December 2, 2022
  • December 2, 2022

National Grid Stock: Solid utility, but limited upside (NYSE: NGG)

By on June 28, 2022 0

Alan Morris/iStock via Getty Images

The British utility National Grid plc (NYSE: NGG) is popular among income-oriented investors for its yield and perceived defensive qualities. I like the defensive nature of his business, but the dividend doesn’t seem safe for me, and I see limited price upside because of that, and the structural economics of the business.

Reasons to love National Grid

Looking back on Seeking Alpha over the past few years, a variety of writers have been either optimistic or neutral on the name. While I don’t mean to simplify their respective theses, the main themes that emerged in favor of the name were yield (e.g. National Grid Is The Clear Winner In The Dividend Bout Against Utility ConEd) and the potentially defensive qualities of the sector . (e.g. National Grid: a “constantly not stupid” purchase).

I think the big gap in National Grid’s infrastructure business continues to be very attractive. It owns and operates the high voltage electricity transmission system in England and Wales and the electricity system for all of Britain. It also owns a number of electricity distribution networks located in the United Kingdom. In addition, it operates the UK’s gas transmission network (although it announced in March that it plans to sell 60% of this business), which focuses more on electricity. I see this as positive for the investment case, as it reduces exposure to an area which, due to increasing environmental pressure, is likely to see fewer customers in the UK (GAS) and instead focuses on electricity, which in practical terms, at least, I think is here to stay on scale longer in the UK than gas as a power source.

This strong business moat is the foundation of an attractive business model that many investors love National Grid. However, when it comes to the dividend, I see stocks as less attractive than many investors think.

The dividend is not funded by current free cash flow

Currently, the dividend yield is 4.8%. For many investors, the long-term investment scenario has been about its defensive qualities supporting a dividend, and 4.8% looks like an attractive yield.

Looking ahead, however, is the dividend sustainable even at the current level, let alone the annual increase investors have grown accustomed to?

The past two years have been marked by significant net cash outflows. Last year, net cash outflow from continuing operations was £1.6bn after paying £0.9bn in dividends. The year before was even worse. In fact, the past few years show that the company has consistently had negative cash flow even before paying ordinary dividends, which only makes the situation worse.

2019

2020

2021

2022

Ordinary dividends (£m)

1160

892

1413

922

Net cash flow (£m)

-1682

-2074

-2921

-1617

Table compiled by the author based on data from companies’ annual reports

How does the company grow the dividend despite negative cash flow? A look at its net debt can explain it.

National network net debt (£m)

National network net debt (£m) (company annual reports)

Graph compiled by the author using data from company annual reports.

I don’t think that’s a pretty picture – net debt has doubled over the past decade. This in itself is not a problem, in the sense that with its critical infrastructure assets the company should be able to maintain its banking facilities and the cash flow should service the debt. But when it comes to the dividend, I feel less comfortable.

At the moment, I don’t see any particular trigger for National Grid to cut its dividend. This would hurt a key part of the investment case, which would likely drive the stock price down. Even during the pandemic, when other companies took the opportunity to push through a dividend suspension on the pretext of business uncertainty, National Grid stayed the course.

But in the long run, I think the economy will turn out. National Grid consistently sees large-scale negative cash flow and its net debt is growing. In a responsibly run business, at some point the answer to this combination of factors – if they persist – is cost reduction, and that may well include the dividend. So while I don’t see any particular reason for the company to cut its dividend anytime soon, I also don’t think the current economy can last forever.

NGG’s assessment is complete

Currently, National Grid has a market cap of $47 billion and trades on a price-earnings ratio of 17.

There are reasons to expect that it can continue to increase its revenues in the future, thanks to its monopolistic position in the distribution of energy in the United Kingdom. Capital expenditure requirements may continue to be demanding, however. But, for a company with that kind of moat, I don’t think a P/E of 17 is unreasonable. But I don’t think it’s cheap either: National Grid has a lot of debt and I consider its current dividend to be structurally unsustainable in the medium to long term, unless something fundamental changes the economy of the country. ‘company.

While a shift from investors to defensive ideas such as utilities may help support the stock price in the current environment, from a long-term fundamentals perspective, I see little to no change. ‘advantage.

So why am I in a “Sell” mentality rather than just being neutral? In short, I see limited or no capital gain opportunity and an attractive income opportunity that I believe may ultimately be unsustainable, which could hurt the stock price.