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Is now a good time to buy shares in National Grid?

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Stocks in utilities companies tend to be relatively safe bets when the markets are in turmoil. So now might seem like a good time to buy shares in National Grid (LSE: NG). After all, its share price initially held up well as the FTSE 100 began to crash in late February. However, by late March it had declined by 24%. But given that the FTSE 100 fell by nearly 32%, National Grid shares did fare better, although perhaps not as well as some might have hoped.

National Grid owns and operates electricity and gas transmission and distribution infrastructure in the UK and US. Even with lockdowns in place, it reports that it has seen little impact on demand for its services, as expected. So, why did its share price fall so far?

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Buying for dividends

Well, there is a chance National Grid will see an increase in the time customers take to pay, with some debts becoming impossible to collect. But with £5bn in undrawn bank facilities, it should be able to cope with any near-term cash flow problems. Yes, the coronavirus outbreak is causing some operational uncertainty, but I don’t think it’s enough to justify National Grid’s shares losing a quarter of their value in the market crash.

A slew of dividend cancellations and cuts in the European utilities sector seems to be the cause of the share price looking steady initially, then joining in as the market crashed. National Grid investors likely hold the stock mainly for its dividends, so the concern is understandable, and I think justified.

National Grid announced in early April that final dividends for 2020 would reflect expected business performance. Such a statement could suggest a cut is coming without actually saying it. That could mean the near 5% dividend yield, a big part of the stock’s appeal, is at risk.

National gridlock

National Grid is heavily regulated everywhere it operates. There is a price to be paid to maintain a monopoly, with limits on the firm’s profitability and floors on its investment spending.

Utilities companies in the US and the UK are heavily regulated. Right now, the US regulatory environment is kinder to National Grid’s profits than the UK’s, so its shift to a bigger US focus seems fortuitous.

Around 60% of its revenues come from its US operations, up from approximately 45% five years ago. Massive investment in the US and the sale of UK gas distribution networks in 2016 have driven the change. 

However, new regulations in the UK could offset any gains from the shifting focus towards the US. A final decision is due before 2020 is out, but as it stands, National Grid’s cost of equity is above what OFGEM thinks its return on equity should be. This is negative for the stock price. Looking at forecasts for free cash flow, it could struggle to pay its dividends, let alone increase them above inflation, which is its current policy. It cannot easily increase free cash flow because of regulations. 

I think National Grid will take the opportunity to cut dividends in 2020. The share price will have to fall to make the yield attractive. Future dividend growth will be linked to inflation, which is forecast to be weak. So I will not be buying any more shares in National Grid today. I think they have further to fall.

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James J. McCombie 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.

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