Argus Analyst Upgrades National Grid

12/12/2016 9:00 am EST

Focus: FUNDS

John Eade

Chairman and CEO, Argus Research Group

We have been looking for a favorable entry point to raise our rating on this UK-based electric utility, explains analyst John Eade of Argus Research.

We are raising our rating on National Grid plc (NGG) -- an international electric and natural gas delivery company -- to BUY from HOLD.

In the U.K, NGG owns and operates the electricity transmission network in England and Wales, as well as a natural gas transmission network and four gas distribution networks.

National Grid also has electricity and gas distribution operations in the Northeastern U.S., as it has acquired Keyspan, New England Electric System, Eastern Utilities Associates and Niagara Mohawk.

The company now earns nearly a third of profits from the U.S., where growth is likely to be faster than in the U.K.

The shares have underperformed over the past quarter, falling 16.7%. Earnings and dividend estimates in U.S. dollars are coming down as the pound deteriorates, and continued weakness in GPB is a risk.

In general, we prefer to avoid the utility industry during periods of rising interest rates, for two reasons.

First, utilities are heavily debt-financed, and their interest costs are likely to rise. Second, investors seeking income often migrate away from utilities and toward bonds as fixed-income rates move higher.

That said, in our view, National Grid’s underlying business fundamentals remain strong. National Grid’s operations are 90% regulated, which provides a high level of earnings visibility.

The company is benefiting from investments in its UK network and from a favorable regulatory environment, which should enable it to earn returns well above its cost of capital.

In the U.S., National Grid’s business is poised to recover, driven by rate increases, cost-savings programs, and new capital projects. The balance sheet appears solid and able to support the dividend, which yields about 3.5%.

On valuation, NGG trades at 13.7-times our FY17 EPS estimate, toward the low end of the five-year historical average range of 11.7-17.0 and below the peer average of 16.5 for current- year P/E.

The current yield, based on our FY17 dividend estimate, is 3.5%, which is also below the peer average of 4.0%, but gives a premium valuation signal.

Using a dividend discount model, we arrive at a fair value for NGG in the mid-$60s per ADR, about 15% above current levels. Blending our approaches, we have set a target price of $62.

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By John Eade of Argus Research

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