Contrary to what some seem to believe, utilities aren’t foolproof toll-taking businesses that can be run on autopilot, but the U.K.’s Centrica (OTCPK:CPYYY) has committed a lot of unforced errors along the way. Although the company has done a good job of improving customer service and developing retail customer retention efforts, the company’s foray into upstream oil and gas has destroyed value, and the company’s efforts to generate growth from businesses like connected homes and distributed generation are uncertain at best. Making matters worse, aggressive pricing actions from competitors in the U.K. market has the government talking about taking a harder line on regulation and implementing more price controls.
Centrica offers a yield above 5%, and the company’s cash flow should continue to grow from here (albeit slowly). With upstream capex now significantly de-prioritized, more of that cash could be directed towards shareholders once the company goes a little further with deleveraging. The shares look poised around fair value, with the potential of the growth opportunities balanced by the regulatory and competitive risks.
A New, Hopefully Better, Centrica
Formed from the demerger of British Gas 20 years ago, Centrica is the largest supplier of electricity and gas to retail and business customers in the U.K. through its British Gas business. Centrica also operates through the U.S. and Canada through its Direct Energy business, and Centrica’s Storage business owns the largest natural gas storage facility in the U.K. (when operational). Centrica owns gas-fired generating assets and a stake in nuclear operator, British Energy, as well as an oil and gas upstream business.
British Gas serves close to 16 million customers in the U.K. where it enjoys a little more than one-third market share in the gas business (ahead of Iberdrola‘s (OTCPK:IBDRY) Scottish Power, EDF‘s (OTCPK:ECIFY) EDF Energy, SSE (SSZEY), and RWE‘s (OTCPK:RWEOY) npower, and E.ON (OTCPK:EONGY)). Basically, the same roster of competitors figures into the electricity market, where British Gas holds roughly one-quarter market share. Although electricity and gas consumption has declined over the last decade (due in large part to more efficient major appliances) and concerted efforts by the government to encourage competitor have led to share losses, Centrica’s UK Home business remains a profitable and worthwhile business and generates more than a third of the company’s profits.
The biggest change in Centrica’s operations has been the de-prioritization of its upstream oil and gas business. Centrica was far from the only utility to try going upstream, acquiring producing oil and gas fields, with the idea that there would be advantages to vertical integration. Those advantages never materialized, in part, because of changes in the downstream energy markets, but also due to Centrica investing over $10 billion into high-cost oil and gas assets that were hit disproportionately hard when oil and gas prices plunged.
While Centrica’s upstream businesses did once account for around two-thirds of operating profits, they never earned a sufficient return on capital, and management has been backing away from the business. Capital investments have been dramatically reduced, and the company has been exiting businesses; the assets in Trinidad and Tobago are gone, and the company will look to sell off its Canadian assets in 2017. On a more encouraging note, Centrica has done a good job of reducing operating costs, and I don’t believe this downsized operation will be the drag on results it has been.
Will The New Focus Deliver More Value?
Centrica’s foray into upstream energy didn’t work out, and that’s not the first strategic blunder in the company’s history. Over a decade ago, the company diversified into (and then sold out of) businesses like internet financial services and auto insurance. More recently (in 2016), management made two reasonably cogent acquisitions (an energy trading company that can help with risk management and a specialist in cogeneration), but did a very poor job of managing and communicating the process (including a sizable and unexpected equity raise).
Now the company is pursuing connected homes and distributed generation as growth opportunities. The idea of connected homes is pretty familiar now, with companies like Honeywell (NYSE:HON), Alphabet (NASDAQ:GOOG) (NASDAQ:GOOGL), and others involved to varying degrees. Centrica has staked out strong initial share in the U.K. market, but it’s still a very small market, and the company is a long way from the 10% overall share it’s going to need to make real money from this initiative. At the same time, there’s no guarantee that the connected home concept is going to catch on and be more than a novelty. The distributed generation opportunity is not as speculative in my mind, but there’s a great deal of competition, including companies offering renewable energy sources like solar.
In contrast to all of that, Centrica has, in my opinion, missed some opportunities. The company put its eggs in the oil/gas basket and didn’t go upstream into renewables like solar or wind in a meaningful way, whereas as E.ON, RWE, EDF, and others all have. I’m not necessarily saying that buying/building billions of pounds’ worth of solar and wind farms would have been a good use of capital either, but I think it would have been better. Centrica has also had challenges with its storage business, as its large Rough facility is not aging well and a significant percentage of the wells are offline. While this business isn’t a large profit center, it still seems unwise to let strategic assets fall into disrepair.
Opportunities Amid Threats
I don’t think it’s all bad at Centrica. The turnaround plan that management laid out in 2015 was logical and seems to proceeding well. Management targeted GBP 750 million in cost savings by 2020 and is about halfway there now, with another significant chunk expected to come in 2017. The company has also executed on its strategy to reallocate capital away from the upstream operations and toward the downstream assets. Last, and less proven, are the opportunities to drive growth from newer efforts like connected home products and distributed/cogeneration.
On a more negative note, some of Centrica’s competitors have announced meaningful tariff increases this year and the reaction from the U.K. government has been vocal. Some U.K. government officials want to implement tougher pricing regulations, and even though Centrica is far from the worst offender with respect to the cited behaviors, some of the proposed pricing controls could have a significant negative impact on earnings (20% or worse). I suspect that the final outcome of this process will be less serious for Centrica, but it remains an outstanding risk factor.
I’m not expecting much growth from Centrica. Population growth in the U.K. is not robust, and I don’t expect per-capita consumption to increase (in fact, I would expect it to decrease given ongoing initiatives to make appliances and homes more efficient). While efforts like the connected home products could stimulate some growth, I suspect that they will ultimately become more effective as customer retention products than real growth drivers. I also don’t expect much from the distributed generation/cogeneration efforts, as I believe ample competing approaches will reduce the profits to be had.
I’m looking for low single-digit revenue growth and relatively stable low-to-mid-single-digit free cash flow margins. Centrica does have more work to reduce leverage (including improving its pension situation), but the sharply reduced level of capital investments in the upstream business will help, and I think dividend payments could rise meaningfully in a few years’ time.
The Bottom Line
Centrica has made too many mistakes for too long for me to rest easy at night with these shares, and that history has been at least partially continued by the new management team. Still, the company’s turnaround plan is credible, and I think the U.K. consumer energy business is on good footing (regulatory risk not withstanding). For investors who want a more income-oriented idea and can accept elevated risk in the pursuit of potentially higher payouts in a few years, Centrica could be worth a look, but the share price seems quite fair today.
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