When I think of integrated gas and electricity company Centrica (LSE: CNA), two factors jump out at me as the firm’s greatest weaknesses and top the list of what makes the company less attractive as an investment proposition.
1) Cyclicality
One constant in Centrica’s business is Change. Cycles buffet the firm, influenced by macro-economic events, weather, war and other factors. Input prices and output-demand waver about, and hitting a profit result can be like shooting at a moving target.
In an update on 8 May, the firm reckons challenging market conditions experienced this year in the UK and in the US will knock full-year profits. In Britain, lower energy consumption due to mild weather has reduced demand compared to last year. In the US, the opposite has occurred, with exceptionally cold weather hitting consumers. That might sound optimistic for profits but, unfortunately, the extreme weather caused costs to rise, so profits are down across the Atlantic, too.
Centrica expects full-year adjusted earnings per share to come in around 22p to 23p per share, between 13% and 17% down on last year. Indeed, the firm thinks full-year residential energy supply revenue will be down around 10% on 2013 levels and the company’s post-tax margin will be just 4% – a figure that falls below the 4.5% to 5% margin needed to sustain investment in the firm’s operations. That seems worrying, but is symptomatic of the challenges that cyclicality throws at Centrica.
2) Regulatory risk
There is no doubt that energy and other utility suppliers face much scrutiny, as consumers struggle with seemingly ever-escalating domestic bills. In March, for example, Ofgem announced a Competition and Markets Authority (CMA) investigation of the UK energy market. Â
Centrica reckons network costs have increased by over 40% since 2007 and environmental costs have doubled over the same period. So, there’s always the risk that regulation might go too far, at a time when firms like Centrica are already struggling to turn a profit. The directors point out that to maintain a stable business, pricing needs to reflect the underlying costs impacting the business.
Centrica derives profits from both upstream and downstream operations roughly equally. Last year, based on location of customer, 66% of revenue came from the UK, 28% from North America and 6% from the rest of the world. The firm’s downstream operations supply both gas and electricity. Looking forward to 2015, the directors say the outlook for gas prices is benign, but there is upward pressure on the market cost of power, including an increase in network charges, and higher costs associated with renewable energy. Â Overall, the firm expects a return to earnings’ growth.
What now?
Centrica’s forward dividend yield is around 5.8% for 2015 and the P/E rating is running at about 12. City analysts following the firm expect earnings to grow by around 5% that year, so the valuation isn’t excessive.