shares in the company, which owns virtually all of the UK’s electricity transmission infrastructure, as well as an ever-growing portfolio of assets in the US, currently support a dividend yield of 5.7%, around two percentage points higher than the FTSE 100 average.
What’s more, City analysts are expecting the company’s reported earnings per share to grow steadily for the next two years, hitting 62p for 2020, up from 52p as reported for 2015.
However, storm clouds are brewing on the horizon for this defensive income champion. Due to growing regulatory headwinds, its future outlook is no longer as bright as it once was, which is causing investors to think twice before they invest. But should you follow suit?
Ignore the noise?
Personally, I believe that a lot of the concerns surrounding the company are overblown.
The most significant risk to National Grid’s future are the threats regarding nationalisation from the Labour party. While this is something to think about, in reality, nationalisation is not likely to happen until at least the next general election in 2022. And even then, I believe politicians are unlikely to wave such a move through parliament (especially considering the sums of money involved).
A more immediate risk to the company’s profitability is Ofgem’s efforts to curb its profits. The regulator has promised to cut the level of returns National Grid is allowed to make on its assets from 2021 and has been consulting on “baseline” cost of equity — the amount network companies pay their shareholders — of 3-5%. This is down from 6-7%, set when the current range of price controls came in during 2013.
If the regulator introduces a limit at the bottom end of the 3-5% range, National Grid would undoubtedly suffer. Last year, the company generated a return of 13.1% on assets.
Rather than waiting to be told what to do, National Grid’s management has taken action to reduce the firm’s reliance on the UK. Last year, the company increased its capital spending in the US by 15% to £2.4bn at constant currency while cutting spending on UK electricity transmission infrastructure by 3%, to just under £1bn.
The company’s overall capital investment budget for the year grew 14% to £4.3bn.
Growing in America
National Grid’s US business is now contributing more to the group than ever before. At actual exchange rates, underlying operating profit from the firm’s US-regulated businesses jumped 13% for fiscal 2018 to £1.7bn. Meanwhile, operating profit from the UK electricity transmission business declined 15%. As a result, National Grid now generates more than 52% of its income from regulated businesses in the US.
National Grid’s overseas expansion is the main reason why I believe that this company is set to continue producing steady returns for shareholders for many decades to come.
If the company continues to invest in its North American power network as it has been, even if Ofgem clamps down in 2021, the impact on earnings should be controlled.
A bigger market
What’s interesting is that when it comes to the level of returns regulators allow companies to generate from assets, the US is stricter than the UK at present.
According to National Grid’s 2018 full-year earnings release, the company is allowed to achieve a return on equity of 9.4% from its US assets in 2018, compared to 10.2% for the UK. That said, for fiscal 2018, the group only produced a return on equity of 8.9% for US-regulated assets, compared to 13.1% for electricity transmission assets in the UK.
However, there are limited opportunities for growth here in the UK, but in the US, National Grid only operates in three markets currently, Massachusetts, New York and Rhode Island.
So, I believe there’s still a huge market the group can grow into, which will lead to better returns for shareholders over the long term, even though the profit generated from assets will be smaller.
Overall, while there are some risks to National Grid’s business model on the horizon, its my view that the group’s actions to expand internationally should more than compensate for problems at home. With this being the case, I believe that the company remains an attractive defensive income investment today.
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Rupert Hargreaves owns shares in National Grid. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.