 Hampstead is the deepest underground station in London. Late in the evening, however, residents can still occasionally hear the rumble of trains as they lie in bed. It's a reminder of the world that exists underneath the capital and the country as a whole. Tubes, gas pipes, sewers, water mains, electric cables and telecommunication lines all stretch below our feet.One of the biggest infrastructure projects currently under way in the UK is the London Power Tunnels programme. Run by National Grid (NG.), it involves rewiring the city's ageing electricity system via a series of new tunnels buried 40 metres below the surface. The project started back in 2011 and is expected to cost around £2bn in total. The stakes are high, therefore but for National Grid, it's just one of the challenges on the horizon. In May this year, the utility giant announced £60bn of investment over five years to upgrade and expand the power grid in England and Wales (as well as to bolster its US assets). The capital expenditure plan is far larger than analysts had expected and is nearly double that seen over the prior five years. Investment in the grid is increasingly urgent. Electricity demand in Great Britain is expected to be 50 per cent higher by 2035, with electric vehicles and heat pumps proving particularly burdensome. Artificial intelligence could add to the strain; analysts at UBS expect data centre usage to rise from 2.8 per cent of European electricity demand today to 8.4 per cent in 2030. There is another problem, too. National Grid is rewiring the network to accommodate more power from renewable sources, such as wind. This is needed to hit the government's goal of a net zero grid by 2030. Unlike dirtier forms of power, though, renewable energy tends to be generated in remote areas often offshore in the North Sea. These new sources of supply need to be connected to cities and towns."It is the biggest build-out of the networks since Victorian times," says National Grid chief executive John Pettigrew. "Most of our networks were built in the 1960s when they were transporting energy from the north of the country, where the coal mines were, to the south of the country, where most of the population was. Now we need to rewire Britain so energy is coming from offshore wind in the North Sea and the Celtic Sea."Read more from Investors' ChronicleWhy watchlists could be investors' secret weaponCore holdings from the 'sin', technology and investment trust sectorsYou don't have to be invested in China to care about the market rallyHow to solve London's housing shortageExisting infrastructure isn't robust enough to support these changes. Bottlenecks in the grid mean electricity from northerly wind farms sometimes cannot reach areas of demand. As a result, wind farms are paid to stop generating electricity, while power stations are paid to produce electricity closer to where it is needed.Battery storage providers have also been frustrated at National Grid's infrequent use of their technology. A representative of National Grid's electricity systems operator the oversight business sold to the government in a deal that completed this month told the FT in September that outdated computer equipment and cable shortages were partly to blame. An investment opportunity Tackling these issues won't be cheap. However, National Grid doesn't operate like your average company. It is a monopoly whose returns are determined, largely in advance, by energy regulator Ofgem. Rather than hurting profits and breeding uncertainty, therefore, the group's huge investment programme has transformed its growth prospects.Before digging into this, though, it's necessary to understand what National Grid actually does. At its simplest, the company makes sure electricity is transported safely and efficiently from where it's produced to where it's needed. Its main focus is transmission, which involves moving?electricity at a high voltage through a network of pylons, overhead lines, cables and substations. The company has over 7,000km of overhead power lines across England and Wales enough to stretch from London to Miami. The distribution business is smaller, and involves moving electricity at a lower voltage from the grid to customers. It serves people in the Midlands, South West and South Wales.National Grid's revenue comes from us, the customers. In everyone's electricity bill, there is a small charge roughly £20 a year that covers the cost of transmission. National Grid also charges about £100 a year for distribution in the areas it serves.The more complicated question, however, is what drives these revenues. The amount of money National Grid can make primarily relies on the size of its infrastructure network or its "regulated asset base". This is roughly calculated by taking the value of the assets at privatisation, plus all the money that has been poured in since then, minus depreciation. Ofgem then determines what level of return the company can make from these assets, taking into account the cost of debt and the cost of equity. The calculations are complicated, but the core idea is simple: the more National Grid invests in the network, the more it can earn (in the UK, there is another tailwind too the asset base is indexed to inflation). In theory, therefore, National Grid's investment push should increase its earning power. Its asset base is expected to swell from £63bn this year to £100bn by FY2029, representing a compound annual growth rate (CAGR) of around 9.5 per cent. Analysts at Bernstein are forecasting that operating profit will grow even faster in the same period. "National Grid offers exposure to multi-decade growth in electricity networks in stable and well-regulated markets, providing excellent earnings visibility," HSBC analyst Charles Swabey concludes. Schroders fund manager Ashley Thomas agrees, stressing the group's "secure and transparent" growth profile. These enhanced growth prospects are not necessarily reflected in the share price. There are a variety of ways to value the company but, given its presence in both the UK and North America, many analysts favour a sum-of-the-parts approach. JPMorgan, for example, says given the structural opportunities the UK network should be valued at a 40 per cent premium to its regulated asset base, and values the US infrastructure at 1.4 times its current worth. As such, it has a target price of 1,200p for March 2026, up from today's price of around 990p.The stock looks reasonable from a price/earnings (PE) perspective too. National Grid has traded on an average forward PE ratio of 15 times for the past five years, but now attracts a multiple of just 13.6 times. Given its rapidly expanding asset base, this discrepancy seems unjustified. Glitch in the systemNot everything is set in stone. A shortage of trained workers and supply chain hold-ups could hamper National Grid's investment plans. Meanwhile, Ofgem still has the power to cause problems."Given the expected step-up in UK transmission capex, the crucial unknown is the regulatory framework that will underpin regulated assets growth and returns," says HSBC. The current regulatory period ends in March 2026, with a new five-year regulatory period starting the following month. For now, though, the signs are positive. Last year, for example, Ofgem introduced the term 'investability' in a consultation to "recognise the scale of investment required in coming decades". In July of this year it also expressed an early view on the returns National Grid should make in the next regulatory period. This was largely as expected, with Ofgem guiding for a return on equity of 5.43 per cent for the UK transmission network. More negotiations will follow. "You have seen some regulators shift from being purely focused on minimising the cost to the consumer to also thinking about how we allow the energy system to decarbonise, and what we actually need to do from a grid perspective," notes BlackRock fund manager Alastair Bishop. For investors, though, there is another fly in the ointment. One of the ways that National Grid raised money for its £60bn capex plan was through a £7bn rights issue announced in May. This took a lot of the pressure off the balance sheet, which was looking strained, and paves the way for higher overall profits in the future. However, it also swelled the share count by roughly 30 per cent. Earnings growth on a per share basis looks muted, therefore and National Grid's own forecasts should be taken with a heavy pinch of salt. The company expects underlying earnings per share (EPS) to grow at a compound annual rate of 6-8 per cent between financial years 2025 and 2029. However, by starting the guidance from 2025, the management team has avoided showing the impact of the elevated share count. Deepa Venkateswaran, head of European utilities at Bernstein, calculates that if an undisturbed EPS figure for 2024 were to be used instead, the compound annual growth rate will only sit at between 2.8-4.3 per cent. Accounting for bonus shares issued in 2024, this growth figure climbs to 5.1 per cent. These numbers are lower than the 6-8 per cent EPS growth achieved in the previous five-year period and lower than the forecasts communicated by the company, Venkateswaran concludes. The rights issue also impacted National Grid's famously reliable payouts: the dividend has been rebased from 58.5p a share down to 45.3p a share. It is set to start growing again in line with inflation from next year, under the same progressive policy as before. The dividend hit suggests there has been a strategic shift towards growth at the expense of income but many are unfazed by this. "It remains a classic income thesis," says Tommy Kristoffersen, fund manager at EdenTree Investment Management. "But instead of it being a wobbly, risky income thesis, it's underpinned by this £60bn capex plan which, in turn, is underpinned by a government that knows that it's necessary to support renewable expansion."Schroders' Ashley Thomas is similarly bullish. "Having been rebased, there's little prospect of the dividend needing to be reduced or not being able to increase in line with inflation, given revenues are largely inflation linked." Higher up the supply chainFor investors concerned by the recent rights issue, there is another way to tap into the power grid story. "The opportunity for outsized investment returns may well be in parts of the supply chain," says BlackRock's Bishop. "We think that this is a trend that is only really starting to gather momentum, and we are already seeing evidence of bottlenecks appearing."These bottlenecks are creating a "perfect environment" for pricing power among the equipment providers, according to Fidelity portfolio manager Alexander Laing.Cables are an obvious starting point. The global cable market was worth 154bn (£129bn) in 2019 and is expected to grow to 236bn by 2030, fuelled by the global electrification push. Europe's three key players Prysmian (IT:PRY), Nexans (FR:NEX) and NKT (DK:NKT) are clearly benefiting. Shares in all three groups have risen by roughly 80 per cent in the past year. These stocks all focus on high voltage cables (which are typically higher margin), have similar growth ambitions, and have announced capacity expansion plans in recent years. However, Prysmian which is the "unrivalled global leader, with a market share of around 8 per cent", according to one analyst is particularly interesting.After a big acquisition push, the company is now exposed to both the European and US markets, and is investing more in high voltage equipment than its peers. It hasn't all been plain sailing. Group sales actually declined by 3 per cent on an organic basis in the first half of 2024, dragged down by a weaker electrification division (this includes lower voltage cables for the construction sector). Demand for high voltage cables has also been lumpy in the past and most large projects have seen some delays. As a result, analysts have warned that there is a risk to pricing if supply comes online too quickly. However Prysmian's transmission arm saw sales jump by 10 per cent and margins widen in the first half of 2024, and the structural tailwinds show no sign of flagging the transmission division is set to deliver high double-digit organic growth up to 2027.Cables aren't the only option, of course. The biggest bottleneck at the moment is in substation equipment, notably switchgear and large transformers. There are just three players in this space, for whom this sector forms just one part of a much larger business: Siemens Energy (DE:ENR), Hitachi (JP:6501) and GE Vernova (US:GEV). Meanwhile, in the UK, there are the contractors that physically carry out the work. Balfour Beatty (BBY) which is involved in the London Power Tunnels Project Costain (COST) and Renew Holdings (RNWH) have all been bolstered by infrastructure investment in the past year. As investment in energy grids around the world ratchets up, these companies are likely to garner more and more attention for the roles they play. Indeed, as energy generators and battery storage funds continue to struggle to attract investors, the less glamorous world of tunnels, cables and pylons is already sparking plenty of interest. And at the centre of it all sits National Grid a formerly stolid income play that now has the wind in its sails.Across the Atlantic When you think of National Grid, you think of pylons spanning the English countryside. However, the company also has a big American business which shifts electricity and gas across New York and Massachusetts. These operations account for almost 40 per cent of the group's underlying operating profit and will absorb almost half of the £60bn investment plan. The growth drivers in the US business mirror those in Europe. National Grid is working on some large transmission projects to help hit 2050 climate goals, for example. It is also "storm hardening" assets as climate change takes its toll.But the regulatory backdrop is different across the pond. While the premise that utilities should be able to recover their cost of service and earn a reasonable return on their investments is familiar, the process is more ad-hoc and fragmented rather than conforming to five-year regulatory cycles.National Grid must submit formal rate filings to various regulators when extra revenue is needed, and it can take over a year for a final decision to be made. As a result , there is often a gap between the regulated return on equity and the return on equity the company actually achieves.Analysts are generally bullish on the US business's prospects HSBC expects the regulated asset bases in New York and New England to grow at a compound annual growth rate of 12 per cent and 14 per cent, respectively, between now and 2029, with Ebitda increasing by 59 per cent to over £4.5bn. However, the bank does have qualms about the long-term role of gas. "We believe there remains a good case to trim or offload US gas networks over time, although we acknowledge this is unlikely to happen until the early 2030s given the balance sheet position post the rights issue." National Grid has form on this; it has been gradually divesting its UK gas distribution business over the past few years, selling the remaining stake this summer. |
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