Is This Share Buffett's Next UK Buy?

Published in Company Comment on 18 May 2012

A fat yield, strong earnings and a huge moat makes this a true 'buy and hold' share.

Moats were once essential for keeping intruders out of castles, because they presented a simple but effective barrier to entry. Today, they are just as useful for keeping would-be competitors away from profitable businesses, but they come in many more shapes and sizes.

Although big miners like Rio Tinto (LSE: RIO) or BHP Billiton (LSE: BLT) might still rely on large holes in the ground to provide them with a moat, modern economic moats usually consist of some combination of superior market share, tangible assets or regulatory advantage.

The UK's biggest moat?

Today's share features all three of these benefits and offers one of the widest moats you will find in the UK. National Grid (LSE: NG) operates a heavily regulated business, has a monopoly in its main UK market and has outperformed the FTSE 100 on a total returns basis for more than 10 years.

With that in mind, I was keen to take a look at its full-year results when they were published on Thursday.

Hidden depths

National Grid emerged from the UK utility privatisations of the Eighties and Nineties. It was listed on the London Stock Exchange in 1995 and has since grown into one of the largest companies in the FTSE 100, with a £24bn market capitalisation and £14bn annual revenues, which are split nearly equally between the company's UK and American businesses.

In Great Britain, National Grid is the monopoly owner and operator of the electricity (National Grid operates only the electricity transmission network in Scotland, the group doesn't own it) and gas transmission networks. It also operates the gas and electricity systems, ensuring that supply is matched to demand at all times. Finally, it owns four out of the eight regional gas distribution networks -- the networks that take gas from the transmission network to your house.

American activities

In the US, National Grid's activities are focused on the northeastern states, where it has both transmission and distribution businesses. The US electricity and gas markets are more heavily regulated than in the UK and prices are controlled and linked to inflation, providing a stable and controlled business environment -- albeit slightly less profitable than in the UK.

National Grid's US electricity transmission business only covers New York, Massachusetts, Rhode Island, New Hampshire and Vermont but contains 13,800km of cable -- about 90% more than the 7,300km which makes up the entire electricity transmission network in England and Wales! This demonstrates just how large the US market is -- regional licences like those held by National Grid are still substantial businesses.

National Grid also operates gas and electricity distribution networks serving about 3.5m customers in New York, Long Island, Massachusetts, New Hampshire and Rhode Island.


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Show me the money!

National Grid's 2011-12 results contain few surprises. Total revenue fell 3.5% to £13.8bn while profit before tax rose by 5% to £2.6bn. The company confirmed the expected 8% dividend increase, taking the total dividend for the year to 39.28p -- a 5.8% yield at current prices.

An 8% dividend increase is pretty impressive and is substantially above inflation. However, this could change. A 4% dividend increase is planned for the current year, and National Grid confirmed that it will be announcing a new dividend policy for future years.

The nature of this policy will depend on regulatory developments in the UK, where utility companies are currently in the process of negotiating a new pricing regime that's intended to fund substantial upgrades to the grid. Given the vast amounts of capital expenditure needed to fund such work, National Grid's substantial dividend could increase at a slower rate over the next few years.

Debt, debt, debt

My recent article on SSE (LSE: SSE) attracted some comments from Fools who were not keen on the leverage it uses to fund its capital expenditure. They pointed out that capex exceeded profits last year for SSE.

This is also true for National Grid, which spent £3.4bn on capex against pre-tax profits of £2.6bn. As a result, National Grid's net debt rose by £0.9bn to almost £20bn. Despite this, interest cover is a healthy 3.9x and the effective interest rate on its debt is only 5.4%, comfortably below the Return on Capital Employed (RoCE) of 8.6% in the UK and 7.6% in the US.

Although this level of debt is rather fearsome and represents leverage of 80% of National Grid's market value, I think that the regulated and asset-intensive nature of this very large business makes it acceptable, even though I would not normally be keen.

The fact that both National Grid and SSE boast about their capex levels in the highlights at the top of their annual reports suggests that they don't think it will deter investors, either.

A Buffett buy?

National Grid's wide moat, regulated near-monopoly businesses and strong dividend history made me think about Warren Buffett, who is known for his enthusiasm for stable, conservative businesses that generate a reliable stream of dividends.

Buffett doesn't often invest outside the US, but he does already have energy interests. His firm Berkshire Hathaway (NYSE: BRK-B.US) owns MidAmerican Energy, which owns a number of utility businesses in the US as well as the electricity distributor Northern Powergrid in the UK.

(What's more, Buffett has invested more than $1bn in building a 5% stake in Tesco (LSE: TSCO), showing that he's happy to do business in the UK. To find out how much Buffett paid for his Tesco shares, read this free report.)

One to watch

National Grid is virtually guaranteed to maintain its monopoly position in England and Wales and its US business provides attractive diversity and exposure to an alternative market. Although its profits are lower in the US than in the UK, it is closing the gap and expects to make further improvements this year.

I reckon that National Grid could just become a Buffett buy at some point, especially if its share price falls substantially over the next year as the new regulatory pricing regime is confirmed. After all, no one will ever build parallel, competing electricity and gas networks. This means that National Grid should remain a very safe place to put your money.

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Further investment opportunities:

> Roland owns shares in Tesco but does not own any of the other shares mentioned in this article. The Motley Fool owns shares in Tesco.

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trmeer 21 May 2012 , 10:37am

Sure Buffett demands a moat but he also requires long term growth, low debt and the price to be well below intrinsic value. Utilities grow very slowly, they have loads of debt and currently they are almost all selling at PE ratios above the FTSE 100 average. Warren Buffett would not touch a utility and this seems like a pretty cheap name drop to me. GlaxoSmithKline or Reckitt Benckiser would be much more Buffett like, were they to fall 20% into value territory.

Afrosia 22 May 2012 , 1:14pm

250% gearing? I'm out.

extramild 22 May 2012 , 6:40pm

No - this is an awful journalism - Buffet requires a business to have a excellent return on equity (its about 10%), to be capital-lite and to have low debt.

Satan will be skating to work before Buffet buys NG.

tentacle 23 May 2012 , 7:11pm


"Warren Buffett would not touch a utility..."

As noted in the article W.Buffet does in fact invest in utilities.
And I think also in railroad companies that have some of the characteristics of a utility.
W Buffet is not a saint and has also invested in Goldman Sachs and speculated in silver.

TonyTwoTimes 27 May 2012 , 3:03pm

Hi extramild and trmeer,

Buffett used to dislike capital intensive businesses, specifically utilities.

That was until a few years ago when he bought Mid American Energy Holdings (a utility), which was soon followed by America's second largest railroad Burlington Northern Santa Fe for $44 billion in 2009.

extramild 03 Jun 2012 , 9:42am

Hi TonyTwoTimes,

You are correct about Buffet and Mid American and Burlington Northern. What I was reacting about in the above article is the hopeless nature of the journalism and the pure lack of research and knowledge about what it is that Buffet looks for in a stock.

I do not believe that it necessary to tack Buffets name into a article about NG just to get a few more eyeballs on the website.

I write as a shareholder in NG and for that reason I would love to see a dispassionate, reasoned analysis of the strengths and weakness of NG, sadly the above article is nothing of the sort.



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