Perverse logic behind National Grid revamp
Deal that serves little industrial purpose will not help investors
At a time when investors everywhere are engaged in a frantic hunt for yield, it might seem odd that the listed owners of some of Britain’s biggest income-generating assets should be looking to sell them.
Yet try telling that to National Grid and SSE, two of the UK’s largest energy utilities. In the past few months, their executives have been considering the sale of stakes in their gas distribution networks. These pipeline systems that run gas to the nation’s households and businesses produce stable index-linked returns on their massive pile of assets. That means cash flows — and ultimately dividends — worth many hundreds of millions of pounds every year.
Last week, it emerged that National Grid was close to a sale, at a value that would represent a premium to the £8.5bn that the energy regulator appraises as the network’s asset value. A disposal of a majority stake is expected soon, at a price equivalent to an enterprise value of £10bn-£11bn.
The sale will reduce the size of National Grid’s regulated business, which spans both gas and electricity, and hence the cash returns available to fund dividends for investors. The group has already told shareholders that it does not need the proceeds to invest in its other activities. National Grid is proposing to return the cash to them to do with it what they will.
So why is National Grid trying to shrink its business? Apparently the reason has to do with the differential growth rates it expects from its gas and electricity networks. Gas consumption has fallen, partly because of high consumer prices (although these have now tumbled) and the widespread adoption of more fuel-efficient systems. There is also the longer-term thrust of UK energy policy, which favours alternative technologies such as renewables over gas when it comes to generating power.
Reducing the company’s exposure to gas could conceivably hoist reported growth rates by allowing the group to focus on faster-growing electricity networks. In effect, it is a bet that power is likely to need more new infrastructure in future years than it will gas.
Profits in these utilities are ultimately tied to the cash level of net new investment that is required to build the pipes or wires that comprise the regulated asset base. Put crudely, increase the amount of cash you are pumping in at a faster rate and that should make the profits go up quicker too.
Now this may sound plausible enough on the surface. But step back, and it bears the hallmarks of an act done not to make the underlying business run any better, but rather to manage the company’s stock price. Granted, the move may achieve what National Grid’s chiefs hope, which is to grow the company’s regulated asset base at close to 7 per cent rather than the 3-4 per cent growth rare it might otherwise achieve.
But it is far from obvious how these faster growth rates compensate investors for the decline in cash returns from the gas operations, which could ultimately reduce what will be a far less well-covered total dividend. The principal beneficiaries are more likely to be the management themselves, who may benefit from a more volatile stock price in the form of valuable equity based incentives. Then, of course, there are the bankers who will receive large fees from the deal.
True, there will be an immediate and sizeable influx of cash, but this will not assist the income investor. It simply presents them with a pressing problem, which is how to reinvest it to achieve comparable returns.
Nor will it be easy for UK pension funds to buy the asset from National Grid directly — assuming they wanted to. A swift glance confirms that most of the British infrastructure assets sold in recent years have been bought by specialist foreign buyers, whether Canadian pension funds, sovereign wealth vehicles, or private sector players such as the Li Ka-shing vehicle, CKI. All these have their eyes on National Grid.
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That is not an accident: it reflects the fact that most conventional funds are too small — and inexperienced — to compete for such large unlisted entities. There is also the problem posed by risk-averse governance; trustees and investment consultants tend to shrink from such deals.
So, a transaction that serves little industrial purpose will leave income investors scratching around ever harder for yield in a thinner listed market. It shows again the perverse outcomes that can follow when managers forget their job is to run a business that adds value primarily by means of the goods and services it provides to customers.
Churning business portfolios is ultimately an activity that assists only insiders. Until they curb the self-interested activities of these agents, end investors will continue to lose out.