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The Moat
In Britain, they deliver gas and electricity across the entire country. In fact, it is the sole transmission and distribution network operator in England and Wales. It also owns the high pressure gas transmission network in Britain. They deliver gas to about 11 million consumers in Britain. In addition, NGG has electricity transmission systems in the northeastern US with approximately 3.3 million customers and delivers gas in upstate New York to approximately 565,000 customers.This is a company with unparalleled moat. To compete with them, one needs to put another set of lines and pipes, which is prohibitively expensive and hard to do.
Risk: Regulated Industry
The moat is not free. All of the company’s operations are subject to government regulations on both state and federal level. This guarantees the company a relatively steady income but it has no pricing power. When the cost of the managing the network rises, for example due to inflation, it has difficulty raising prices. To pass the prices to the customer, it needs to go through lengthy lobbying process to guarantee success.On a positive side, NGG operates in 20 different regulatory regions. A few governing bodies will not materially affect the profitability of the company.
Risk: Capital Expenditure
Looking at the cash flow and the income statement of the company, the picture is not great. The company generates around £3.3 billion in operating profit and earns around £1.2 billion from depreciation and amortization. The figure has been quite stable in the last three years at least. So, the company generates £4.5 billion every year.Where does it use the money? It spends £3 billion on purchase of PP&E, around £800 million in interest expense, and currently (in 2012) £1 billion in dividends. This adds up to £4.8 billion. The company is running a bit short on cash flow. Not surprisingly, the cash balance has decreased every year in the last three years.
The company funds the deficit by taking debt. In the last three years the company has taken £9 billion in loans and repaid £3.8 billion. The additional £5.2 billion has gone towards capital expenditure and dividend payments.
In the long term, I do not like this strategy. Given the stability of the business, this may work for a long time. The company will continue to break even and deliver increasing dividends. Do not expect it to ratchet up the dividend by a rate which is much higher than the inflation though. Also, an increase of say £10 billion in debt will only increase interest expense by £400 million. The company will easily be able to pay the additional interest expense.
Business Analysis
Shareholder Return
NGG is an ideal dividend paying stock. It has an insurmountable moat, stable pricing, and a very generous dividend policy. The company has been able to grow its dividend at a rate of 5% compounded since 2003, handily beating the inflation. The payout ratio has stayed around 60% on average.The shares outstanding of the company jumped during 2010. The reason was that the CEO felt that the company has too much debt and a boost to the equity in such uncertain times is not a bad idea. The end result is a near 500 million increase in the number of shares in the last 9 years. This has taken away nearly £3.5 billion from the shareholders, at the current price of £7 a pop.
In the meantime (2003 to 2011), the company has paid nearly £8.9 billion in dividends and has ratcheted up dividend at a compounded 7.7% rate from £0.21 in 2003 to £0.38 in 2011.
Ignoring the £3.5 billion dilution, the total money returned to the shareholders is only £8.9 billion, which is £2.24 per share. If you bought your shares in 2003, you paid something like £5 per share and now they sell for £7 (very close to their yearly high of £7.14). Adding the £2.24 returned to the shareholders, this is a compounded 8% return over the last 8 years. Not a very enticing figure but quite respectable.
Management
The chairman of the board is Sir Peter Gershon, who was appointed at the beginning of the year 2012. He is a member of the UK defence academy advisory board and HM government efficiency board. Apart from the public sector, he had also been chairman at Premier Farnell Plc and MD at Marconi Electronic Systems. He seems to be very well connected in the UK government and has experience in the private sector. His connection will benefit a company like National Grid quite a bit.The CEO of the company is Steve Holliday, who is on the job for the last 11 years. Much of his earlier career was spent in the oil and gas industry, especially at Exxon. As a CEO in 2010, he oversaw the rights issue in 2010 which was not popular with the shareholders. He has although maintained a very generous dividend payout to the shareholders.
The management pay is quite fair. At £6.7 million it is quite normal and furthermore no RSUs or options were awarded. The company treats its shares quite nicely.
Balance Sheet
The company has £20 billion in long term debt. The debt has been always high for NGG. Also, the interest expense is nearly £749 million. With £3.5 billion in operating profit, the interest cover is quite high at 4.67. This gives a lot of leeway to National Grid. It may need to take additional debt to upgrade its infrastructure and it is nice to know that they can service additional debt.Although the long term debt is six times operating profit and consequently very high, I feel that the stable business and predictable earnings make the debt load serviceable.
Valuation
The company is trading around its 52-week high price.The company is a dividend paying stock and has been able to jack up dividend at the rate of 7.7% in the last eight years.
Assuming a dividend growth rate of 3% and starting dividend in 2011 at £0.38, the current price of £7 assumes a discount of 8.5%. At a 10% discount the price will be £5.45.
I would suggest waiting until the stock drops and trades around the range.
About the author:
I started investing in December 2009and my first stock CreditSuisse (CS) tanked to almost half its
value. This nudged me to start learning about investing from the ground
up. I am a long term value investor and am planning to generate sustainable amount of money from investment income by the time I am 40 years old i.e., 2025.
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