Many investors who focus on a low price-to-earnings (P/E) ratio and high dividend yield in their search for value will have a hard time swallowing the maxim legendary investor Warren Buffett lives by: “It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price”.
Today, I’m considering whether FTSE 100 utility Centrica (LSE: CNA) (NASDAQOTH: CPYYY.US) is a wonderful company, and whether its shares are trading at a fair price.
A wonderful company?
Buffett’s Berkshire Hathaway investment company bought control of an unlisted utilities group called MidAmerican Energy during 2000. At the end of last year, Mid-American’s book value was $16bn (£10bn at current exchange rates); Centrica’s book value at the same date was £6bn.
Clearly, Buffett sees the utilities sector as an industry in which wonderful companies may be found. In part, though, this is because Berkshire’s ever growing billions have to be deployed somewhere, and capital-intensive industries offer a way for Buffett to put his vast funds to work.
Buffett expects MidAmerican’s “huge investment in very long-lived, regulated assets” to “produce above-average, though certainly not spectacular, returns in the decades ahead”. In fact, he reportedly went so far as to say at a meeting of US regulators during 2006 that owning utilities is “not a way to get rich – it’s a way to stay rich”.
Buffett is happy for MidAmerican to retain all profits within the business, growing assets and increasing future earnings. Hence, MidAmerican has never paid a dividend.
This, of course, contrasts with UK utilities, where many shareholders are seeking to “stay rich” from a steadily rising cash dividend that maintains or increases their purchasing power against inflation. All the FTSE 100 utilities distribute the lion’s share of their profits in dividends.
However, as the table of retained earnings below shows, Centrica is less far away than its Footsie peers from MidAmerican.
| Company | Retained earnings (%) |
|---|---|
| MidAmerican | 100 |
| Centrica | 39 |
| SSE | 29 |
| National Grid | 27 |
| Severn Trent | 23 |
| United Utilities | 12 |
Buffett doesn’t generally like a lot of debt in a company, but he does tolerate a higher level within regulated businesses. MidAmerican’s net gearing at the last year end was 133%; Centrica’s was a far more conservative 68% — so no concerns that the UK company has too much debt to be a Buffett wonderful company. Furthermore, despite its relatively modest gearing, Centrica still manages to deliver a good double-digit return on equity.
A fair price?
MidAmerican has this year made a bid for a company called NV Energy. We can compare the so-called ‘takeover multiple’ (EV/EBITDA) for NV Energy (8.6) with that of Centrica (6.4). EV stands for enterprise value (a company’s market capitalisation, plus net debt), and EBITDA stands for earnings before interest, tax, depreciation and amortisation. And the lower the multiple, the cheaper the business.
In summery, then, Centrica appears to me to have Buffett ‘wonderful-company’ qualities, and to be trading at a better than fair price based on how much MidAmerican is prepared to pay for NV Energy.