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Centrica offers safety in numbers

As competitors leave the market, the electricity supplier’s defensive qualities look undervalued
Centrica offers safety in numbers

If the past few days have taught us anything, it is that safety and security have a value in times of upheaval.

Tip style
Value
Risk rating
Medium
Timescale
Medium Term
Bull points
  • Strongest player in a consolidating market
  • Balance sheet now in net cash position
  • Utility offers defensive qualities
  • Low PEG ratio implies cheapness
Bear points
  • Service arm has not performed well
  • Upstream still accounts for most profits

This is as true for the domestic energy sector as it is for investors looking for the best home for their money on global financial markets, and is one reason why British Gas parent Centrica (CNA) has been the focus of so many upgrades in brokers’ earnings forecasts in recent months.

The energy market became increasingly competitive during the past decade, with the number of suppliers serving residential customers rising from 14 in December 2011 to 70 by mid-2018, according to regulator Ofgem. The ensuing battle for market share created generous deals for customers but ratcheted up the cost of acquiring (and keeping) customers for suppliers.

Life was made most difficult for the ‘big six’ legacy suppliers – a group that included British Gas, SSE (SSE)EDF (FR:EDF) and Eon (DE:EOAN). Their collective share of both the gas and electricity markets was almost total in 2011, but had slipped to 70 per cent by the third quarter of last year as challengers poured in.

Although British Gas remained the main player in both, its share of the gas market dropped from almost 44 per cent to 28 per cent and the electricity market from 24 per cent to 19 per cent over the same period.

But sliding market share turned out to be just one problem. Centrica’s thin margins disappeared entirely in 2019 as wholesale gas prices plunged, while the ensuing impairment to its upstream exploration and production business led to it declaring a £1.1bn pre-tax loss for the year. 

When combined with an actuarial loss of almost £400mn on its defined benefit pension scheme, shareholders’ funds dropped by more than half to £1.2bn from £3.1bn a year earlier. This sparked a downgrade by ratings agency Moody’s just as the pandemic hit.

Former chief executive Ian Conn had fallen on his sword by then, with his departure announced in the second half of 2019 as the company began a major restructuring that involved a withdrawal from upstream activities. Chief financial officer Chris O’Shea was promoted to oversee the transformation.

The progress made since can clearly be seen on its balance sheet. The sale of US energy services and supply arm Direct Energy brought in $3.6bn (£2.7bn) and meant 2021 closed with net cash of £680mn, having started with debt of £3bn. The $1.08bn (£800mn) sale of the Norwegian assets of upstream business Spirit Energy, agreed in January this year but not yet complete, will add to its financial firepower.

Centrica also stands to benefit from the huge upheaval experienced in the sector over the past year caused by a surge in natural gas prices – from 51p per therm at the start of 2021 to a peak of 451p in mid-December.

Many energy suppliers failed to adequately hedge requirements to protect themselves against massive price swings and the price cap imposed by the regulator to limit rapid increases in customers' bills meant they were simply forced out of the market.

Since the start of last year, 30 companies serving more than 2.8mn customers have gone bust. British Gas has taken on a quarter of these as a Supplier of Last Resort.

A further 1.6mn customers will be up for grabs once the special administration period for Bulb’s parent Simple Energy ends. The UK government had to pump in £1.7bn in emergency funding in November to allow Bulb customers to continue receiving energy throughout the winter, but it will soon either be restructured, sold or broken up.

Although the cost of acquiring customers due to competitor failures will be much lower than in previous years, it isn’t completely free.

Centrica committed £113m of its working capital in 2021 putting people on standard tariffs that were still lower than the prevailing cost of energy. This figure is expected to continue rising in the current quarter, but will be recovered from the second quarter and into 2023, CFO Kate Ringrose told investors at the group’s full-year results presentation last week.

The main challenge for the company is ensuring it holds on to new joiners, particularly as it will have to impose hefty price rises when the default price cap set by Ofgem increases by 54 per cent on 1 April.

Competitors will face the same problem, though, and the ability to pass on higher prices will do its profits no harm. Given that new joiners will already have moved supplier at least once over the past 12 months, many customers may not be keen on switching again, particularly in a market that is still undergoing turbulence.

Since then, Centrica has played up its role as a safe pair of hands.

One problem that emerged during last year’s shakeout is that some businesses took customers’ money that should have been used to pay suppliers and instead spent it on other things. When questioned by MPs last month, Ofgem chief executive Jonathan Brearley admitted that as much as £200m of customers’ money had been lost.

Centrica has opened separate accounts to hold customer deposits and O’Shea has been critical of the way the sector has been regulated.

Last week, he called for a widespread strengthening of the rules, including the adoption of “financial services-style prudential regulation”, which would include fit and proper person tests for directors and capital adequacy rules for suppliers.

This stance may reassure customers, but Centrica still has work to do on service levels – especially in its services and solutions arm that installs and maintains boilers.

The company’s overall Trustpilot score, based on more than 86,000 reviews, is 3.1 out of five, which is hardly a ringing endorsement. Strikes, higher staff absence rates and chip shortages for boilers contributed to installation delays last year. Customer complaints doubled to 12.1 per cent.

O’Shea said the division’s cost per job is between one-third and a half higher than external third-party contractors. Its attempt to narrow this by introducing new employment terms for its 7,000 engineers led to the aforementioned strikes, which dented first-half profitability and led to 450 departures from the business. It has added 1,500 new recruits under its new terms but 40 per cent of these are apprentices – a sign of the difficulty in recruiting skilled engineers in the current market.

Neither do current levels of profitability offer complete assurance. Its three core divisions – services, energy supply and B2B – all delivered profits that were about 30 per cent below consensus estimates, UBS analysts said.

Although pre-tax operating profit doubled to £948mn, over two-thirds of this was driven by upstream operations. This is a problem given that Centrica has earmarked the proceeds from upstream to be set aside to deal with decommissioning liabilities as it drives towards a ‘net zero’ business model.

Such considerations need to be balanced against the opportunities now before the business.

Little about the company's recent trading history points to operational balance. Over a five-year period, Centrica’s shares have been a terrible investment, losing two-thirds of their value. However, brokers aren’t the only ones reassessing its potential.

The company’s shares have climbed by 48 per cent in the past six months and it has fared well in a number of our recent stock screens – it topped a Joel Greenblatt-inspired ‘magic formula’ screen based on earnings yields and returns on capital and fared well in a Cornerstone Value screen based on Jim O’Shaughnessy’s teachings.

Despite recent gains, its current price equates to 10 times this year’s forecast earnings – slightly below its five-year average but well below its peers. It seems like a reasonable price to pay for the biggest player in a consolidating market.

Last IC View: Hold, 49p, 23 Jul 2021

Company DetailsNameMkt CapPrice52-Wk Hi/Lo
Centrica (CNA)£4.55bn77p80.0p / 45.2p
Size/DebtNAV per share*Net Cash / Debt(-)Net Debt / EbitdaOp Cash/ Ebitda
47p£485mn-177%
ValuationFwd PE (+12mths)Fwd DY (+12mths)FCF yld (+12mths)P/Sales
94.0%5.3%0.3
Quality/ GrowthEBIT MarginROCE5yr Sales CAGR5yr EPS CAGR
6.5%4.1%-11.5%-20.4%
Forecasts/ MomentumFwd EPS grth NTMFwd EPS grth STM3-mth Mom3-mth Fwd EPS change%
74%18%19.0%18.0%
Year End 31 DecSales (£bn)Profit before tax (£mn)EPS (p)DPS (p)
201926.86537.25.00
202024.42606.50.00
202118.37614.10.48
f'cst 202220.08247.93.07
f'cst 202319.28949.83.43
chg (%)-4+8+24+12
source: FactSet, adjusted PTP and EPS figures
NTM = Next Twelve Months
STM = Second Twelve Months (i.e. one year from now)
* includes intangibles of £5.8bn or 20p per share