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Centrica Plc: Q4 Update, Raising Our Price Target – 25 November 2014

Company Overview:

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 288.00
52 Week High 349.00 52 Week Low 280.30 P/E (F) 15.15
Dividend Yield % 5.4 Dividend Cover 1.56 CEO: Sam Laidlaw
CFO: Nick Luff Previous Price Target 260.00 Current Price target 280.00

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Centrica shares remain under pressure; management revise 2014 earnings expectations lower

Much has been made of Centrica shares and their growing dividend throughout recent years however, recent developments in energy markets and the utilities sector have seen the group’s status as an income investor’s favourite come under threat.  

This is as persistent weakness in UK gas prices, warmer weather and stoppages at some facilities have each contributed to a further downward revision to lower expectations for earnings at Centrica during 2014.

In addition to this, political risk has also weighed on the shares with support for the Labour Party and its cost of living campaign yo-yoing up and down in the opinion polls throughout the period.

As a result, the opening days of October saw the shares break below the 300.00 pence level for the first time since 2012, before eventually falling to a 2 ½ low at 280.00 pence by the close of the month.

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EPS Outlook

If lower expectations were not enough of a weight around Centrica’s ankles already, the interim management statement released in late November was the final blow for shareholders, torpedoing any remaining hopes of improvement before year end.

This was as management announced that the extended delay in bringing its part owned nuclear facilities back on line, along with warmer weather and energy efficiency measures taken by consumers, had each contributed to a further downward revision to full year earnings expectations by the board.

Centrica now expects earnings to be in the region of 19/20 pence per share, which is some way below the previous bottom end of the range estimate of 21.00 pence per share.

Centrica Plc Share Price // 8 Hour Intervals

CENTRICAPLCENDNOVEMBER

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What does 2014 earnings performance mean for subsequent periods?

Given the second downgrade to expectations for the current year, both Centrica management and a range of observers have been quick to note the increased likelihood of earnings growth for the 2015 period.

While we acknowledge that a rebasing of expectations does increase the likelihood of positive numbers for 2015, we are skeptical of just how much of an improvement investors are likely to see.

On this subject, we note that Centrica earnings are highly correlated with gas prices in both previous as well as present periods.

Given that there has typically been a lag between sharp falls in wholesale prices and a backwards step in earnings for Centrica, we believe it is possible that much of the current years decline is attributable to overambitious forecasts by management and the analyst community, that relied too heavily on the assumption that the July 2009 – Dec 2013 rally in UK Nat Gas prices would continue.

For this reason, we also believe that there could be a further sting to come from the 2014 collapse in wholesale prices, which could then negate the benefits of expectations having been reduced for the current year.

Further from here, we also attribute a large portion of the poor 2014 performance to long term trends, which were also referenced in the interim management statement released earlier this month. Most notably, households are consuming less energy as a result of a number of factors, including more energy efficient home boilers, better insulated houses and several years of longer summers combined with milder winter periods.

Going forward, at least some of these trends are likely to remain in place, notably; the move by British households toward energy conservation and efficiency.

While it is not possible to predict what the weather will be like next year, it is reasonable to expect that milder weather could continue as a factor in weak domestic demand.

This is while, even if geopolitical and capacity factors were to drive a sudden turn for the better in wholesale markets next year; energy bosses may be reluctant to capitalise upon this at the retail end of operations given the prevailing political environment and the ongoing Competition and Markets Authority review in the UK.

All in all, we see risks inherent in the automatic assumption that because earnings dipped due to “one off” factors this year, they are likely to improve in 2015. If anything, we see a broadly similar performance next year as most likely, with the best case scenario outcome being some form of meagre earnings growth.

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Launch of UK capacity market is a positive long term development for Centrica

While Centrica and its competitors are believed to be reducing investment in further capacity generation in some areas while prices remain weak and political risks elevated, the launch of the first ever capacity auction in the UK (Dec 19) could change the long term investment plans of UK energy producers as well as provide a welcome boost to earnings in future years.

The auction will involve qualifying companies bidding to supply a set amount of the UK’s energy requirement for future years. It is intended that the government will quote prices to participating companies, who will in return, announce the amount of capacity they can guarantee at the said price as their bid.

The prices quoted by the auction operator will then be reduced from the initial £75 per KW, in increments of £5, until there is just enough bids remaining to ensure that the nation locks in its anticipated requirement for the year in question.

The government believes that such a process will not only ensure that the “lights remain on” in future years, but that it will also provide a degree of foresight for energy companies when it comes to earnings expectations and returns on investment for future years.

The government also hopes that such a mechanism will encourage energy producers and suppliers to invest further in UK capacity and therefore, reduce uncertainties over future energy security.

While the first auction is set to take place in December 2014, this will be for generated supply running from the 2018 through to the 2019 year. As a result, although positive for Centrica, the benefits are largely long term in nature.

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Balance Sheet, Dividend and Valuation Update

From a valuation perspective, Centrica is now trading on 15X 2014’s projected earnings, with this multiple due to fall to 13.6X for 2016 if consensus industry estimates are to be believed. The current 15X forward earnings is largely unchanged from the time at which we initiated coverage at 310.00 pence, when the consensus for full year EPS was at 21.0 pence.

However, the valuation is somewhat above its nearest competitors who average just under 13X forward earnings for the current year, a more desirable price point given the immediate prospects for much of the sector.

All in all, we believe that on a valuation basis, Centrica is expensive. This is because the sector as a whole is stagnating, with any material growth expected over the subsequent year likely to be due as a result of under-performance in 2014 and rebased expectations, not any form of organic progress on the ground.

This poses a problem for investors because risks to the energy sector still abound, most notably in the trajectory of commodity prices, the direction of balance sheet gearing and the current political backdrop.

Further from here, the economy also presents a risk to the group, despite 2014’s recovery. This is most notably the result of stagnant wages, high levels of household indebtedness and the potential for interest rate increases in late 2015 to further stretch household budgets.

These factors reduce the likelihood that households will markedly increase their consumption of energy during the near term, at a time when the outlook for wholesale gas prices is uncertain, even as they remain some 20% lower than at the same point in 2013.

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).

Therefore, at the very least; we expect that further dividend growth will be lacklustre if forthcoming at all and that it is possible this could form an additional pressure upon the shares during the months ahead.

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Summary

Critical to the future performance of Centrica shares are a number of external factors, most notably; gas prices in the UK, retail demand and the outcome of a 2015 general election.

On these subjects it is worthy of note that much of the recovery in European gas markets throughout the second, third and fourth quarters has been induced by the crisis in Ukraine and seasonal trends in anticipated demand.

Should underlying demand remain weak and the nascent recovery reverse once into 2015, then management will have a hard time painting a picture of a rosy outlook when presenting full year results in February. Looking further ahead, we also believe that the tail end of 2014 gas price weakness is yet to be fully reflected in Centrica’s financial performance, indicating that 2015 earnings could also suffer.

In addition to each of the above, the general election in the UK remains a close call, one which is sure to see the cost of living and energy bills feature prominently in the election manifestos of the major parties. This represents an additional weight upon Centrica shares over the near term, while the current Competition and Markets Authority review could pose a risk for somewhat longer.

Further from here, cost management will also be critical for the group as without this Centrica will face challenges when it comes to reducing balance sheet leverage, which rose by 24.75% during 2013.  

All of these issues will be key determinants of whether or not the group is able to grow earnings once into 2015 and therefore, maintain its dividend current dividend policy during the year.

Despite our view of the current and future outlook for earnings, the rebasing of expectations in Q4 has driven a number of analyst upgrades and we believe that with the shares now having fallen to a 2 ½ year low at 288.00 pence, much of the negative news flow appears to have been priced in.  

For this reason, we believe that in the absence of further energy market weakness or an escalation in political uncertainty; further downside is likely to remain limited for the time being while recent analyst upgrades could even provide scope for a minor recovery between now and the close of Q1 2015.

Accordingly, we adjust our price target today in order to reflect recent developments by raising it from the current 260.00 pence per share, to 280.00 pence. However, we note that while we anticipate a moderate turnaround for the shares, we believe this will be short term in nature and that gains are likely to remain capped at 315.00 pence.

This is while our overall view of the shares is that we remain un-attracted to them and therefore, maintain our negative outlook.

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