National Grid's transmission lines and pipes deliver a safe and steady trans-Atlantic income stream, according to Morningstar analyst Travis Miller and Morningstar DividendInvestor editor Josh Peters.
With its purchase of New York-based Keyspan in August 2007, National Grid (NYSE: NGG; LSE: NG) became one of the world’s 15 largest utilities by revenue and reaffirmed its ability to woo regulators on both sides of the Atlantic. Despite heavy regulation that can constrain profits, (it) continues to create shareholder value.
National Grid holds an enviable position between energy suppliers and consumers in both the United Kingdom and the northeastern United States. It achieved its dominant position in the UK during the government’s unbundling of energy generation, transmission, and distribution assets in the 1980s. It now owns or operates nearly every power wire and natural gas pipe in the UK and serves 11 million customers through England’s largest natural gas distribution network.
In 2000, National Grid entered the northeastern US and now gets about half of its revenue from the region.
National Grid operates in 20 different regulatory regimes, which diversifies regulatory risk, but requires substantial negotiating effort.
The UK’s five-year rate cycles remain the key earnings drivers. Transmission rates, which expire in 2012, allow National Grid to earn a real return of 4.4% per year after tax on its asset base. Gas distribution regulation, which expires in 2013, allows a 4.3% real return after tax on its asset base. Because gas rates were negotiated during late 2007 when interest rates were falling, they are lower than those for transmission. However, National Grid has matched or hedged most of its debt based on its regulated allowed returns, so earnings are mostly protected from interest rate volatility.
In the US, federal regulators set transmission rates and state regulators set distribution rates based on allowed returns on equity, which currently average about 11% across National Grid’s US operations. The firm has also been able to negotiate rate mechanisms that allow profits to benefit from cost efficiencies and avoid commodity cost exposure. The firm has proved adept at avoiding rate cases and preserving favorable terms, resulting in excess returns for shareholders.
National Grid funds itself primarily with debt, which is roughly 70% of its regulatory asset value, but the stability of transmission and distribution cash flows makes this feasible. So, too, is the dividend, at 70% of earnings, at a proper and sustainable level, in our view.
Recent regulatory rulings on both sides of the Atlantic include investment mandates that could grow the company’s asset base 30% by 2012. With reasonable regulated returns on this spending and dilutive new share issues unlikely, we think dividend payments can rise 5%-6% per year. National Grid’s three-year goal of 8% annual growth may be within reach as well.
We estimate total returns in the 11%-12% range. [At Tuesday's New York closing price of $47.43, National Grid had a forward dividend yield of 7.4%—Editor.]
