Analysis: Tough going for Centrica

It is too soon to say whether Centrica’s radical new strategy will be successful, but its interim results show that it is still battling the headwinds buffeting the rest of the sector, says Nigel Hawkins.

The past 12 months have not been particularly kind to Centrica as it seeks to roll out its new commercial strategy. Its share price is now slightly below the corresponding period in November 2015, while the FTSE-100 is up by around 10 per cent over the same period.

Centrica’s new strategy, which embraces its large customer base but also entails running down its oil, gas and power portfolios, is its response to the various challenges, which have arisen in recent years.

First, the plunge in the global oil price, which halved between June 2014 and January 2015, has had a major negative impact since it has dragged down gas prices in its wake. Remember, too, that in recent years Centrica has assembled a portfolio of exploration and production (E&P) assets, whose returns were predicated on far higher energy prices than is the case currently.

Second, the political temperature rose in the lead-up to the 2015 general election. In late 2013, the then Labour party leader, Ed Miliband, launched an aggressive policy against energy companies, focusing on their profit margins and their scope to reduce consumer prices.

Subsequently, the Competition and Markets Authority (CMA) was charged with investigating key aspects of the UK energy market. After a laborious inquiry and the publication of a 750-page doorstopper report, the outcome was a damp squib.

More recently, though, there is a market perception that the government, now led by Theresa May, is quite likely to clamp down on the least savoury aspects of the current UK energy market, which she has characterised as containing “dysfunctionalities”.

It is against this background – low oil and gas prices and an adverse political climate – that Centrica has adopted its new strategy. It seeks “to provide energy and services to satisfy the changing needs of our customers”. In essence, like mobile phone companies, Centrica is seeking to drive profitability from its very extensive customer base.

It is premature to conclude whether this policy rebooting has been successful or not. To date, though, as the somewhat lacklustre 2016 interim results showed, Centrica still has much to do.

In the first half of 2016, adjusted earnings fell by 14 per cent, while earnings per share were down by a formidable 17 per cent. Centrica emphasised that unseasonably warm weather, especially in North America, had a major negative impact upon its results.

In its UK supply and services division, adjusted operating profit was £506 million, compared with £543 million in 2015.

In the US equivalent, whose potential Centrica has identified as a long-term priority, the decline was more pronounced. Adjusted operating profit fell to £58 million, compared with £110 million previously. The US business sector was noticeably weak, and E&P adjusted operating profit fell to £88 million.

Neither the connected home nor the central power generation divisions were able to cover the other divisional shortfalls. Indeed, both reported sharply lower adjusted operating profits. However, a more detailed analysis of Centrica’s results shows some discernible progress on the financial front.

In particular, its well-promoted cost-cutting policy delivered material savings, with adjusted controllable costs down by an impressive 9 per cent over the 12-month period. Furthermore, Centrica now expects annual savings for the full year to amount to around £300 million.

Aggressive cost-cutting was central to delivering a formidable level of operating cashflow over the period, amounting to £1,372 million. This metric is now a key performance indicator and was instrumental, along with far lower capital expenditure, in cutting net debt to £3.8 billion, a comparatively low level when set alongside the other big six UK energy suppliers.

Aside from improved profitability and lower controllable costs, investors will also be anticipating tangible progress on the disposal front.

In terms of E&P assets, there are many current sellers, most notably Shell, for whom large asset disposals are crucial to underpinning its future dividend stream. For Centrica, the key disposal will be its Canadian assets, which are already in play. Investors will be watching closely to see how much it can realise from this planned sale.

On the power station front, selling plants will be challenging given low power prices and the difficult market in which gas-fired plants are operating.

Overall, it may be that the full-year results for 2016 will show an improvement. However, the warmish weather of recent weeks is hardly good news for Centrica, whose energy business thrives on lengthy periods of cold weather – assuming, of course, it has access to sufficient gas supplies, at the right price, to meet this enhanced demand. And, like other E&P operators, a sharp – and sustainable – recovery in the oil price would be very welcome.

Aside from its positive impact at the profitability level, it should also increase receipts from its planned E&P disposals.

For many years, Centrica’s share price had been boosted by speculation that it may be acquired by Russia’s Gazprom; today’s frosty UK-Russia relations suggest this is improbable.

Perhaps the next 12 months will be kinder to Centrica. A weather-driven boost in energy demand and a rising oil price would suit its agenda – and share price rating – rather nicely.