By Vitaliy Katsenelson, CFA
If you need words to describe National Grid, “stable,” “predictable,” and “unexciting” spring to mind. Reading its financials stirs so little excitement that if you can’t sleep, you might want to leave a copy of its 20-F (a 10-K equivalent filed by ADRs) on the nightstand. In the competition for boredom, in fact, National Grid is likely to place second only to Service Corp. — yes, the funeral home company. Even so, its stock definitely deserves to make up a core holding of your portfolio — though at a lower price than what it now sports.
National Grid runs tollbooth-like businesses — it collects money for allowing gas and electricity to travel along its vast network of power lines and pipelines. To make things even better, the company is the only game in town — at least in the United Kingdom, where it is a legal monopoly. And that’s the very best kind. It’s the only operator of electricity transmission in Great Britain and owns four of the eight largest gas-distribution networks in the U.K., having sold the other four in 2005.
A powerhouse in the U.K.The gas-distribution business in the U.K. is a bit different from the American system, in that National Grid doesn’t bill end consumers. Instead, it bills gas shippers (which are unrelated to National Grid) that have contracts with gas suppliers. The gas suppliers, in turn, bill the consumers. Also different is that the prices National Grid charges gas shippers for using its distribution network are regulated by Ofgem (the U.K.’s utility-regulating body) and not by competitive pressures. But even though the company does not have to take on any consumer credit risk, it does face a very remote risk of a shipper default. Fortunately, a lot of things have to go wrong for that to happen.
In the electricity transmission business, it doesn’t own the electricity-distribution networks to the end customer, though the segment is the company’s largest source of profitability.
What’s more, the gas and electricity businesses are highly regulated. The company is allowed to receive a 6.25% pre-tax real return, after inflation, on regulated asset value. That’s a low rate. However, combined with 55% debt financing, it results in a 9.8% return on equity, after tax. Though I usually like to see a higher return on equity from the companies in my portfolio, this is adequate when you consider the incredibly low-risk nature of this business.
Stable cash flowsThe beauty of transmission and distribution businesses like this is that their cash flows are insensitive to the volatile price swings in the commodities they transport. If revenues fall short of the projections because of a decline in demand, National Grid is allowed to recoup the shortfall via price increases the following year.
The transmission business, though, is not a high-growth sector by any stretch of the imagination. Its growth is tied mostly to inflation and to growth in the gross domestic product. There is, however, a unique opportunity knocking on the growth door for the electricity transmission segment in the U.K.: the replacement of aged power lines. The majority of Great Britain’s power line infrastructure was built in the 1950s and 1960s and is in the very late stages of its useful life. That creates a growth opportunity for National Grid, as capital outlays to replace it will double next year, thus increasing its billable asset base and stimulating bottom-line growth.
National Grid’s future growth will also be spiced up by its wireless and broadcast TV transmission businesses in the U.K. With the demand for wireless towers growing at a very fast clip, and with more equipment being added to existing towers, these businesses should generate double-digit profits for National Grid and make incremental sales extremely profitable. National Grid has only an 11% share of this market, however, and the opportunity for profit will depend on the wireless companies’ willingness to part with their towers — they currently own approximately 80% of the nation’s towers.
The company’s management, meanwhile, has done a terrific job of cutting its costs in the U.K. That was especially evident in National Grid’s first-half 2005 numbers: Operating profit in the U.K. gas distribution business was up 21%, with costs declining 4% since March 2005. Cost-cutting should continue into 2007, but the bulk of it is already behind the company.
It makes sense, then, that the electricity-transmission business is not a primary political target. According to Ofgem, transmission charges account for only 3% of consumers’ final bills, and that makes it very hard for politicians to score points by pointing fingers at the likes of National Grid. From a diversification standpoint, the company generates about one-third of its revenue from its gas and power transmission and distribution businesses in the northeastern United States, where it enjoys regulated-monopoly status.
As for the U.K. gas business, National Grid is taking steps to prepare itself as the nation turns into a net importer of natural gas. It’s expanding its network to connect to new suppliers, and it has built a new liquefied-natural-gas (LNG) importation facility that should generate returns above regulatory set limits — providing yet another source of incremental asset growth.
QVGLet’s look at National Grid’s stock from a “QVG” perspective — quality, value, and growth. First of all, this company is not shy about using debt, which now stands at about 58% of total assets — a normal level for a very capital-intensive, regulated industry with a low return on assets.
Furthermore, National Grid is a monopoly. Frankly, I wish every company in my portfolio was a monopoly. By definition, monopolies have a very strong moat around their business, and that guarantees continuity of cash flows. As a regulated monopoly, though, National Grid will not have Microsoft-like profit margins, nor will it generate Google-like growth. But it should maintain its very stable 10%-11% net margins and deliver sustainable and predictable growth in earnings per share. Standard & Poor’s has provided its own stamp of approval on the company’s debt with an “A” credit rating.
Mid-single-digit growth in earnings should come from revenue growth and cost-cutting. Even without going after new projects, National Grid is capable of growing earnings at 2%-3% a year as a function of U.S. and U.K. economic growth. Investments in new assets such as the LNG facility, modernization of power lines in U.K., and margin improvements from cost-cutting should spice up earnings growth further by a couple of percentage points.
Thus, without taking a lot of risk, this company can deliver a very predictable 5%-7% EPS growth depending on the progress of cost-cutting and asset growth. Any growth coming from the wireless and TV transmission business would be icing on the growth cake. Combining 5%-7% EPS growth with a 4.6% dividend yield results in roughly a 9%-11% total return. That doesn’t sound boring to me!
And it gets betterThe company has also stated that it will grow its dividend 7% per year over next three years. National Grid comes with a hidden bonus, too: The stock works as a great hedge against a declining dollar. With the dividend paid in pounds and converted into U.S. dollars, it becomes even more valuable to U.S. investors if the dollar declines — a bet I am willing to make in the current environment. (An appreciating dollar, of course, would have the opposite effect.) In addition, a high dividend yield creates a solid support for this stock, as it is a big attraction for income-hungry investors.
ValuationShares are trading at 14 times March 2006 projected earnings — which is basically a slight discount to its U.S. counterparts such as Exelon, NStar, and Consolidated Edison.
There is one weak link in this story, however. The stock has little, if any, margin of safety. Though I don’t foresee investors losing a bundle in these shares, the lack of margin of safety (discount to fair value) in its price-to-earnings ratio is a concern. Since this stock won’t punch anyone’s lights out, even with its healthy dividends and modest earnings growth, buying in at the right price is important.
This is where discipline comes in. An investor must be able to differentiate between a good company and a good stock — two often confused but different ideas. National Grid is a good company — no question about it. But the stock is fully valued at the current price. I’ll therefore put National Grid on my watch list, and if its stock revisits the $42-$43 (12 times earnings) level, I’ll be buying it with both hands.