Centrica: Still Not As Cheap As It Looks

U.K. gas and energy company Centrica (OTCPK:CPYYF) has had an excellent period, moving up 45% over the past year and more than tripling from its pandemic-era 2020 lows.

My most recent piece on the name was Centrica Looks Cheap But Beware in July 2021, when I gave the shares a “hold” rating. At that time, I still owned the shares. Since then, the US dollar value of the shares is up 124%, while the London shares are up around 150%. I have sold my position since my last article.

Right place, right time

Centrica deserves credit for some strategic moves in recent years that have helped it improve its balance sheet dramatically. But it has also benefitted substantially from industry broad headwinds that have pushed up energy pricing and therefore profitability.

The war in Ukraine and its impact on energy pricing has been significant both for Centrica and the wider energy industry over the past year. How long that will continue is uncertain, but as energy markets and pricing in the U.K. find a new equilibrium in the coming year to two, I expect a negative impact on profitability at Centrica.

Centrica Business Has Been Producing Solid Operating Cash Flows

In fact, although revenues at the firm last year soared 60%, it reported a loss at both the operating level and statutory profit level. This is the third time in five years that Centrica made a loss and made an operating loss.

However, that loss reflected a £2.4bn negative re-measurement of energy contracts. In cash terms, things looked better. Free cash flow from continuing operations was £2.5bn, up from £1.2bn the prior year. Relative to the company’s current market cap of £6.5bn, that makes the current valuation look very cheap based on free cash flow from operations. On top of that, at the end of last year, Centrica had adjusted net cash of £1.2bn. So the enterprise value is actually £5.3bn: little more than double last year’s free cash flow from operations.

Looked at like that, Centrica may well seem like a bargain even after the share’s strong performance over the past year (and more). Centrica’s focus on free cash flow from operations is not the full story, however. When looking at total cash flow (including financing and investing, as well as operating cash flows), last year saw negative free cash flow of £169m. That was down from almost £3bn the prior year, a number reflecting a large disposal at the company.

Centrica’s focus on operating cash flow in its headline reporting feels disingenuous to me: investing and financing are very real costs for the firm. In general I find that Centrica does a poor job with communication and I see this as a concern when considering whether to invest in a company.

So, what can we expect from cash flows in future? Largely that depends on energy prices. But there are also a lot of other variables in the company’s cash flows. Over half a billion pounds was spent last year purchasing securities (and the company is currently in a buyback programme too). Take that out and Centrica would have been significantly free cash flow positive at a stroke. But the unevenness of cash flows and the constituent elements makes me slightly nervous.

Risks

I sold my Centrica shares last year partly because I lack confidence in management ability. Centrica’s history is littered with self-goals and the shares are 26% cheaper than they were five years ago.

That has not changed, in my view. Recent public relation problems include the perception of price gouging, massive pay rise last year for the chief executive and publicity about forced installation of prepayment meters for some energy customers including vulnerable groups. Never a company to miss an opportunity to put one’s foot in it rather than maintain a tactful silence (or speak out against what is in my view an unjustifiable practice), Centrica’s chief executive went on the record last month in defence of prepayment meters albeit not in all circumstances.

That level of management incompetence makes me concerned for the long-term business performance.

Another clear risk is energy prices falling, which is bound to happen at some point. Centrica also has an energy trading division, which I see as exposing it to risks associated with sudden large moves in energy prices, whether up or down. The energy marketing and trading division's operating profit jumped 1,900% last year to £1.4bn. Not only is that the sort of apparent profiteering that poses a risk of another PR calamity (and possible regulatory attention) for Centrica, it also shows the potential volatility of this part of the business.

But the key risk I see for Centrica is the relentless long-term structural decline in demand for gas, which is central to its business. Last year’s customer numbers perked up slightly, as rivals went to the wall and Centrica benefited, but the long-term direction of travel is clear. Last year, British Gas Energy had 7.5m residential customers. That is a sizeable number, for a market of around 28m households. Step back a decade, though, and the equivalent customer number was 15.7m. In other words, British Gas’s customer base has more than halved in just a decade. Partly that might be because of its reputation for poor customer service, but the main driver is simply that gas has been declining as an energy source both residentially and commercially in the U.K. (and Irish Republic, where the company also operates). That is set to continue in my view. From 2025, the UK government plans to ban gas boilers in newbuild homes, which I see as foreshadowing a possible wider future ban. I see that as government overreach, but regardless of the politics, it is certainly a critical risk to the long-term future of Centrica, for whom gas remains a central business plank.

Valuing Centrica shares

I prefer not to value Centrica shares based on last year’s results, but with a forward-looking approach.

The long-term outlook for its core market is weak, management is not great in my view and short-term swings in energy prices could lead to profitability moving around. That could mean the Centrica share price continues its upward march in the coming year or two. But in the long-term I am bearish on the outlook for the name.

I said in my July 2021 piece Centrica Looks Cheap But Beware that “there are lots of reasons to be optimistic if one has a high risk tolerance.” I think that is less true now: the risks are still there, but the optimism has been reflected in a much higher share price than a couple of years ago. That could continue to be the case if energy prices stay elevated. But as a long-term investor, I am not optimistic that there are strong grounds for further upside here and accordingly retain my “hold” rating.

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