This Undervalued Utility Is Buying Back Its Shares at Good Prices

We are reaffirming our fair value estimates for

National Grid’s most recent regulatory filing suggests the company has repurchased about GBP 280 million, or about two thirds of its minimum plan for 2017. The company has an agreement to spend GBP 425 million on repurchases by the end of December, but management might ramp up its pace to meet its goal of returning all of the capital by the end of its March 2018 fiscal year.

We think National Grid has been able to repurchase shares at value-accretive prices, given the weakness in its stock price during the past two months. We estimate its average share-repurchase price is GBX 962 per share, an 8% discount to our fair value estimate. We assume the overall share-buyback plan is value-neutral, but it could be a slight positive to our fair value estimate if the average repurchase price remains below our fair value estimate.

National Grid also maintains an option to sell an additional 14% interest in its U.K. gas distribution business, leaving it with a 25% interest. A further sell-down at the same price as its initial divestiture would not have a material impact on our fair value estimate.

U.S. Investment Becoming More Attractive National Grid has grown into one of the largest utilities in the world since since U.K. regulators unbundled energy distribution, transmission, and supply in the 1980s. The company began acquiring Northeastern U.S. utilities in 2000 and made its biggest move buying New York-based Keyspan for $11.8 billion in August 2007.

National Grid earns about 30% of its profits from the United States, but that is rising as the dollar strengthens, U.S. regulation improves, and the company pursues large investment opportunities in the U.S. Selling a 61% stake in its U.K. gas distribution business in March 2017 will also help even the mix of U.S. and U.K. earnings. Even though U.K. regulation is more constructive, the U.S. is becoming more attractive for incremental investments.

National Grid’s long-term U.K. rate structures offer transparent earnings and dividend growth at least in line with inflation. The dividend grew 10% annually on average between 2005 and 2012, but dividend growth has slowed dramatically as financing needs required management to target inflation-linked growth.

National Grid must deliver on its eight-year U.K. investment plan. Management initially expected GBP 26 billion of investment but has cut that to the lower end of its revised GBP 16 billion-20 billion range because of slowing generation growth.

In the 2013-21 RIIO regulatory framework, National Grid can earn an average 4.4% real return on its transmission and distribution assets plus incentives that could add 300 basis points or more to its earned return on equity. National Grid consistently has earned those incentives, and we expect it will continue to do so during the RIIO rate cycle. The United Kingdom’s annual rate adjustments for inflation and interest costs also should help National Grid achieve consistent 10% nominal returns on equity.

In the U.S., National Grid must manage costs and improve its rate structures to reduce regulatory lag. It perpetually earns well below its U.S. system average 9.8% allowed return on equity. Management has said it plans to invest $2 billion annually in the U.S., a level that will require more constructive regulatory support to be accretive for shareholders.

Returns Mostly Exceed Costs of Capital Service territory monopolies and efficient-scale advantages are the primary moat sources for regulated utilities like National Grid. Regulators in the U.K. and Northeastern U.S. grant National Grid exclusive rights to charge customers rates that allow it to earn a fair return on and of the capital it invests to build, operate, and maintain its electricity and gas networks. In exchange for its service territory monopoly, regulators set returns at levels that aim to minimize customer costs while offering fair returns for capital providers.

This implicit contract between regulators and capital providers should, on balance, allow National Grid to earn at least its cost of capital, though observable returns might vary in the short run based on demand trends, investment cycles, operating costs, and access to financing. The risk of adverse regulatory decisions precludes regulated utilities from earning wide economic moat ratings. However, the threat of material value destruction is low, and normalized returns exceed costs of capital in most cases, leaving us comfortable assigning National Grid a narrow moat.

Thus far, National Grid has proved it can continue earning some of the best returns for any utility in the world within the U.K.’s RIIO regulatory scheme. In the U.S., National Grid has struggled to keep pace with its allowed returns and regularly earns 200-300 basis points less than its U.K. operations. It remains active in all of its U.S. jurisdictions to enact rate structures that boost earned returns and stabilize cash flows.

National Grid is improving its earned returns in the U.S. and maintaining premium earned returns in the U.K. We expect returns will ebb and flow across economic and interest rate cycles.

Longer term, National Grid’s moat should strengthen as U.K. and U.S. regulators pursue policies that reduce fossil fuel power plant emissions, promote renewable energy, and increase gas consumption. The U.K. Climate Change Act mandates a 34% cut in carbon emissions by 2020 from 1990 levels and an 80% cut by 2050. In addition, declining natural gas production from the North Sea is spurring U.K. policies aimed at weaning retail customers off gas and expanding liquefied natural gas import capabilities, necessitating a shift in the gas transmission infrastructure.

In the U.S., all of the states in which National Grid operates have aggressive renewable portfolio standards that must be met in the next decade. The influx of cheap shale gas into the Northeast is reshaping infrastructure needs to meet retail demand, and National Grid is well positioned to benefit from that demand.

Uncertainty Is Low Regulatory risk is the primary factor in our low fair value uncertainty rating. Regulators seek to keep customer bills low, while the company tries to increase profits. Investor returns depend on the rates regulators set. In the U.K., regulators prefer incentive-based rates that require certain investments and efficiency standards. Current U.K. regulation also allows for annual inflation adjustment, protecting National Grid from falling earned returns as costs rise. The current U.K. regulatory framework is in place at least through 2021.

U.S. regulators typically offer no inflation protection or rate incentives, subjecting the utilities to risks from inflation and rising interest rates. In addition, regulators could punish the company if costs--and, thus, rates--rise too fast. New York regulators have been tough on National Grid’s utilities, but there are some attractive growth opportunities. This demonstrates the uncertainty of utility regulation. Some of those plans are coming up for renewal.

National Grid’s aggressive investment plan during the next decade should not change its solid credit profile, given the favorable regulation in place, particularly in the United Kingdom. We expect it will be able to fund the rest of its capital spending program with cash from operations, new debt, and only minimal market equity issuance. It introduced a scrip dividend in 2013 but plans to repurchase shares in line with the take-up, which we expect to average about GBP 350 million.