As I have mentioned, takeover speculation is rife in the utility sector (AWG and Scottish Power have both received bids recently). With private equity houses awash with cash, it should be no surprise that the share prices of many stable yet essentially low growth companies are going through the roof.
Turkey of the week: National Grid (NG, 718p), tipped as a BUY by The Times and The Daily Telegraph
National Grid (NG) is a classic example. It owns and manages electricity and gas networks in the UK and US. At last week’s interim results, operating profits were up a modest 3% to £1.1bn generating earnings per share of 21.7p. The board also announced plans to demerge its wireless masts business together with selling-off its electricity cable interests in Australia.
However, roughly half of the company’s assets are regulated by Ofgem. Therefore, every five years, Ofgem calculates National Grid’s Regulatory Capital Value (or RCV), and specifies the prices that it can charge, how much it should invest, and what level of return shareholders can receive. For example, a real return of 4.4% post tax is presently set for its £8.4bn UK transmission division. I believe this RCV figure, rather than say the p/e ratio, is the prime indicator of underlying value for National Grid’s regulated assets. If actual returns are greater than specified, then bills will be reduced by Ofgem at the next pricing review in order to ensure that customers get value for money.
So, in terms of figures, how does this apply to National Grid? Well, together with its £6.4bn UK gas distribution assets, NG’s total RCV is £14.8bn.
In addition, its US business is worth around £7.5bn, with the rest of the group valued at a further £6.5bn. Consequently, on a sum-of-the-parts basis, National Grid’s enterprise value is around £28.8bn, which, after deducting net debt of £11.7bn, a £1.4bn pension deficit and £0.5bn of other liabilities, suggests it should have a market cap of £15.2bn, or 560p per share.
But it doesn’t. The shares currently trade at 723p – by my reckoning about 30% over their actual value. As a secondary check, it is worth noting that earnings per share are only predicted to grow by around 8% a year on average over the next three years. On this basis, I would value the stock at best on a 12 times 2007 p/e multiple, or about 600p per share.
Finally, there is another looming dark cloud on the horizon. On 4 December, Ofgem is announcing its 2007-2012 price review for National Grid’s UK transmission assets. In line with cheap available financing, Ofgem is planning to reduce the existing post-tax return of 4.4% to 4.2% for the next five years. National Grid, on the other hand, is pushing for 4.8%. If Ofgem sticks to its guns, then NG’s future growth plans could be hurt, thus further undermining its lofty valuation.
Recommendation: TAKE PROFITS at 718p