National Grid downgraded on weakening returns

RBC Capital Markets downgraded National Grid PLC to 'sector perform' with a price target reduction to 1,050p, citing growing risks and a structurally lower outlook for returns in both the UK and US. The downgrade reflects concerns over a sharp decline in UK regulated returns under Ofgem's RIIO-3 draft determination, projecting a fall in return on equity from 6.92% to 4.84%, coupled with anticipated earnings decline in the US as favorable COVID-era allowances expire, reducing allowed equity returns from 9.6% to 8.6%.

Analysis

RBC Capital Markets has downgraded National Grid PLC (LSE:NG.) to 'sector perform' from 'outperform', lowering its price target to 1,050p from 1,120p, due to a confluence of escalating risks and a structurally diminished outlook for returns in both its UK and US operations. The downgrade is significantly influenced by regulatory pressures in the UK, where Ofgem’s RIIO-3 draft determination proposes a sharp reduction in the regulated return on equity to 4.84% from 6.92% under RIIO-2, a level RBC describes as “excessive.” This, alongside higher corporation tax and inflation treatment uncertainties, poses a risk of further UK earnings decline in the second half of the decade. In the US, National Grid is expected to face a “cliff-edge drop in earnings” as favourable post-COVID allowances expire between 2026 and 2029, with forecasted allowed equity returns falling from 9.6% to 8.6%, thereby limiting the US business's ability to counteract UK headwinds. RBC contends that these cumulative political and regulatory risks are currently underappreciated and show no signs of stabilization. Consequently, despite RBC acknowledging a potential 10% total return to its revised price target, the broker concludes the risk/reward profile no longer supports a positive stance, deeming the stock “no longer cheap enough” to offset the growing pressures on group returns. National Grid's shares traded down nearly 1% to 1,078.44p following the announcement, a level above RBC's new target price.

Key Decisions for Investors

• Investors should consider the implications of RBC's downgrade to 'sector perform' and the 1,050p price target, particularly as the stock currently trades above this level, suggesting downside risk based on this specific analysis.
• Heightened scrutiny of regulatory developments is warranted, especially the final Ofgem RIIO-3 determination for UK operations and evolving US state-level regulatory decisions concerning return allowances post-2026.
• Re-evaluate earnings forecasts and dividend sustainability for National Grid, factoring in the anticipated multi-year pressure on returns from both UK regulatory changes and the normalization of US earnings.