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Centrica Plc Interim Update – 24 September 2014

Centrica Shares under Pressure, Risks Continue to Exist

Since our first review, shares in Centrica Plc have failed to make any real headway in either direction. Following a post-interim update rally, CNA.L has fallen back to its July level of 307.00 pence and is now vulnerable to a further leg downwards.

Largely in line with our expectations, external events have continued to paint a picture of a troubled company operating in a challenging environment. While there have been some positives for the group, most notably that it has found a replacement in BP’s downstream CEO Iain Conn for outgoing chief executive Sam Laidlaw, adverse developments have managed to outweigh these.

The opening to September saw EDF Energy announce that a number of its UK-based nuclear power stations would remain closed until December as a result of faults detected earlier in the summer. With a 20% interest in each of the affected sites, the news of sustained closures is just another factor that bodes ill for earnings at Centrica during the final half of the financial year.

In addition to this, abnormal weather in both the UK and the US has depressed energy demand while competitive pressures have also weighed on prices.

As a result, the interim update released by management at the end of July was largely downbeat and left many investors with little incentive to renew their interest in the shares.

Centrica Plc Hourly Intervals

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Labour Party Sets the Ball Rolling on its 2015 Election Campaign; Energy Policy in Focus

In addition to a downbeat set of interim results, the closing stages of summer also saw the Labour party set the ball rolling on its 2015 election campaign. In his opening speech, Ed Miliband, renowned in the energy sector for his pledge to force price freezes, set out many of the policies that will form the foundation stones of his pitch for leadership next year.

Whether focused on the NHS, carbon emissions or the cost of living, a common denominator throughout the speech was a significant implied financial cost of the party’s policies.

Despite a number of assertions regarding levies on big businesses of all kinds, ranging from energy companies to hedge funds, a number of questions relating to how these costs will be covered still remain unanswered.

On an almost positive note, much of the party’s earlier talk about price freezes for energy companies has now been replaced by talk of efficiency and emissions initiatives.

However, when the Labour Party are challenged on both the compatibility of their pledges with the desperate need to bring down the national budget deficit, as well as the likely impact of these upon the cost of living, they could quite easily respond by once again dragging the idea of further levies and price freezes out from the closet.

In short, the Labour Party appears determined to take advantage of a populist distaste for energy companies, banks and big businesses in order to fund policies which it hopes will enable it to capture the Prime Minister’s chair at the 2015 election.

This poses a problem for Centrica going into the new year, particularly as current opinion polls place the party with a narrow lead against the Conservative Party.

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Balance Sheet, Dividend and Valuation Update

From a valuation perspective, first half earnings at Centrica were substantially lower, at 10.5 pence, than during the same period for 2013. With management issuing negative guidance for the full year performance before EDF’s announcement that four nuclear power stations would remain closed until December, the earnings outlook for the remainder of the year is resolutely negative.

In terms of the dividend, CNA.L’s yield is attractive at levels above 5.5%. However, the dividend cover is low and in danger of falling further during the quarters ahead. The key catalyst behind our expectations here is the likely decline in earnings at the group, matched with existing projections for management to continue to increase the dividend for FY14 and onwards.

In addition to the above, the debt pile attached to the Centrica balance sheet continues to grow. If allowed to continue, such liabilities could further threaten both earnings at the group level as well as its ability to increase cash returns to shareholders, particularly in the face of rising servicing costs.  

While management continue with their drive to cut costs and improve efficiency at the group, the targeted numbers involved here pale into insignificance when compared with the scale of the liability side of its balance sheet.

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Summary

Our outlook for Centrica Plc remains largely unchanged from our previous update. We continue to see downside risks to both earnings as well as shares, leaving the risk reward ratio for new or continued investment skewed heavily against investors.

All in all, earnings will be lower for the year, with a negative outlook for investor sentiment toward the group going into 2015.

With the general election fast approaching in the UK, and the “cost of living crisis” set to become a central theme of both Tory and Labour campaigns, UK-listed utilities are likely to face yet more scrutiny over costs and service as this time approaches, which could compound existing vulnerabilities in the shares.

In addition to this, earnings pressures are likely to constrain the group’s ability to raise the dividend over the near term, which may further reduce the attractiveness of the shares, particularly in the face of a rising rate environment.

Consequently, we reiterate our negative outlook for Centrica Plc in that we believe a break below the 300.00 pence level is imminent. Today we assign a downside price target of 260.00 pence per share to the group, which implies a further reduction of 15% from the current 307.00 pence over the near to medium term. This is while we expect any upside from here to remain capped at 340.00 pence. 

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