Centrica Plc Full Year Update – 05 March 2015
Centrica Plc (CNA.L) is an integrated energy group that supplies electricity and gas to both Britain and the US. The group is the largest provider of gas and electric in Britain while the US business is smaller but growing rapidly.
The group operates under four segments which are British Gas, Centrica Energy, Centrica Storage and Direct Energy. CNA.L is described as a vertically integrated energy organisation because it has operations across the full spectrum of the energy value chain.
It sources its own natural gas through exploration and extraction, transports and prepares recovered gas for sale, facilitates both retail and wholesale orders and also provides after sale equipment and services. The group holds 70% of the UK’s storage capacity for natural gas.
|Index||FTSE 100||Ticker||CNA.L||Latest Close||245.50|
|52 Week High||348.80||52 Week Low||242.00||P/E (F)||12.6|
|Dividend Yield %||5||Dividend Cover||1.4||CEO:||Ian Conn|
|CFO:||Jeff Bell||Previous Price Target||280.00||Current Price target||190.00|
Kicking ourselves with regret as outlook for Centrica sours further and shares fall to a 5 year low
We wrote at great length previously about our concerns for both earnings and the dividend at Centrica Plc, which led us to assign a 300.00 pence price target to the shares in the summer of 2014, that was subsequently revised lower to 260.00 pence as a result of a further deterioration of the business’s fundamentals.
However, in response to what seemed like “bad news becoming priced in” we later upgraded our price target but assigned a negative outlook to it (280.00 pence). With the benefit of hindsight we can now say that such a move was foolish.
First and foremost, the reprieve from pressure that we observed in Centrica shares during October was short lived, mostly due to a further fall in gas & oil prices during December. This saw market expectations for Centrica in Q4 downgraded and the shares responded by falling through both our revised target as well as our earlier price target.
While the rebound that we anticipated for Q1 came through as expected, when the shares recovered to touch noses with the 300.00 pence level in early February, this also proved to be a short lived occurrence as the market later responded to news of one of the worst full year financial performances for quite some time.
Centrica Plc Share Price / Daily Intervals
UK Natural Gas Price / Monthly Intervals
Brent Crude Oil Price / Monthly Intervals
Centrica “rebases” dividend after announcing a poor full year performance
In detail, the cost and earnings pressures that we saw building at Centrica throughout 2014 have now led to management unveiling a sharp decline in profits for the full year, which prompted a 30% “rebasing” of the dividend.
This validates our earlier view that dividend cover at the group was too low and forecasts for earnings and dividend growth were overly ambitious.
“The net effect of these dynamics is a dividend at risk. From here we expect that dividend growth will be constrained, while looking further out the existing pay-out also appears vulnerable.” – Stockatonia Research, July 2014
“The net effect of the above factors is that with lower earnings this year, and only meagre growth likely in the next, the dividend at Centrica now appears exposed (1.5X cover for 2013, falling to 1.1 X cover for 2014).” – Stockatonia Research, November 2014
Furthermore, earlier pledges to contain costs at the group are yet to yield any noteworthy benefit, as evidenced by full year financial statements, which showed operating costs expanding by 22.5% for the period.
As a result, the new management team at Centrica have announced a strategic review of the business, which we take to mean that both asset sales and a simplification strategy could be on the cards.
In addition to this the board has reiterated the group’s earlier pledge to continue existing attempts to drive down costs, although so far, it appears that much of this will take the form of cuts to exploration and production expenditure.
In our view, these measures are unlikely to shield shareholders from further pain over the near to medium term and as a result, are a classic case of too little too late.
The road ahead for Centrica Plc
In 2014, a sharp fall in the oil price and an equally steep decline in UK natural gas formed the dominant driver of share prices across the listed energy production and services sectors. This also contributed greatly to 28% reduction in earnings per share at Centrica Plc.
We believe that the full impact of these price falls is yet to be reflected in earnings for Centrica Plc and therefore, we anticipate that the year ahead for shareholders will be equally as difficult as the last.
This is because we expect that the renegotiation of wholesale supply agreements and the potential for existing hedge arrangements to expire will place further pressure upon margins, while the group will also find it difficult to avoid passing on lower prices to retail customers, which means that the average household fuel spend will probably decrease once again in 2015.
In addition to the above, prices for Brent crude oil and UK natural gas fell by 65% and 52% respectively in 2014, while Centrica’s operating costs expanded by 22.5% for the period.
Despite this, adjusted earnings per share have only fallen by 28% to date, which underlines the relevance of our belief that there could well be more pain to come for shareholders during the months ahead.
Furthermore, the group still remains exposed to a number of other “peripheral” risks, such as the ongoing Competition and Markets Authority review.
The general election in May also poses a threat to the group as the energy sector represents an easy target for politicians looking to boost their popularity, a target which has already been exploited by the Labour party through their pledge to freeze prices if elected this year.
Such ongoing uncertainties could remain a weight around the ankles of Centrica shares for quite some time to come.
Balance sheet, dividend and valuation update
In relation to the balance sheet, both short term as well as long term borrowings increased at Centrica Plc during 2014, contributing to a total increase of 7.8% in overall liabilities. For a business that is supposed to be focused upon maintaining its credit ratings, and considering that it is already highly geared, this is disappointing.
In our view, this underlines the scale of the challenges that Centrica management will face during the year ahead as they attempt to reduce expenditure and minimise borrowing at a time when low oil and gas prices continue to place pressure upon margins.
In terms of the dividend, we do not believe that we have seen the end of the “rebasing act” at Centrica. This is because the recent cut to the dividend brings the total payout for 2014 down to just 13.5 pence which, with EPS at 19.2 for the full year, still leaves the group’s dividend cover below 1.5X (1.4). This is not what could be called a sustainable payout ratio.
Furthermore, we anticipate that in a best case scenario outcome earnings per share will fall by an additional 20% this year alone, which brings EPS down to 15.4 pence. If we are right about this and management are to target cover of roughly 1.5X over the medium term, then they will need to cut the dividend further during 2015.
From a valuation perspective, we believe that Centrica remains overvalued in light of our expectation for further pressure upon earnings during the coming quarters. At present the group trades on a multiple of 12.6X (H) earnings which in our view, although reduced from the 15X EPS at the time of our last update, will not protect the shares from further selling in 2015.
While shareholders at Centrica Plc have endured a terrible 2014 we believe that more pain could be on the way in the current year.
In this regard, we note that the group will probably have to face lowering retail prices further during the period, which will contribute to a reduced average for household spending.
This is while it is also possible that wholesale supply agreements overhanging from the days of higher prices will likely face renegotiation or expiration, which could add further pressure upon earnings.
In light of the 52% reduction in gas prices, we assume that the 2015 decline in earnings will be in the region of 20%, which brings the total reduction closer to that of the underlying gas price but does not take account of the expanded cost base at Centrica.
For this reason, we see a best case scenario outcome for the group as being one where earnings per share are in the region of 15.0 – 15.4 pence 2015. We note that this is moderately below consensus projections for the full year, although we expect these to be revised lower later on in the period.
In light of our projection for earnings and our beliefs regarding the dividend at Centrica during 2015, we expect that any potential recovery in the shares will be short lived over the near to medium term.
Given that exact information regarding cash flows and energy prices during the year ahead are limited, and considering that we expect the dividend to fall further and that our EPS estimate will be a best case scenario outcome; we believe that our estimates and a market multiples based techniques will be the most appropriate for deriving our price target in this case.
In order to derive this target we take our projection for earnings in 2015 (15.4 pence per share) and assume that the market is happy to rate Centrica somewhere between the current industry average and the group’s own longer term average in terms of multiples.
This provides an implied trading range of 187.00 pence – 231.00 pence per share. With this in mind, and given that these estimates are on a best case scenario basis, we prefer to place our price target at the lower end of this implied range.
For this reason, we revise our price target lower today to 190.00 pence per share, which corresponds with both our valuation estimate as well as the 61.8% retracement off from the 400.00 pence high which appears to have drawn to a close to the July 1996 – October 2013 long term trend.
The next scheduled event of note for Centrica Plc will be the release of the interim management statement and the annual general meeting on 27 April 2015.
As always, we shall endeavour to keep all of our members up to date with developments as they occur, as well as at the time of release in April.
The contents of this report and the Stockatonia website (https://www.stockatonia.co.uk/