High-yield Centrica primed for recovery

Centrica has been implementing a new strategy focusing on its customer-facing businesses - British Gas, US-based Direct Energy and the Irish Bord Gais - since last summer. With exploration and production (E&P) of gas more capital-intensive by nature and wholesale prices in the doldrums, management decided to cut its investment in this business. Instead, the group pledged a further £1.5bn in operating and capital resources to its supply businesses from 2015 until 2020, reducing its investment in E&P by the same amount. On top of this, management is aiming for £750m in annual operating efficiencies by the end of this period, including £200m of annualised savings in 2016 and £500m by 2018. The group is moving to a smaller E&P business, focused on the North Sea and East Irish Sea, which is expected to require between £400m and £600m of capital expenditure a year. If wholesale prices continue to weaken during 2016, management has the flexibility to reduce spending to the lower end of this range.

While it is still early days in the energy group's transition to a leaner and more simplified business, the recovery plan looks on course. Upstream business Centrica Energy reduced organic capital expenditure by a third to £728m in 2015. And European and American unit cash production costs fell 6 per cent and 13 per cent, respectively, although the latter partly reflected lower Canadian royalties due to lower North American gas prices. As a result, while operating profit was down significantly at the E&P business, free-cash-flow was positive last year.

For the group as a whole, adjusted operating cash flow was up 2 per cent last year to £2.25bn, as increased cash flow for its customer-facing business offset lower wholesale prices on E&P. This helped the group pay down 9 per cent of its net debt, which stood at £4.74bn at the end of last year. Management is targeting 3 to 5 per cent annual operating cash flow growth by 2018 at flat real commodity prices of $35 per barrel of Brent oil, 35p per therm UK NBP gas and £35 per MWh UK power.

To give Centrica more financial flexibility, the dividend has been reset at 30 per cent below the 2013 level. For new shareholders the lower 12p payout still represents a hearty 5.3 per cent yield and management is aiming at a progressive dividend policy. Crucial to achieving this aim will be the planned improvements in cash flows.

A key risk for the group's new strategy is the possibility of downward pressure on the margins of its supply businesses from increased competitive pressure as a result of the ongoing Competition and Markets Authority (CMA) review into the energy market. However, the market breathed a sigh of relief earlier this month when the CMA announced a fairly benign set of proposals in relation to the big six energy suppliers. The only recommendation that may increase competition was the establishment of a central database including details of customers that have been on their variable standard tariff, or any default tariff, for three or more years. However, proposals were far from the heavy-handed interventions feared, such as regulation of supply margins.

Against this backdrop, differentiation and the strength of the brand will be crucial, which Centrica is well placed to deliver on. The group is in the process of developing a number of customer initiatives aimed at standing out from its rival suppliers. This includes its international 'connected home' range of smart products such as its Hive motion sensor and smart thermostats. In the US, Direct Energy is going from strength to strength, increasing its operating profit by a massive 119 per cent to £328m. The business has benefited from higher-margin consumer contracts on the retail side as well as higher-margin contracts sold from 2014 onwards on the business supply side.