A silver lining
Declining inflation in the UK, if sustained, could lead to a fall in National Grid (LONDON:NG)’s earnings, dividend and RAV growth. However, we believe such a scenario could also to be detrimental to the wider UK equity market and could, in fact, highlight National Grid’s relatively more stable earnings and dividend. As a ‘safe haven’ we believe National Grid shares could outperform relative to the market under such a scenario.
Falling rate of inflation…
The UK’s Office for National Statistics (ONS) has released official inflation data for January 2015, showing that the rate of Retail Price Index (RPI) inflation in the UK has declined to 1.1% for the 12 months to January 2015. A significant part of this decline is attributable to the fall in oil and food prices and the Governor of the Bank of England has warned that UK inflation “will likely fall further, potentially turn negative in the spring, and be close to zero for the remainder of the year”.
…negative for EPS, DPS and RAV if sustained
Revenues (c. £4bn) at National Grid’s UK regulated businesses are linked to RPI. A sustained period of low inflation or deflation would negatively affect National Grid’s earnings, although its impact would be partially offset by £6.6bn (31% of group net debt) of inflation-linked bonds. Every 1% fall in our 2.5% pa inflation assumption would reduce our FY16 EPS (assuming no impact to its US division) by 0.4% and 3.3% by FY18. In addition, dividend and RAVs are linked to RPI and could also be negatively affected under such a scenario. We calculate every 1% reduction in our 2.5% inflation assumption would result in a -1.6% fall to FY16 DPS and -3.8% for FY18. National Grid’s current 5-6% annual nominal RAV growth (based on an inflation assumption of 3% pa) would also be lower. Every 1% permanent fall in our RPI assumption would reduce our RAV growth by 0.6% pa.
Valuation: A silver lining
Despite the adverse impact on National Grid under a sustained period of low inflation, we believe such a scenario would have wider implications for the UK equity market as a whole. Given the relatively more stable nature of National Grid’s earnings, its shares are more likely to outperform relative to the market. In the three months post the collapse of the credit market in 2008, when RPI fell from 5.0% to 0.9%, National Grid shares outperformed the FTSE 100 by 13%. It is also worth highlighting that a temporary fall in inflation could actually benefit short term earnings, as lower interest costs more than offset any revenue impact. Our valuation range of 769-1,020p/share remains unchanged.
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