I’ve been concerned about the Centrica (LSE: CNA) share price for a while because the underlying business looks like it is deteriorating. Any doubts I had about that were removed with this month’s release of full-year results.
A worrisome update
The energy and services company’s chief executive, Iain Conn, told us in the report that the firm delivered a “mixed” performance in 2018 “against a challenging external backdrop.” He said volumes in the Spirit Energy and Nuclear businesses “were disappointing” and recovery in the North America business was “slower than expected.”
Looking ahead, he admitted that the firm’s financial performance in 2019 will be affected by the UK default tariff cap “and continuing lower volumes in Exploration & Production (E&P) and Nuclear.” The 2018 to 2020 target range for average adjusted operating cash flow is, therefore, “under some pressure.”
My goodness! That’s a lot of negatives in one update and, naturally, the shares plunged on the day, down around 12.5%. However, that was part of a much larger move lower. Today’s share price around 125p means that since September 2013, the stock has plunged around 70% — ouch!
Out of favour for a reason
But here’s the really disturbing thing. During that entire move down, Centrica has presented us with a high-looking dividend yield and will have attracted many dividend-hunting investors. I think the whole sorry saga underlines the inherent dangers with a dividend-led investing strategy. Generally, high dividend yields mean that a firm is being assigned a low valuation by the stock market and very often that happens for good reasons.
Of course, all investing strategies have their dangers. It’s not always a picnic if you deal in growth shares, or momentum stocks, or micro-caps. But I think there is one thing to keep a close eye on when dabbling with any strategy and that’s the quality of the underlying business.
Centrica doesn’t score well on quality indicators right now. The return-on-capital figure is running just over six and the operating margin a bit below three. Meanwhile, with the market capitalisation at almost £7bn and the enterprise value at more than £11bn, we can see straight away that the firm carries a lot of debt, as we might expect with capital-intensive operations.
The trading record is grim too. Earnings, operating cash flow and the dividend have been trending down over the past five years or so, and that’s exactly opposite to what we want to see from a business supporting our dividend payments. I reckon it’s best to demand that revenue, profits, cash flow and the dividend rise a bit each year before we can be reasonably confident that a dividend-led investment in a company’s shares is secure.
Here’s where I’d invest instead
Cover for Centrica’s forward-looking dividend payments is thin from expected earnings, and I think the dividend looks vulnerable. Any further deterioration in operations could lead to a cut in the payment.
I would abandon the Centrica share price now and forget about the firm’s 9% dividend yield because I don’t want to invest in troubled businesses. I’m not looking for a turnaround, I’m looking for steady growth and a robust and expanding dividend. So I’d rather gain my exposure to firms like Centrica within a FTSE 100 tracker fund where I’m sheltered from single-company risks.