Analyst’s view: Centrica – the base-line 35 strategy

Since former Labour Party leader, Ed Miliband, announced his plan to impose a 20-month price on energy prices in late September 2013, Centrica’s share price has headed south.

This trend has been accelerated by the recent plunge in wholesale gas prices; as such, Centrica’s market value has now virtually halved over the last 18 months. 

Not surprisingly, Thursday’s full-year results sought to reverse this negative trend – and partly succeeded in doing so.

After all, several commodity-based companies have recently reported grim figures.

Anglo American is being emasculated, Glencore’s shares have plunged, whilst oil majors, such as Shell and BP, have both announced alarming falls in underlying earnings – and heightened fears of medium-term dividend cuts.

The market had been warned that Centrica’s figures would be poor as chief executive, Iain Conn, confirmed that 2015 had been ‘a difficult year’ in the December trading statement.

The key message in the full-year figures was the unrelenting focus on the £2.25 billion adjusted operating cash flow, slightly above the 2014 figure.  

Crucially, Centrica has adopted a Base-line 35 strategy, whereby its cash flow projections are predicated on a minimum $35 per barrel Brent oil price, a 35p per therm NBP gas price and a £35 per MWh UK electricity price.

Assuming that prices do not remain below these benchmarks for any length of time, Centrica feels confident it can underpin its earnings.

Elsewhere in the results, there were few surprises. Revenues at £28 billion were down by 5 per cent on 2014; a similar decline was applicable to underlying earnings.

Adjusted earnings per share (EPS) were 17.2p, compared with 18.0p in 2014; a reduction in the tax charge from 30 per cent to 26 per cent, due to lower E and P returns, mitigated the EPS fall.  

A final dividend of 8.43p was announced, giving a full-year payment of 12p per share: the 2014 equivalent was 13.5p. With a dividend cover of 1.4x, investors should feel reasonably reassured about Centrica’s future dividend payment capability.

The market, too, welcomed the 9 per cent decline in net debt, which is now £4.7 billion – and comparatively far lower than other ‘big six’ energy players.

Overall, Conn was right to highlight a ‘resilient financial performance, with solid 2015 adjusted earnings, despite the challenge of falling wholesale oil and gas prices’.

Given its E and P difficulties, returns from British Gas’ residential energy supply business are especially important. In 2015, operating profits from this segment were £577 million, compared with £439 million in 2014.

Whilst average gas use per customer rose last year by 5 per cent, British Gas has implemented two tariff cuts, equivalent to a c10 per cent saving for customers.

Less satisfactory has been British Gas’ business division, which delivered poor returns and faced on-going billing problems.

Whilst there was a robust performance from its Norwegian assets, Centrica’s overall E and P operating profits were dire, down by 73 per cent; they were depressed by plunging oil and gas prices.

And, despite a £21 million increase from its 20 per cent stake in the eight nuclear power stations that are now majority-owned by EDF, generation returns remain poor.

Inevitably, the unplanned outage at the Combined Cycle Gas Turbine (CCGT) plant at Langage had a negative impact; overall operating losses from generation were £118 million, a similar figure to 2014.

Neither figure, it has to be said, will exactly encourage potential investors to build new CCGT plants, although they could probably negotiate a very favourable gas supply deal. 

Significant progress has, though, been made in the US energy supply markets – a priority for the new Centrica.

Direct Energy Business was the stand-out performer, with sharply rising operating profits, due in part to cold weather in early 2015. Direct Energy Residential also increased its returns.  

Particularly striking in the overall accounts – though not surprising given recent oil company results – was the large post-tax impairment charge of £1,846 million.

Around 80 per cent of this charge was attributable to Centrica’s E and P assets, whose cash flow potential has been heavily reduced by falling prices.

Much of the remaining impairment charge related to power stations, most notably the 20 per cent nuclear power station stake.  

Given all the events of the last 18 months or so – and not forgetting the ongoing Competition and Markets Authority (CMA) enquiry – Centrica has been fundamentally reviewing its strategy.

New Centrica will increasingly be focusing on ‘customer-facing activities of energy supply, services, the connected home, distributed energy and power and energy marketing and trading’.

From this somewhat convoluted mantra, it can be deduced that E and P will play a far less prominent role. Electricity generation will also be scaled back as the confirmed exit from the wind sector demonstrates.

Capital expenditure, which has already been sharply pruned, will be increasingly targeted towards the chosen priorities, including the US energy supply market.

As such, Centrica’s E and P aspirations have been markedly cut back, with a new target of producing between 40 and 60 million barrels of oil and gas equivalent (mmboe) per year, compared with the c80 mmboe for each of the last two years.

Furthermore, Conn has reaffirmed that the UK, the Netherlands and Norway remain the preferred areas for Centrica’s E and P operations – and not the non-core markets of Canada and Trinidad and Tobago.

Looking forward, reducing the operating cost base will be pivotal: an annual cut in operating costs of £750 million by 2020, when compared with base costs in 2015, is being targeted.

If this strategy were successfully implemented, Centrica should be able to deliver an adjusted operating cash flow comfortably in excess of £2 billion per year for the foreseeable future – assuming, of course, that the three Base-line 35 prices do not trend below that level.

By doing so, the dividend should be underpinned. Hence, there is a real likelihood that the share price could rally after a dismal 18 months or so.    

Nigel Hawkins (nigelhawkins1010@aol.com) is a Director of Nigel Hawkins Associates which undertakes investment and policy research