Questor share tip: National Grid shares hit by fears of interest rate hike

Interest rate fears

National Grid has such a long track record of paying inflation-linked dividends that it has come to be seen as a bond-like investment to many. The predictable revenue and profits that are generated from managing the electricity and gas infrastructure in the UK allow an equally steady dividend yield of 4.4pc every year.

However, owning the shares to collect the dividend income is still higher risk than owning government bonds. If interest rates begin to rise, then investors will switch from equities to government bonds, and the latest minutes from the US Federal Reserve show that an interest rate rise in June is still on the cards if the economic data supports such a move. That is why National Grid shares have retreated from all-time-highs of £10.10 per share last week.

Infrastructure asset base

The actual business of managing gas and electricity networks

in the UK and US is performing well. New CEO John Pettigrew, who replaced Steve Holliday in March, reported adjusted pre-tax profits up 9pc to £3.14bn for the year ended March 31, from revenues largely flat

at £15.1bn.

The utility group invested £3.9bn during the year into its infrastructure assets bringing the total value to £42bn. With such a large asset base delivering steady revenue, National Grid can fund a large debt burden, resulting in net debts rising £1.4bn to £25.6bn at the end of March.

National Grid continues to benefit from record low interest rates which have greatly reduced the cost of borrowing during the past decade. The average cost of the debt fell to 3.8pc at the end of March, from 4.3pc a year earlier.

Letting off gas

The company said that the plans to sell a majority stake in its UK Gas Distribution business are still on track. The value of all the pipes which take gas to homes and businesses across the UK is about £8.7bn, and typical deals in the sector are completed for about 130pc to 140pc premium of the underlying assets. The £12.2bn target price is most likely to come from a consortium of Canadian pension funds and global infrastructure funds.

The deal is expected to complete by the first quarter of 2017 and the cash received will be used to reduce borrowing levels before a possible return of cash to shareholders through a special dividend, or increased share buybacks.

The industry in this country is closely regulated by Ofgem, which effectively sets the prices that National Grid is allowed to charge in the following eight years. The current agreement gives clarity on the amount that can be returned to investors through dividends and allows long-term infrastructure investment until 2021.

National Grid increased the annual dividend by 1.1pc – in line with retail price inflation (RPI) –  to 43.34p, going ex-dividend on June 2 and paid on August 10. This means the shares offer an inflation-linked prospective dividend yield of 4.4pc.

The shares have a good track

record, but unfortunately are not looking very attractive at the moment, as they are trading near record highs. On a price to earnings ratio of 16 times they look expensive for a utility stock that isn’t expecting much earnings or revenue growth during the next 10 years. Hold.

Ricardo

834p +11½p

Questor says HOLD

Ricardo the British engineering company is enjoying steady demand for its expertise in reducing carbon emissions from a range of different engines, and with revenue up 32pc and a strong order book the company is on target to hit market expectations for the full-year.

Dave Shemmans, chief executive, said: “I am pleased with the continued growth in our existing Technical Consulting business and the successful integration and performance or our recent acquisitions.”

The company paid £42.5m for Lloyd’s Register Rail last year, and this was a major factor in helping revenue increase 32pc during the 10 months to the end of April. Even excluding the extra sales from recent acquisitions, the revenues increased by 9pc compared to a year earlier.

Ricardo is an expert in engine design and uses this knowledge to reduce emissions from existing commercial car and rail engines. The company also has a major contract to build the engines for the McLaren supercars, with volumes steadily increasing during the second half of the year. 

The engineer said steady demand for work in Asia and the Middle East helped keep the order book total at £207m, up from £152m at the same stage last year. Management are confident they are on track to hit market expectations for full-year revenues of about £307m, giving £33.6m in pre-tax profits and 47.8p in earnings per share.

The shares are trading on 17 times forecast earnings and offer a prospective dividend yield of 2.3pc. Ricardo is well placed with its technical expertise in demand around the world and we remain supporters. Hold.