I like dividends but I’m avoiding National Grid shares. Why?

Windmills for electric power production.

At surface level, it is easy to understand why National Grid (LSE: NG) is a popular choice with many income investors. National Grid shares offer a dividend yield of 6.5%, for a start. That means that, for every £10,000 I invested in them now, I would hopefully earn £650 per year in dividends yearly.

That dividend has risen annually for years. Over the past three years, for example, the annual dividend per share has risen 19%. That is a substantial increase in my view.

Business with few competitors and strong demand

But any smart income investor knows not just to look at a dividend history.

After all, dividends are never guaranteed. So it is important to look at the source of the dividends. How is the company making its money and will it be able to continue to do so, based on what we currently know?

Here again, National Grid shares have some promising characteristics.

After all, although energy sources may change, the need to transport power around a network is going to be here for decades to come. National Grid’s existing infrastructure is expensive and difficult, if not impossible, to replicate. Realistically, I expect nobody will even try to do that, although firms may attempt to compete against selected parts of it.

National Grid is the sort of power monopoly that billionaire investor Warren Buffett usually loves. Indeed, Buffett’s company Berkshire Hathaway actually owns Northern Powergrid, a regional grid and supplier focused on the north of England.

So why on earth do I have no interest in owning National Grid shares?

High debt and large spending requirements

In a single word, the answer is ‘debt’. Lots of it.

National Grid started last year with £41.0bn of net debt (basically debt left over once assets are taken into account). By the end of the year, that number was £43.6bn.

That continues a long period of ballooning net debt. A decade ago, it stood at £21.2bn. That means that, in the decade up to last year, the company’s net debt – which was already substantial – more than doubled.

Why? Running a power network and maintaining it is an expensive business with high capital expenditure requirements. I expect that will remain the same.

The flipside of that spending is that it enables National Grid to run its business, earning money. But as in many regulated utility businesses, prices are set by the government or regulator as well, not just the market.

Why I won’t buy the shares

Do shareholders care? They are earning a juicy dividend and National Grid shares have moved up 15% over the past five years.

But a growing dividend and increasing net debt often cannot both survive forever. One way to reduce debt is to spend less money paying the dividend and more on paying down borrowings.

National Grid has not done that. Instead, this month it issued millions of new shares as part of a rights issue aimed at raising £7bn in capital.

That should strengthen the balance sheet for now.

But while I see it as prudent, I think it shows the very reason I have no interest in owning National Grid shares: I think the dividend is at risk if the company’s net debt keeps growing. A rights issue buys time but it has not resolved that fundamental challenge.

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C Ruane has no position in any of the shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.