NGG - National Grid: Grid Investments Could Power Growth

2023-11-13 18:49:07 ET

Summary

• National Grid benefits from more EV adoption in the future.
• In terms of grid investments, National Grid expects capital investments of £42 billion from FY2022-2026, up from the previous £40 billion.
• National Grid's stock has faced headwinds given the higher U.S. Treasury yields, but currently trades for a fairly attractive estimated 2025 forward P/E valuation.

National Grid plc ( NGG ) is a leading utility in the United Kingdom and also in Northeastern United States.

As a regulated utility, the company earns a specified rate of return on its rate base according to regulators. As such, National Grid benefits from increased grid investment and preparation for more EVs, which will increase demand for electricity from the grid.

In terms of grid investments, National Grid expects capital investments of £42 billion from FY2022-2026, up from the previous £40 billion as the company is increasing investment in the decarbonization of energy systems.

With the capital investments, the company expects to grow underlying EPS of 6-8% CAGR. With the planned increased grid investments, a fairly attractive fiscal period ending March 2025 estimated PE of 13.45x as of November 12, and the potential for increased valuation if U.S. Treasury yields normalize in the medium term, there is reason to be bullish on National Grid.

Electrical Vehicles

One reason to be bullish on National Grid is that it benefits from the increasing adoption of electrical vehicles or EVs.

Although new EVs will not put too much stress on the grid in the United States or the United Kingdom this decade, they will help demand growth in the 2030s and they also represent an opportunity for investment for utilities in the medium term.

In terms of the future, EV fleets will help stabilize the grid by providing storage solutions from vehicle-to-grid technology that are still largely in developing stages currently. Grids need battery storage given they are increasingly using renewable energy that can fluctuate substantially in terms of their power generation.

According to one estimate ,

" EV batteries could meet short-term grid storage demand by as early as 2030 if we assume lower storage requirements from the literature and higher levels of participation and utilisation. By 2040-2050 storage demands are met across almost all scenarios and even low participation and utilisation rates. "

Although it has a lot of potential, vehicle-to-grid needs a lot of technology such as charging stations with special software. Currently most vehicles and charging stations are unidirectional so it will take significant investment for bidirectional EV charging infrastructure.

So more EVs sold could translate to needed capital investments that increase the rate base for the grid and profits for a regulated utility company like National Grid which has a portfolio that is around 70% electricity and 30% gas.

Geographically, National Grid has significant operations both in the Northeastern United States and also the United Kingdom that will require more grid investment in the future.

First Half 2023/2024 Results

In the first half of National Grid's 2023/2024 year, underlying operating profit fell 14% year over year to £1.796 billion with the decrease mainly due to one-time items such as St. William property sales in the first half of the prior year. Factoring those into the comparables, underlying operating profit results were in line with management expectations. Underlying EPS was 23.9p, down 27% year over year, with the decrease mostly due to one-time items.

In terms of its capital program, regulated capital investment in the period increased 10% year over year to £3.529 billion. Management also increased the dividend 8.7% year over year.

In terms of guidance, management reaffirmed that they expect underlying EPS for FY2024 to be modestly lower than the 69.7p it had in FY2023 given the effect of capital allowances this fiscal year.

According to National Grid, the company's ADRs, or American Depositary Receipts, represent 5 ordinary shares and are traded on the NYSE Stock Market under the "NGG" symbol. So in FY2023, NGG had underlying earnings of £3.485 per share or $4.26 per share under current exchange rates. In terms of estimates, analysts are expecting $4.14 per share for the fiscal period ending March 2024.

In terms of FY2022-2026, however, management continues to see growth as they expect a capital investment of £42bn, group asset growth of 8-10% CAGR, and underlying EPS of 6-8% CAGR.

In terms of its balance sheet, National Grid has a net debt of £43.9 billion at the end of its half year 2023/2024, up slightly from £41 billion at the end of its fiscal year 2023 as the company funds a lot of its capex with debt. According to S&P, National Grid's debt rating is " BBB/A2 " which is considered investment grade.

Risks

Global warming could worsen weather events such as wildfires and flooding that disrupt National Grid's operations.

If the British pound depreciates versus the U.S. dollar, the company's British operations will be less profitable in terms of U.S. dollars.

If Treasury yields rise further, National Grid's valuation could face more headwinds.

Regulators might not allow National Grid to earn as much from its rate base as the market expects.

U.S. Treasury Yields

In the near term, National Grid stock is affected by where U.S. Treasury yields are.

Given inflation, U.S. interest rates have increased substantially in the past few years. U.S. Treasury yields have also increased in the past year and half with one key factor being the expectation for higher interest rates for potentially longer.

With higher U.S. Treasury yields, many investors are less interested in dividend stocks and that's likely been a headwind for National Grid's valuation and its stock which currently has a dividend yield of 5.54% as of November 12.

In terms of its valuation, the company currently trades for a forward PE of 14.74 as of November 12, which is generally near the lower end of the recent range with the exception of late 2022.

In the middle of 2022, UK energy regulator Ofgem proposed reducing the return on equity allowances for British electricity distribution companies to 4.75% for 2023-2028 from 6%-6.4% for the current 5-year period.

Ofgem on November 30, 2022, ultimately decided on a UK Power network rate cost of equity allowance of 5.23% . So while it is still lower than the cost of equity allowance of the previous 5-year period, it is better than the past proposal. With the expected capital expenditure increases in the coming years, it allows National Grid to continue to increase its earnings per share.

While I don't know where U.S. Treasury yields will go in the near term, I think U.S. Treasury yields will go lower in the medium term, however, as eventually inflation decreases.

If yields go down, I think the valuation of National Grid will benefit.

With the rate base increases given grid modernization, the eventual normalization of U.S. Treasury yields, and also the fair valuation of the company, I think the stock is a buy with an 'equal weight' in a diversified portfolio.

In terms of annual EPS estimate, analysts estimate National Grid will earn $4.14 per share for the fiscal period ending March 2024, and $4.53 per share for the fiscal period ending March 2025.

In terms of valuation, National Grid PLC, would trade for a forward PE ratio of 13.45 for the fiscal period ending March 2025.

I think as interest rates begin to normalize in the medium term, the stock could have a higher valuation of at least 15x for that period.

Given the expected grid investments in the future, I think National Grid will meet or beat its annual EPS estimate for the fiscal period ending March 2025, and a 15x valuation will give a price target of at least $67.95 by 2025. With its annual dividend of around $3.38, that would give a total return of around 22.5% by this time in 2025.

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