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uTILITy WeeK | 22nD - 28Th January 2016 | 19 Finance & Investment Analysis I n the UK, there are eight gas distribution businesses, whose role is to move gas from the National Transmission System (NTS) to the end-user. Following the privatisation of British Gas in 1986, gas transportation and distribution became the exclusive purview of Transco. Aer years of anguished debate about Transco's regulation, the business eventually became part of the expanding National Grid. Back in 2005, National Grid sold four of its regional gas distribution businesses – Northern, Scotland and Southern, along with Wales & West. It still owns four gas dis- tribution businesses, East of England, North London, North West, and West Midlands, and they have a combined customer base of almost 11 million. However, with its high net debt of £24.6 billion, National Grid recently announced that majority stakes would be sold in these businesses, with completion due early in 2017. Despite gas distribution being National Grid's second most profitable UK business, this policy was justified by outgoing chief executive Steve Holliday, who confirmed that "gas distribution in the UK is now a mature business with low growth of around 2 per cent a year". Low growth maybe, but gas dis- tribution companies are highly valued by the market for their long-term, low-risk returns. National Grid's four gas distribution busi- nesses have a regulatory asset value (Rav) of £8.5 billion. If a premium of, say, 30 per cent were applied – not out of line with recent deals in the utilities sector – a valuation north of £11 billion would be reached. That is equivalent to almost half of National Grid's net debt. The second-largest gas distribution busi- ness is run by SGN (formerly Scotia Gas Net- works). It is an Anglo-Scottish undertaking and includes the large Southern gas region. SGN's owners are split between FTSE-100 stock, SSE, and the Canadian-based Borealis, which has taken stakes in other UK utilities. Its 2014/15 figures show that SGN is a strong business. Operating profit was £372 million, slightly up on the £359 million of the previous year. Total capital and replacement expenditure was a formidable £369 million as priority was given to modernising gas pipelines. SGN's Rav is just below £5 billion, so once its net debt of £3.4 billion is stripped out a book value of c£1.5 billion remains. A 30 per cent implied premium over Rav would give a figure of almost £2 billion. And on a non-financial note, SGN deservedly won two awards at the Utility Week Awards last month. The two other UK gas distribution busi- nesses are rather smaller undertakings. Northern Gas Networks (NGN) is based in the northeast of England, although it is also present in parts of Cumbria and Yorkshire. It supplies around 2.7 million homes and busi- nesses. Its ownership is dominated by Hong Kong/Chinese undertakings. The lead share- holder is Cheung Kong Infrastructure (CKI), which owns various UK utilities, including both Northumbrian Water and UK Power Networks. CKI's focus is very much on long-term cash flow, with outperformance of the regu- latory settlement being key. CKI also owns Wales & West Utilities (WWU), which is based in Newport. WWU operates c2.5 million gas supply points in its wide area and supplies around 7.5 million people. The company's assets include c35,000km of gas pipes, covering the equivalent of one-sixth of the UK by area. In terms of regulation, the periodic review of 2013 – the first to adopt the RIIO outputs- based methodology – has been crucial. Between April 2013 and March 2021, Ofgem has projected total expenditure (totex) of £16.8 billion, which illustrates the priority being accorded to replacing old gas pipes and providing new gas connections. Given that just a third of the regulatory period has passed, it is still premature to assess the likely outperformance. However, Ofgem did publish an annual report covering 2013/14, the first year of the eight-year period. It concluded that, even in year one, the variance from Ofgem's expected costs and the actual outcome aver- aged 16 per cent. While highlighting the back-ending of some investment schemes, Ofgem did com- ment that the combination of a mild winter – which was kind to gas pipes – lower than expected economic growth and planning delays were key factors for this substantial variance. Of course, in subsequent years, the actual outperformance figures for the gas distribu- tion companies may look less good. Crucially, Ofgem also addressed the gas safety issue and pronounced itself generally satisfied with what the gas distribution com- panies were doing. Over the next few months, as National Grid begins selling majority stakes in its remaining four gas distribution companies, the market will keep an eagle eye on the prices being paid. With last year's general election produc- ing a working majority for the Conservatives, the political risk now is rather lower than would have been the case a year ago. But if aggressive bidding is the order of the day, expect not only National Grid's share price to respond favourably but also those of other regulated businesses, most notably the three quoted water companies. With the current vogue for long-term solid investments, this sale may even set new valuation parameters in terms of the Rav pre- mium for utility businesses. Nigel Hawkins, director, Nigel Hawkins Associates What's a GDN worth? National Grid is selling a majority stake in its four remaining gas distribution networks, and according to Nigel Hawkins the market should be willing to dig deep for this one-off opportunity. national GriD key numbers six months ended 30 september Adjusted operating profit (£m), at actual exchange rates 2015 2014* UK electricity transmission 610 687 UK gas transmission 159 110 uk gas distribution 428 434 US regulated 351 273 Other activities 288 107 Total group 1,836 1,611 * 2014 reflects reclassification of £34 million of financial controls remediation costs from other activities to US regulated business.