In The Pursuit Of Dividends: National Grid

Jan.30.14 | About: National Grid (NGG)

In this article we travel "across the pond" and examine National Grid (NYSE:NGG).

Trading international stocks is not for the fainthearted, even though in the case of National Grid, I trade the American Depository Receipts (ADRs) and not the actual Stock [LSE:NG].

Once you consider a non-US dollar denominated stock, whether through an ADR or directly, then you are automatically introducing currency exchange risk into your investment. In essence, you have become an implied FX-trader. This is why I normally choose companies that have significant operations in the USA. This presents for me some sort of a currency hedge. Otherwise, a company that is flourishing in its home country might cause you some serious capital loss due to that country's currency dropping against the USD. Of course, the other direction is also possible.

The other risk is that of culture. In essence, in many countries a club-like or a family board of directors is something that is desirable. The very thing I screen board of directors CVs for with "avoid" in mind, is what may be considered a template of successful business in other countries. This is why I choose UK-based companies, as the corporate and financial culture is close to the USA, and hence I can apply similar metrics to what I am used to in measuring such companies.

The NGG ADR's, per BNY Mellon as the listing bank, have a 1:5 conversion. That is, one share of the ADR represents 5 underlying shares of the London-listed shares .

NGG, at the time of writing, is a $48 billion company, with a trailing PE of 12.4, and a dividend yield of around 4.86%. Note that most services misrepresent NGG's dividends-- both yield and payout. This is because NGG has two semi-annual dividend payouts with different values. These are normally paid at mid-year and end-of-year. If you check the dividends history, you will not discern a growth pattern, but you can definitely note that no dividends payout was missed, including around the Financial Crisis.

The company does not have an Altria (NYSE:MO) - like dividends commitment, nor an Annaly (NYSE:NLY) - like legal mandate, but NGG has stated that it will grow its dividends payout in line with (RPI) inflation. In essence, think of its dividends as an "inflation adjusted" bond payout.

From a historic perspective, NGG is still "young," compared to some of the other companies we discussed in this series. The company was formed in 1990, and entrusted with transmission assets of the British Central Electricity Generating Board. The company has since expanded into Gas, Generation, and abroad, and now generates almost 2/5ths of its income from its USA-based assets -- mainly in the North East.

Since NGG is the first utility we discuss in this series, it is worthwhile to digress into the electrical utility business. In essence, this is a funny business, in which private companies, like NGG, are still conducting significant business that is regulated by the government and in return are guaranteed a certain rate of return on "deployed assets" in their regulated business. The assets are usually either generation facilities or transmission lines and equipment. Transmission can be either long-haul or (urban) end-customer distribution.

As such, it is extremely hard for such portion of the business to lose money, except due to Force Majeur or, alternatively, gross mismanagement and malice (Enron comes to mind). After all, they are guaranteed the customers and the business through generation, transmission and distribution rights. And they are guaranteed a minimum profit margin. What better business model do you need?

Yet, this is a very capital intensive business. Assets costs are in the billions of dollars, and extreme reliability is required. Further, deregulation of some aspects of the business -- for the lack of a better word -- has created the need to compete and to participate in capital markets created solely for energy trading (Enron's legacy worldwide). Hence, these energy companies now have to perform non-traditional business, and be very good about it.

NGG's Board of Directors strikes me as a typical -- whether it is true or not -- "government appointed" board. This is not to take anything from the notable CV's that the members have. After all, it is run by an engineer as the chairman, and seems quite adherent to the UK governance standards. Mind you, my earlier statement about my preference for an activist board that knows the core business cannot be satisfied more than in this board, as there are as many engineers on the board as you would expect in the management of a pure Engineering company! The rest are ex-regulators and financiers.

I just would feel sorry for the executive management, which by the way mirrors the board, for having such strict oversight, as this board may have tilted "overboard" when it comes to being competent. As an investor, this may actually be as much governance and oversight as you can hope for!

Because of the Foreign registrant status, the SEC reports are not of much help. As such, you may as well go to the company-listed filings. In particular, the last annual report, is something that you need to examine, and it is the one we will refer to in the following discussion.

If you are serious about your investment in NGG, you have to get used to reading the foreign-styled reports. For instance, there is no breakup of the listing of executive compensation here, which is listed as lump sum (page 109). The total compensation amount for the team -- GBP 16 million -- sounds meager in US standards for a company this size.

Page 7 is a must read and it explains why I use this utility in my trading set in lieu of other US utilities. There it is listed that, with improvement, return on equity in the USA was 9.2%, while that in the UK was 13.6%! In the utility business, a 10% return would be considered very respectable!

The main concerns start with the "other" section (page 25), which seems to have violently sprung into a loss -- no explanation is discernible. You will also need to examine pages 53 and 54, as it is clear that the net debt has increased by about GBP 2 billion, though not as much as the increase of borrowing -- about GBP 5 billion -- would have suggested. Yet, there was a drop in operating cash flows between 2012 and 2013.

Here, it is understandable that if you have a business like this NGG's, which generates in excess of 10% return on equity, then borrowing at the current depressed interest rate levels is very rewarding, and that seems to be what is going on. Effectively, the margin between the Cost of Funds (COF) and your operating margin works well in your favor.

Given the type of governance and regulation that this company undergoes on both sides of the Atlantic, it is no surprise that examining the finances as listed in the annual report does not seem to reveal any deep points of concern beyond what we discussed above.

As for prospects, the company itself has done a good job in the above report in discussing the issues (pages 10 and 11). You see, similar to our discussion relating to telecoms in my article about AT&T (NYSE:T), most utilities -- and in particular communications and electrical -- are subject to similar challenges.

On the one hand, a utility is a consumer oriented entity. Hence, the macroeconomic fortunes of the general public play prominently in the fortunes of the utility. Further, these are highly-regulated businesses, and hence regulatory risks and "government greed" -- read it fees and taxation -- play a major role. Finally, infrastructure technology is a continual overhang over these companies.

I believe that rising interest rates, assuming the trend continues, is also a major risk to operating cash flow.

In the case of NGG, they seem to be attempting to ride the alternative energy wave. Yet, "attempting" is the right word to use, as out of 3.8 GW generation capacity in the US, only 4.6 MW is solar, according to the above annual report. You would not have guessed how insignificant that business percentage is from examining how NGG's annual report and website are littered with pictures of solar panels. Yet, considering the company's major transmission assets, they will make money of whoever generates, regardless of the source. Considering the alternative energy revolution happening in Italy, Germany and Spain, it does not seem the company is a noteworthy participant. Mind you, the company has no generation assets in the UK.

Catering for solar and other alternative energy generation, even for transmission, requires a certain level of stability control that is not needed, except in emergency, for conventional generation. As such, even if the company does not participate well in that space, it is still on the hook for its transmission lines and distribution. Luckily, that portion of the business is "regulated." Hence, infrastructure "spending" makes the company money!

In summary, the company, not withstanding the debt concerns raised above, is an investment grade company. Further, tying the dividends payout with (the UK) inflation, alleviates the most significant fear that investors of high-yielding assets have: payout being outpaced by inflation.

Let us move to charting and technical analysis to see if we can discern patterns and possible entry points.

Examining the 10-year monthly chart below, you can see that the company was highly correlated with the market prior to the Financial Crisis, where you can easily spot the accelerating slope, or rate of price appreciation, in the 2006-2007 period, just to be followed by the 2008-2009 demise. This is not a behavior you would expect from a utility, but given that these are debt-heavy equities, it was logical, and especially so in the case of an ADR like NGG as we will discuss below.

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You can safely dismiss portions the second drop around mid 2010 as, if you check the payout website noted above, the company did distribute a one-time dividend on June 15, 2010 with an excess of $4 payout. The rest of it is also ADR status related, and is explained below.

It is noteworthy in the chart to observe the recent increased separation between the slow moving average and the stock price. This is not desirable, and normally indicates overheating. Yet, it is not as excessive as it was in the 2006-2007 timeframe. Having said that, the slope of appreciation of the price is reasonable -- overall -- in this post-2010 era.

A point worthy of extreme attention is that NGG's fortunes, as an ADR, are tied to the GBP-USD exchange rate. The price drop around the Financial Crisis was greatly amplified by the exchange rate dramatic drop from $2.1 per 1 GBP to less than $1.4 -- see below chart. This can explain away the excessive appreciation of NGG's price around 2006-2007 and the equally excessive correction around the 2008 period. The "EURO crisis" related currency action around 2010 also explains the NGG excessive price correction at that time.

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The above chart is a dramatic reminder and a case in point of the "FX-trader" comment in the opening paragraphs. Note that this FX chart also indicates an increased separation of the spot price and the slow moving averages these days. As such, part of my observation relating to NGG's recent price action can be due to this FX behavior.

To dissect things further, we resort to the 3-year weekly charts. The pattern is tame, with only short periods of overheating. Further, not including the dividends payout, the 40% appreciation over these 3-years amounts to around 12% annualized, a very decent rate, but not excessive, considering the overall market growth in the post Financial Crisis era.

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But as noted, you cannot just look at the stock itself, you need to also consider the FX behavior. As such, this combined 2-year NGG/FX weekly chart suggests that the correlation is a bit more significant than you and I would have otherwise guessed.

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As such, here we have a company with some decent growth company that pays inflation-adjusted dividends. The company is not overly overpriced, at least from a technical analysis point of view. As such, entry at any price point is reasonable, especially as the charts are not showing excessive overheating. Yet, you have to incorporate your FX views of the GBP-USD exchange rate into your buy decision, as a correction on that front may cause depreciation (or conversely appreciation) in the NGG price.

Disclosure: I am long MO, T. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.