National Grid

Moat: 3/5

Understandability: 2/5

Balance Sheet Health: 3/5

National Grid plc operates a regulated electricity and gas transmission network, primarily in the UK and the Northeast US, facilitating the reliable delivery of energy to millions of customers.

Investor Relations Previous Earnings Calls

The moat, understandability, and balance sheet health scores reflect a conservative evaluation to ensure a margin of safety in any assessment.

National Grid’s business is essential for energy distribution, but understanding its regulatory framework and complex financials requires a nuanced perspective.

Business Overview

National Grid’s operations can be broadly categorized into:

  1. UK Electricity Transmission: Owning and operating the high-voltage electricity transmission network in England and Wales, connecting power generators to local distribution networks.

  2. UK Gas Transmission: Owning and operating the high-pressure gas transmission network in the UK.

  3. US Regulated Businesses: These include:

    • New England: Operating electricity and gas distribution networks, primarily serving Massachusetts, Rhode Island, and other nearby states.
    • New York: Operating electricity and gas transmission and distribution networks in New York State, including a portion of Brooklyn and Long Island.

National Grid’s revenue is primarily earned from the regulated transmission and distribution of electricity and natural gas. These are essentially “regulated” monopolies where their returns are set by regulatory bodies. Revenues are mainly derived from:

  • Transportation and Distribution Tariffs: These are charged to energy suppliers, reflecting the value of using the energy delivery networks, which are influenced by factors such as the number of connections, energy demand, regulatory changes, and the infrastructure utilized.
  • Interconnection Revenue: Comes from connection with other distribution providers and utilities, and often has high barriers to entry and strong pricing power.

A crucial part of the business is capital expenditure, needed for maintenance and investments, including green-energy projects.

Industry and Competitive Landscape

The energy transmission and distribution industry is characterized by several key trends:

  • Increased Integration of Renewable Energy: A global push for carbon emission reduction and clean energy generation is causing an influx of renewable energy sources on the electric grid.
  • Modernization of Infrastructure: As infrastructure ages, there’s an increasing need for modernization and digitalization.
  • Evolving Regulations and Rate Structures: Changing customer needs and government policies often impact the way businesses like NGG get paid and can affect their finances.
  • Geopolitical Instability: Russia-Ukraine war and other geopolitical issues have exacerbated energy supply concerns and also heightened inflation and prices, as we saw in 2022.

The industry structure itself can be considered a natural monopoly, since the duplication of assets would be very expensive and the network benefits from large-scale operation. However, it faces a lot of regulatory scrutiny, particularly when it comes to returns. Competitors in the space can be private as well as public companies. The nature of competition is based on several factors including:

  • Pricing strategy and efficiency.
  • Ability to get approval for new projects.
  • Strong capital structure and access to financing.
  • Government and regulatory support and relations.

Overall, the main differentiation is based on the regulatory landscape, which can be very different from region to region, making it hard to compare players and making companies that operate in these markets less attractive for investors.

Financials

National Grid’s financials are complex and require a deep understanding of their regulated operations.

  • Revenues: NGG’s revenue is determined by regulated rates, which means revenues are often quite steady. In the first half of fiscal year 2023/24, total revenues decreased by 10% to 10.27 billion pounds from 11.38 billion pounds. However, underlying revenue excluding pass-throughs grew by 8.4% thanks to inflation. This indicates that their profitability is directly correlated with their regulatory returns.

  • Profitability: The operating profit for the first half was 2.17 billion pounds, as compared to 1.85 billion pounds for the same period in 2022, due to a higher revenue that offset an increase in operating costs. The net income for the period jumped to 1.1 billion pounds, compared to a loss of 713 million pounds in 2022, primarily thanks to an increase in operating profits, and reduced expenses.

  • Cash flows: NGG’s cash flows from operating activities are largely dependent on regulated revenue and operating expenses. In the first half of the 2023/24 fiscal year, cash from operating activities was 2.27 billion pounds, while investments in property, plant, and equipment were 3.6 billion pounds. Negative free cash flow is common in the sector, particularly due to investment in assets and their maintenance.

  • Return on Invested Capital (ROIC): As per historical information, ROIC is somewhat below 10%. Due to different regulations in different countries, it is difficult to get comparable data with peers, and due to that, the company’s ROIC can’t be judged against peers. It’s important to see how this develops in future filings.

It is difficult to calculate ROIC, or any other ratios, using consolidated financial statements. Investors would have to refer to segment data to form a proper opinion.

  • Debt and Leverage: National Grid has high amounts of debt, 47.1 billion pounds, and a leverage ratio of roughly 60%. Debt is used to fund infrastructure upgrades and expansions, and a sizable portion of debt is denominated in US dollars (35.4 billion dollars). The company also has 16.4 billion pounds of lease liabilities, which could mean higher costs in rising interest rates. However, a substantial proportion of the debt is fixed rate debt, which means higher rates have a lower impact than usual. Management also has a clear approach to paying the debt down and to meet ratings requirements, which is a positive sign for investors.

Moat Analysis: 3 / 5

National Grid possesses a narrow economic moat, stemming primarily from:

  1. Regulatory Approvals: The high barriers to entry and the complex and time-consuming regulatory approval process creates a limited supply of players. Government oversight and permission are needed to expand or build more infrastructure, and this serves as a barrier to potential new entrants.
  2. Scale and Existing Infrastructure: Maintaining a vast, pre-existing transmission and distribution network requires lots of investment. Given the economies of scale that are achieved by using these vast networks, a new entrant will face difficulty setting up and reaching scale to compete with incumbents. That said, it also means there is no pricing power when competition has a similar cost structure and it is not a guarantee of a wide moat.

These factors create a situation where National Grid has a strong position within the energy delivery chain in its operating areas, but it is not always strong enough to increase its profits, since it is largely regulated.

Legitimate Moat Risks

Despite the existing moats, the following factors could erode National Grid’s competitive advantage and the profitability of its operations:

  1. Regulatory Changes: Changes in rate-setting methodologies, permitted returns, or regulatory oversight could significantly impact National Grid’s profitability, especially in the short to medium term.
  2. Technological Disruption: New energy technologies like batteries and energy storage may reduce the need for traditional transmission infrastructure. New power generation techniques also mean that the traditional way to generate energy could become obsolete, diminishing the network’s importance over time.
  3. Operational Risks: Natural disasters, severe weather, and system failures could lead to large expenses, reduce revenues, and increase debt due to repair work.
  4. Inflation and Interest Rates: Rising interest rates can increase the cost of borrowing and debt servicing. Higher inflation may also increase the cost of construction and other operating expenses and can reduce profit margins.
  5. Political and Governmental Pressure: Political factors, including elections and government policies, could lead to a change in regulatory and fiscal regime.

Business Resilience

National Grid exhibits moderate business resilience:

  1. Demand Stability: Demand for energy is fairly constant, even during economic downturns, meaning the company will likely continue to sell its products, although volumes and revenues might change.
  2. Geographic Diversification: While there is some concentration in the Northeast of the United States and England and Wales, NGG has a considerable geographic diversification which would likely prevent a full blown collapse of the business.
  3. Regulatory Backstop: As a regulated business, NGG is protected by the regulators to a large degree, who allow reasonable returns on investment in infrastructure, as long as service requirements are being met.
  4. Long-Term Contracts: NGG’s profits are largely protected by long-term contracts with clients.

Understandability: 2 / 5

While the basic concept of energy distribution is easy to grasp, the following makes NGG’s financials difficult to follow:

  1. Complex regulatory environment: Understanding the impact of different regulations for different businesses across various geographical locations is a difficult undertaking.
  2. Accounting adjustments: Frequent special accounting adjustments make it difficult to understand what the actual profits and cash flows of the company are.
  3. Numerous Disclosures: The disclosures from the company are voluminous and may take some considerable effort to thoroughly read and comprehend.

Balance Sheet Health: 3 / 5

National Grid’s balance sheet reflects its capital-intensive nature and its need for constant investment in its assets, but it also makes it somewhat unstable. Here’s a breakdown:

  1. High Debt Levels: The debt-to-equity ratio is above what is considered good for even capital-intensive companies, and can be a concern given interest rate fluctuations and high debt obligations.
  2. Long-term assets: The company has a substantial amount of property, plant, and equipment, which are valuable assets but cannot be sold off quickly in times of trouble.
  3. Unstable Cash Flows: Even though revenue is steady, the amount of required capital investment can make cash flow less predictable. However, management has laid down a detailed financial plan to improve the cash position of the company over time.
  4. Lease Obligations : 16.4 billion pounds is a considerable number, that could add to the risk the company has.

These factors all add up to the fact that the company is less financially sound than other companies that have minimal debt and strong asset positions.

Recent Concerns & Management Commentary

  1. Debt Levels: As we’ve said, the high debt levels can be a point of concern, though management has a clear plan to tackle this, as they stated in their latest earning call, “As we navigate this period of elevated interest rates, our priority is to continue to reduce debt levels across the business”.
  2. Inflation : As with other businesses across the world, NGG has faced inflationary pressures on its operations. However, they have been able to offset these challenges by increasing their revenue and keeping the underlying economics consistent.
  3. Geopolitical risk: The ongoing war in Ukraine and the resulting volatility has created concerns over energy supplies. Though it has had an insignificant impact on the company so far, it’s an aspect that needs to be closely monitored.

Despite these issues, management was very clear in stating the fundamentals of the business are strong and they are confident in improving their performance over time.