National Grid, the UK listed group which owns and operates natural gas and electrical grid assets in the UK and the US, announced earlier this month its intention to sell a majority stake in its UK natural gas distribution business by early 2017. A substantial amount of net proceeds will be returned to shareholders in the form, most likely, of a one-off dividend or some form of share buy back scheme.
This has very big implications and comes in the wake of the New Direction for UK Energy Policy speech from UK energy minister Amber Rudd on the 18 November, in which she stated that “Gas is central to our energy secure future.” It begs the question if gas is so central to UK energy policy why is the UK grid operator National Grid selling its gas grid?
The main reason is that it is an opportune time to sell. Whilst utility stock prices have been crushed in recent years the share prices of regulated assets as well as the prices that investors are willing to pay for such assets are close to all time highs. The simple fact is that investors want cash yield and that is what they get when they buy regulated assets and that it why National Grid itself is currently trading at a 40% premium to its regulatory asset base (RAB). Institutional investors are happy to achieve 6-7% post tax returns which would seem to imply that the value of the National Grid gas distribution business could be over £6.5bn and more importantly over the 40% premium to RAB that National Grid currently trades at. In a nutshell, National Grid has taken the opportunity to capitalize value at the top of the valuation cycle which is probably a good decision if you are a shareholder. It also tells you that management expect the valuation of grid assets to come down (otherwise you would not sell them).
Why could valuations come down?
- Interest rates are expected to rise across the world over the next years. Such increases will lower the yield attraction of regulated assets and most likely the valuations of such assets.
- The gas grid becomes less financially attractive. National Grid generated a return of equity on its UK gas distribution assets of 12.9% last year with 13% the year prior to that. Are these high levels really sustainable especially when other institutional investors are willing to accept 6-7%? Will the UK regulator going to allow this type of return to continue?
- The other issue is the importance of the gas grid. If it decreases in importance and gas usage falls (because of other substitutes particularly on the heating side) then returns will come under pressure. And once this trends begins buyers for assets which they will own for 20 years or more will begin to discount these changes implying lower valuations.
With these risks in mind the decision to sell seems to a wise one but it will be interesting to see how investors react to the above risks. The other interesting point is the repercussions of National Grid’s decision to give the bulk of the proceeds back to shareholders. What this tells us is that there are not many growth possibilities out there for National Grid who has been very aggressive on the M&A front over the last years. Grid assets do not come to the market very often and when they do the best buyers tend to be not other grid companies but instead institutional investors such as the Canadian fund Borealis Infrastructure Management which, for instance, recently bought Fortum’s Swedish electricity distribution business. Begs a bigger question; why we are paying the utility owners of regulated assets higher returns than what other parties in the market would be willing to accept?