EUR 850.00 For Business Accounts Only

Morningstar | Market Too Lenient on National Grid's Regulatory Risk; Shares Roughly Fairly Valued After Free-Fall

U.K. regulator Ofgem has proposed to reduce real baseline return for gas and electricity transmission networks from 7%-8% currently to 4% in the next regulatory period, RIOO-2, due to start in April 2021. This is below our expectation of a cut to 5% and at the bottom of the 4%-6% range laid out by Ofgem in March 2018. Ofgem also proposed to keep the adjusted cost of debt unchanged, in line with our assumptions. These proposals are part of a wide consultation process on the features of RIIO-2 that will continue until the second quarter of 2019. National Grid, whose U.K. gas and electricity transmission networks account for 40% of operating profit, is the most exposed company. Accordingly, its share price fell by 9% on the news. Share price is now slightly below our fair value estimate. Still, if confirmed in 2019, the 4% real baseline return would reduce our fair value estimate by 50 GBX or 6% to GBX 730 per share and our net income estimates by 5% as of 2022. For the moment, we reiterate our fair value estimate of GBX 780 per share along with our no-moat, stable trend ratings.

Risk on National Grid's credit ratings and dividend increases. In line with company's track record and policy, we factor in an annual dividend increase of 2% through 2028, namely our inflation rate estimate. That involves a deterioration of the retained cash flow or RCF /net debt ratio from 10.6% in 2018 to 6.5% in 2023. This is well below the 9% required by Moody's to maintain the current A3 rating implying a risk of rating downgrade which could drive a dividend cut. Factoring in the return cut proposed by the Ofgem would decrease the RCF/net debt ratio by 30 basis points from 2022 on our calculations increasing the risk on ratings and dividend.

Ofgem's proposed return cut recalls that the U.K. is the most challenging regulatory backdrop for European utilities. The average market target price of 900 GBX for National Grid shows the market has overlooked its exposure to it.