Revisiting the investment case following the trading statement November 23rd 2017
Centrica’s statement shocked the market, and the share price, which has been falling steadily, fell a further 17% to £1.36. At this price, the dividend yield is 8.6%, implying that the market is factoring in a high probability of a dividend cut.
The company predicts that its earnings per share will be 12.5p for 2017, with a 0.8p exceptional charge. Analysts had been expecting 15.5p. At 12.5p of earnings, the 12p dividend is only just covered.
To us, the statement contained a combination of good and bad news. However, the reporting has been universally negative. To quote the BBC website
‘Centrica shares dive amid customer exodus. Shares in the owner of British Gas sink 17% after a warning about profits and loss of customers. 3 million switch electricity supplier’.
This reporting, as we will see, is ill-informed and deliberately misleading. It is important to consider the facts.
The UK Energy market
The media tells us that the ‘big six’ energy suppliers, which include British Gas, have a stranglehold on the energy market. Consumers remain on the suppliers’ ‘Standard Variable Tariff’, an expensive default option for customers who don’t proactively move to better deals, despite government encouragement to do so. The Government proposes a cap on the SVT, in order to curb excessive profits.
In fact, the market share of the big six has fallen from 98% to 80% over the last few years, in a market where there are now around 60 suppliers. The smaller suppliers have two major advantages over the likes of British Gas. The first one is that they don’t own assets, buying gas on the open market as the need arises. They are beneficiaries of falling prices, whereas British Gas owns gas-producing assets which it bought years ago, when gas prices were much higher. This has meant that it has been selling gas at a loss, and has caused write-downs in the asset values, weakening Centrica’s balance sheet.
Also, the government recoups the social and environmental costs of energy supply through a surcharge on energy prices, of around £45 per account, which the large suppliers are required to charge and pass on, while the smaller ones are exempt. Centrica believes that this system is unfair, and is proposing that the social and environmental costs should instead be collected through general taxation.
The market consists of around 60% of customers who remain on the uncompetitive SVT, while the other 40% actively switch. Because of the cost disadvantages mentioned above, Centrica can’t offer a tariff low enough to attract switchers, without losing money in the first year. However, the customer will usually switch again after the first year, leaving Centrica with a loss on the transaction. The company has decided that it will no longer chase after these transient accounts.
The number for customer losses quoted by the BBC, 3 million, is not the number in the trading statement, but the total number of losses from Centrica’s high point several years ago. 3 million is around 10% of the original total. Centrica pointed out in the statement that the bulk of the 800,000 clients lost in the period were the low-margin clients which it no longer wishes to attract. One reason for the spike in switching during the quarter was that BG raised its prices by 12.5% during September. It was the last of the big suppliers to do so.
Faced with these challenges, Centrica announced a new strategy several years ago. It would reduce its gas-producing activities, keeping only its assets in Europe, and focus instead on customer service. Specific targets were set, included a steady reduction in customer complaints, which is happening, and a target to increase the numbers of clients who took bundled services (electricity plus gas) together with ‘connected home’ products, which allow consumers better control of their energy use.
Both halves of this strategy are progressing well. From the end of 2017, Centrica will be in Exploration and Production (E & P) only in Europe, through a joint venture. The sales of the other assets has allowed the company to reduce its net debt from £4.5bn at the end of 2015 to a projected range of £2.5-3.0bn at the end of this year, while ‘connected home’ hubs have increased by 42% to 750,000 since the start of this year.
Centrica will hit its Phase 1 strategic targets in 2017, moving onto the next phase in 2018.
Centrica owns a gas storage facility called ‘Rough’ in the North Sea, consisting of 24 undersea wells. The facility was used to store gas in the summer for delivery in winter, for Centrica itself as well as being rented out to competitors. However, two years ago, one of the wells turned out to be leaking, and on investigation it turned out that all of them were. This has led to the facility being discontinued, and its value written off, further weakening Centrica’s balance sheet. The remaining gas, around 180 billion cubic feet, can be sold, once regulatory approval has been granted, which is been given provisionally, and is expected to be confirmed next month. Rough has been a drag on Centrica’s results for the last couple of years, but it should be positive from now on, as the gas, with an estimated value of £400m, is extracted and sold.
The trading statement
There were three main pieces of bad news in the statement.
- Energy sales were lower due to abnormally mild weather in October and November. Milder weather during these months may be the ‘new normal’, and we cannot be sure that the weather will revert to its previous patterns.
- The gas optimisation division helps wholesale customers to switch supply to benefit from the lowest prices. Activity here was low, because commodity price volatility was low. This factor will fluctuate, and isn’t structural.
- The most concerning aspect of the statement is a drop in profits in the business supply divisions in the UK and the US, due to increased competition. The company didn’t quantify the effect on profits, and it didn’t say what measures are being taken to protect market share and margins. We have asked the company for clarification on these points and are waiting for its reply.
The company has stated that it expects to produce adjusted cashflow in excess of £2bn this year, and reduce net debt to ‘comfortably within’ its £2.5 – 3.0bn target range. These two factors underpin an unchanged final dividend. The company is willing to see a lower level of dividend cover, while it continues the transition to the customer-facing growth strategies, which are as yet unprofitable. In other words, the company is saying that it will maintain the dividend.
Investing in Centrica has been a disappointing experience over the last four years, as its price has fallen by almost two-thirds from its September 2013 level. The company has had to cope with sharply lower commodity prices, major asset write-downs as it transitions from being a vertically-integrated supplier to a more customer-focussed business, intense and, it would say, unfair competition in its markets, significant investment in assets such as ‘Boiler IT’ and smart meters on which it has yet to make a profit, and the failure of the Rough storage facility.
The investment case relies on the fact that most of the transition is behind it. Centrica sees its future as a trusted supplier of a sophisticated suite of products into the connected home, while persuading the government to level the supply playing-field. If it can achieve these goals, today’s price will look very cheap in hindsight.
November 23rd 2017
This paper supports our investment case for continuing to hold Centrica in the fund. It should not be considered research or a recommendation to buy or sell Centrica shares