Interactive Investor

Stockwatch: A 9% yield for contrarians

21st December 2017 15:58

Edmond Jackson from interactive investor


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Should you follow the chief executive who bought 100,000 Centrica shares at 145p on 12 December, taking his stake in this FTSE 100-listed integrated energy group to over 888,000 shares?

Or with the price now 137p, is it a futile averaging-down, a propping-up for a company overdue the realities of competition?

Certainly, the chart offers no comfort as yet following a persistent downturn from about 400p in 2013. But it's not just Centrica that's struggled; SSE is similarly under pressure and yielding 7.3%, and so are most privatised transport stocks. BT Group has halved over two years and is now yielding nearly 6% at 275p, while Centrica offers 8.8% if forecasts are credible.

It's as if the market has given up on growth and re-based such stocks for income to compensate for industry risks and competition. In the process, are some falls going too far? We know markets are prone to overshoot.

A substantial yet complex business in flux

Defining fair value is hard due to Centrica's extent of activities and the shock it dealt in a 27 November trading statement. It had lost 823,000 UK energy supply accounts since end-June, while business services have also been hit by intense competition in North America.

UK energy supply constituted 60% of group profits in 2016, and total energy supply/service 80% of group profit. I can't say I'm surprised: five years or so ago as a longstanding British Gas customer I compared the market to find BG more expensive than the competition; I explained to customer service what were the alternative prices, but they would not improve terms, so I switched.

With more people wising up to price comparison, BG is being undermined. Yet the government's bid to introduce a price cap on the standard variable tariff - via Ofgem, effective probably from 2019 to 2023 and with scope to extend - may be a blessing in disguise.

When it was proposed last October, analytics firm S&P Global said the greatest impact would be on Centrica and SSE.

Other big energy firms protested that a cap would compromise better-priced deals: effectively an admission that customers on standard tariffs are being charged excess to subsidise others on those lower-priced.

I suggest that if a cap is introduced it will reduce switching as energy firms reduce their offers, which could also work to Centrica's benefit to preserve its existing customers, if managed well. When this news broke, Centrica's chief executive bought £173,100 worth of shares at 173.1p, and the chairman £99,885 worth at 175p.

Higher oil & gas prices should help the E&P side

Such "asset" businesses were a modest 12% of 2016 profit, although Centrica is one of the leading gas exploration and production companies on the UK Continental Shelf.

Prices are rising globally; in Europe on supply issues after a blast at an Austrian import hub, also a key North Sea pipeline to the UK was closed after a crack was discovered.

Yet demand attrition will be limited: buildings need heating, people have to cook and get around; thus Centrica could benefit from a firmer price environment as an integrated energy firm.

Gas prices are also prone to follow oil, hence OPEC's new-found discipline at output control - with equilibrium oil prices now in the mid-$60's - is encouraging, likewise expectations for robust global growth in 2018.

Cash flow is the crux for dividend strength

The table cites profit/earnings projections down nearly two-thirds on 2016 results, with earnings cover slipping below 1.0 times for the total dividend of 12.0p per share.

But notice how the trend in cash flow per share is significantly stronger than earnings, the dilemma being that capital expenditure is also material in context and such commitments - such as to the E&P side - may be longer-term hence difficult to trim.

The table shows Centrica's 2016 cash flow per share of 45.1p per share compared with 15.3p for capex and 12.0p for the dividend; hence, what impact on cash flow from a projected profits slump?

As yet it's a guess, but 2014 shows profit, earnings per share (EPS) and cash flow slumped and Centrica still managed to raise its payout to 17.2p per share, despite capex per share of 28.7p. Notice also, despite 2015's financial recovery, the dividend needed trimming to a more realistic 12.0p per share.

So it's possible to envisage an aspect of dividend cut possibly in 2018/19 according to how finances pan out. In the meantime, the 23 November update cited the cash flow profile "on track" by way of 2017 adjusted operating cash flow over £2 billion, with capital investment below a £1 billion limit (in respect of E&P capex, smaller acquisitions and other investment).

EPS is guided at 12.5p due to lower profit also warmer weather in October/November reducing energy demand. But with net debt within a £2.5-3.0 billion range, "cash flow will support the current 12.0p level of dividend" (meaning the 2017 year).

Thus, at 137p, the stock is saying investors don't trust this reassurance further out, or that its fall is overdone. Both could be true in the sense that a dividend trim to 10.0p per share would equate to a 7.3% yield, which is presently in line with SSE.

The update added that in "shifting the portfolio...diversifying and growing new sources of gross margin, we would be willing to operate with dividend cover from earnings below historic levels."

It should really have focused on better elucidating cash flow cover, it being the crux for dividend payouts.

This is crucial because downside protection to Centrica shares is all about yield: equilibrium price being where disillusioned growth investors are exiting, replaced largely by income seekers.

Otherwise, £2.7 billion balance sheet net assets comprise £4.44 billion goodwill/intangibles; no prop.

Centrica - financial summary           Consensus estimates
year ended 31 Dec 2012 2013 2014 2015 2016 2017 2018
Turnover (£ million) 23,942 26,571 29,408 27,971 27,102    
IFRS3 pre-tax profit (£m) 2,416 1,649 -1,403 -1,136 2,186    
Normalised pre-tax profit (£m) 3,059 2,707 405 1,231 2,259 872 908
Operating margin (%) 13.1 10.6 1.8 4.7 9.1    
IFRS3 earnings/share (p) 23.9 18.3 -20.2 -14.9 31.2    
Normalised earnings/share (p) 36.6 37.6 16.0 28.8 31.3 12.0 11.0
Earnings per share growth (%) 89.3 2.7 -57.4 79.8 9.0 -61.7 -8.3
Price/earnings multiple (x)         4.4 11.4 12.5
Historic annual average P/E (x) 10.0 8.5 16.1 7.6 6.5    
Cash flow/share (p) 53.0 56.6 21.8 42.0 45.1    
Capex/share (p) 45.4 31.0 28.7 19.2 15.3    
Dividend per share (p) 15.7 16.7 17.2 12.0 12.0 12.0 12.0
Dividend yield (%)         8.8 8.8 8.8
Covered by earnings (x) 2.3 2.3 0.9 2.4 2.6 1.0 0.9
Net tangible assets per share (p) 34.7 9.2 -37.5 -52.2 -31.3    
Source: Company REFS              

Labour re-nationalisation risks are a long-shot

An axe hanging over Centrica and other privatised utilities is renationalisation on terms dictated by parliament. This £7.7 billion group is a prime example of how a radical Labour government could part-deliver on its manifesto promise, rather than the cost and complexity of unpicking say BT Group and water/transport operations held within listed groups or under foreign ownership.

I'd question how realistic all this is, and it's also helpful to investors with fresh money by way of pricing the stock for a substantial yield.

Even the left-leaning Guardian newspaper has indicated the total cost of re-nationalising privatised industries since Thatcher would be in the region of £200 billion; with right-wing media claiming this would be impossible to factor into the UK borrowing requirement, never mind Labour's goals to expand public services and raise public sector pay.

Anyway, a general election is not required until May 2022 unless the Conservative/DUP government fails beforehand and Labour advances in the polls.

Financial uncertainties remain the chief worry

Ultimately, it's the challenge to figure what is the net effect of an Ofgem price cap and whether British Gas' marketing can better meet the competitive environment, which explain Centrica's high yield.

It's hard to imagine news flow improving soon, although it is possible to envisage the stock forming a bottom simply if news doesn't get worse - versus a near 9% yield based on a promised 12.0p dividend in respect of 2017.

Centrica, therefore, offers value for income, potentially capital growth if an approximate such payout can be sustained, as the stock would rise to re-adjust yield for risk.

More cautious investors will await chart confirmation of a low, but risk-tolerant contrarians should consider averaging into Centrica now. Accumulate.

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