MPs think that National Grid (LSE: NG) should be broken up. Last week’s recommendation by a parliamentary committee echoes a similar call last year from energy secretary Amber Rudd.
The argument in favour of breaking up National Grid is that there are potential conflicts of interest within the firm’s UK operations. National Grid is responsible for organising back-up power when UK power stations can’t meet demand. One way of doing this is by importing additional electricity through the interconnector with France, which National Grid also owns.
The interconnector generated an operating profit of £123m last year, up 19% on 2014. While National Grid says it has safeguards in place to prevent any conflicts of interest, critics are concerned.
I suspect shareholders will also be concerned by talk of a break-up. This supposedly dull utility stock has delivered a total return of 100% over the last five years. That’s the result of a 65% share price gain plus dividends totalling 35% of the shares’ value at the start of June 2011.
Should you sell?
I wouldn’t rush to sell my National Grid shares. Calls for a break-up are likely to face determined opposition from the company. It may not happen.
A more realistic concern is that much of the firm’s share price growth during the last five years has been the result of an increase in valuation, rather than rising earnings.
The group’s post-tax profits have only risen by an average of 3.7% per year since 2011. What’s really changed is that National Grid shares were trading on a P/E of about 11 in 2011. They now trade on a 2016 P/E of 16. This has pushed the firm’s dividend yield down from 6.2% in 2011 to 4.4% today.
I’d argue that National Grid’s yield may become less attractive if it falls much further. I believe share price growth is now likely to slow.
A unique advantage?
Unlike other UK grocery giants, Wm Morrison Supermarkets (LSE: MRW) produces much of its own food. The group’s Farmers Boy business produces fresh produce for Morrisons stores. It generated a profit of £64.9m for the year ending 1 February 2015, the most recent period for which accounts are available.
This vertically integrated business model might seem old fashioned, but I believe it’s one of Morrisons’ most attractive assets. Whereas Morrisons’ operating margin was just 2.1% last year, Farmers Boy reported a 9.1% operating margin in 2014/15. Morrisons’ food business clearly helps to support the firm’s profits, dividends and valuation.
Of course, another way of looking at things is that Morrisons could buy the same food from other suppliers for much the same price. Instead of holding on to Farmers Boy, the group could sell it and return the funds to shareholders.
Based on last year’s profit of £64.9m, I estimate Farmers Boy could be worth about £850m on a fairly conservative 13 times earnings multiple. This would equate to about 36p per share for shareholders — around 20% of the current share price.
Should Morrisons sell? Absolutely not, in my view. I believe Farmers Boy gives it a unique advantage over its peers in terms of marketing and financial performance. This is one of the reasons why I believe the shares remain attractive for long-term buyers.