Stockwatch: Get lucky with this 8% yield

by from interactive investor |

Is £7.9 billion integrated energy group Centrica shaping up as a genuine 'buy', or a superficial high-yield play with poor fundamentals?

I drew attention last December at 138p following a drop from 160p after a 27 November update cited the loss of 823,000 UK energy accounts since end-June, plus intense competition in North America.

Versus this bad news, a relatively new chief executive (BP's ex-head of refining) had added 100,000 shares at 145p, having also bought (with the chairman) at 173-175p in October. Cash flow strengths underlined the prospect of a 12p dividend, giving an 8.7% prospective yield.

With Labour renationalisation threats a long-shot and oil & gas prices looking firm, "risk-tolerant contrarians should consider averaging into Centrica while more cautious investors will await chart confirmation of a low." So, where are we post-prelims and the price having thrice risen to 145p?

Source: interactive investor                  Past performance is not a guide to future performance

Near reverse head & shoulders chart pattern

It's not exact but, since December, there's been a modest "first shoulder" followed by a decent "head" (if related to February's wider volatility), and now a "second shoulder" has completed.

In principle that's a classic major reversal pattern, coming after a long drop from 350p in 2014. I wouldn't take that as a cue but, given behaviour patterns are apt to repeat, it's interesting to compare with the fundamentals as to whether Centrica is at a turning point.

It would appear the flow of bad news is at least paused, and, if contained, then the group's challenges are most likely priced in, such that on a chart basis, even small positives can drive medium-term upside.

2017 prelims: cash flow guidance is key

Cash flow is the vital element influencing whether a 12p per share payout is sustainable medium-term.

Headlines from the 22 February results were poor, albeit priced into the stock anyway: adjusted operating profit down 17% to £1,252 million on 3% revenue growth, with adjusted earnings per share (EPS) down 25% to 12.6p and underlying adjusted operating cash flow down 13%.

Exceptional charges make for a complexity of "underlying/adjusted" definitions, with adjusted operating cash flow declared at £2.1 billion, which compares with the £672 million cost of a 12p dividend.

Yes, there are other demands on cash flow, but this strength helps explain why the board says it expects to maintain the payout until 2020 - so long as annual cash flow turns out at £2.1 billion to £2.3 billion and net debt stays in a £2.25-3.25 billion range.

This is supported by a £750 million reduction in controllable costs to £4.5 billion in the last three years, with a further £500 million targeted by 2020.

As regards to turning a supertanker, Centrica represents, it's a pretty good start, although the "new" chief executive has been in place since January 2015, hence the share price slump has probably done most to instil urgency.

Centrica - financial summary            
year ended 31 Dec 2013 2014 2015 2016 2017 2018
Turnover (£ million) 26,571 29,408 27,971 27,102 28,023  
IFRS3 pre-tax profit (£m) 1,649 -1,403 -1,136 2,186 142  
Normalised pre-tax profit (£m) 2,707 405 1,231 2,259 872 1,030
Operating margin (%) 10.6 1.8 4.7 9.1 1.7  
IFRS3 earnings/share (p) 18.3 -20.2 -14.9 31.2 6.0  
Normalised earnings/share (p) 37.6 16.0 28.8 31.3 12.6 14.0
Earnings per share growth (%) 2.7 -57.4 79.8 9.0    
Price/earnings multiple (x)       4.4 11.3 10.2
Historic annual average P/E (x)   8.5 16.1 7.6 6.5 4.3
Cash flow/share (p) 56.6 21.8 42.0 45.1    
Capex/share (p) 31.0 28.7 19.2 15.3    
Dividend per share (p) 16.7 17.2 12.0 12.0 12.0 12.0
Dividend yield (%)         8.4 8.4
Covered by earnings (x) 2.3 0.9 2.4 2.6 1.1 1.2
Net tangible assets per share (p) 9.2 -37.5 -52.2 -31.3 -16.0  

Source: Company REFS                   Past performance is not a guide to future performance

Uncertainties remain for both key divisions

Energy supply/services to consumers and business are Centrica's backbone, about 80% of group revenue/profit, with energy trading at about 10% and down due to legacy gas contracts, the other activities performing mixed.

Last December, I defined the key challenge as figuring out what will be the net effect of Ofgem extending price caps, and whether British Gas's energy marketing can improve.

On 6 March Ofgem confirmed that in response to February's government proposals for a cap on Standard Variable Tariffs (SVT's) it declared its intention to cap prices to end-2023 unless the Secretary of State decides otherwise.

Centrica and other energy suppliers argue that evidence abroad shows this will mean less competition with prices clustering around the cap; and British Gas already claims to be 85% cheaper than other SVT's, though last November withdrawing SVT for new customers as if affirming a negative.

So, it remains uncertain how this will pan out; the extent British Gas can achieve margin growth like it says, with new customer offers.

Meanwhile, Ofgem has already capped pre-payments on energy meters, a move that tightened last October and is partly why Centrica Consumer declared effectively flat operating profit: the effects of warmer weather, competition and a UK prepayment cap offset by cost efficiencies. Again, it remains to be seen if further cost cutting offsets the SVT price cap.

Meanwhile, operating profit for Centrica Business has plunged 67% to £161 million due to competition eroding margins, and warmer weather, both for the UK and US. Management says it is addressing margins and anticipates "good growth prospects" in the US, though investors may await the evidence.

The narrative should also be counter-balanced e.g. the next update on 14 May, by recent cold weather benefiting energy suppliers.

Potential for step-change reduction in gearing

End-2017 net debt fell 25% to £2.6 billion, although, with the Bank of England hinting at interest rate rises, this extent of debt has likely contributed to the stock's fall.

The results indicated "no plans for any major M&A" alongside "intent to pursue sale of UK nuclear investment", which is interesting after Centrica bought a 20% stake in the nuclear fleet of eight power stations for £2.4 billion late in 2009.

While there are very few buyers of nuclear assets acceptable to the government and EDF (which bought them from British Energy earlier in 2009) this would transform Centrica's balance sheet and perception of dividend risk - even lend the prospect of a special dividend.

It's a speculation, albeit with good grounds, a straightforward payback representing over 30% of present market cap. The share price would likely rise with holders having locked in an 8%-plus yield.

Lack of material short-selling

Only 0.58% of Centrica's equity is out on loan, to AQR Capital Management, which represents the entire disclosed short positions - AQR being quite a prolific shorter of UK equities.

The upshot is mixed: while there's no shorting party underway liable to hit the price in response to bad news, equally there's no coiled spring as exists in "most shorted" stocks that need buying back in the market.

Thus, Centrica has fallen about 60% for industry-specific reasons, not manipulation, and hedge funds don't regard it as being in a compellingly weak position. SSE has similarly had about 0.5% of its stock on loan, now reduced to zero disclosed.

Clouds therefore remain, albeit silver linings

Trying to avoid confirmation bias, this update concludes net-positively: the extent of bad news is well-manifest, with scope for it to improve overall. Operationally that assumes trusting management can deliver on further cost reductions and marketing gains, like it says.

Much remains to overcome, but that's why the stock offers an 8%-plus yield. Take your own view of the risks, but given the chance the 12p dividend is supported by cash flow, there's scope to get lucky.

The stock may next take its cue from the 14 May update, which can hardly warn about weather. Speculative buy.

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