Why is Centrica’s share price struggling above their historic lows?

Shares in Centrica remain at their historic lows for the past 10 years, due to some big impairments write down experienced in 2014 and 2015. With a market capitalisation of £11bn and a dividend yield of 6%, is this the perfect time to buy the stock?

 

If you are looking for a ten-bagger, then Centrica isn’t your kind of investment. It is for the income-seekers, especially those retirees. The maximum share price appreciation could be a one-bagger, given the maturity of its business.

To understand a BIG company like Centrica, you need to break it down into easily digestible chunks. So, in this post, I will be covering their Income Statement and Balance Sheet.

Also, there is a brief look into the company’s valuation.

Let’s begin.

Is profit per employee, an important indication?

When energy prices were rising, Centrica was achieving “extraordinary profits”, and it translated to extra productivity per employee.

 Centrica and employee

The one difference you can spot is when times are good, Centrica was able to produce more profit per employee than they are paying their staff.

Now, it is costing Centrica more to hire.

You can see the resemblance of Centrica’s business cycle in the dynamics between cost per staff and profit per staff.

The fall of Centrica’s ROCE

Centrica’s ROCE has been steadily falling. One reason is down to declining capital turnover. During 2010-12, ROCE was supported by rising EBIT margins, due to the increases in energy prices. This blinded Centrica’s management into believing that higher energy price is the future, so they decided to invest heavily too fast and too soon.

By 2014, lower energy prices begin forcing management to write off billions of pounds in asset value, which (ironically) contributed to the revival of its capital turnover (except 2016).

Centrica's ROCE

Here’s the result of Centrica’s impairments charges:

Centrica's impairments

Since 2001, Centrica wrote down £6.2bn of its assets. The causes of this write down were:

-Energy Prices Fallings;

-And mismatch between sales and assets.

Looking at the mismatch, we get this:

Centrica's asset growth

You see Centrica has been building up its asset-based by growing to 342%. That translate into Centrica spending £15bn for the past 15 years on tangible assets. The majority of this spending went towards gas production and storage. Meanwhile, revenue grew by 115%!

The funny thing is that £15bn in tangible spending saw its revenue increase by £15bn! That means Centrica saw no improvement in economies of scale.

But, is the impairments write down over?

Another trick is to assess the change in tangible net book value.

When it peaked in 2012, it has a value of £7.965bn or equivalent of 287% growth since 2001. (Should have been a red flag!) Now, it’s been written down to £5.298bn or 157% growth at the end of 2016. In their interim 2017, it shows PPE at £3.727bn, as they put assets worth over £1bn for sales. That poses a different dilemma because it would reduce revenue for the second-half of 2017 and beyond unless Centrica makes some acquisitions.

 

Lower energy prices and weak British Pound

British Gas, a subsidiary of Centrica recent announcements of 12.5% increase in electricity prices is a sign that the weak pound is becoming a big burden on Centrica. However, the British Pound has fallen from $1.60/£ to $1.30/£, a decrease of 19%! That would limit any rise in profits.

 

Centrica’s Debt Issue (Big Section)

We talked about the build-up of assets and the costs of that build-up, but we haven’t talked about the financing of it. Below is an in-depth analysis of Centrica’s debt. 

 

Lower Interest Coverage

Centrica’s interest coverage is very volatile and indecisive, but you can spot that it is decisively lower than a decade ago, despite lower borrowing costs. Debt is consuming more of the company’s assets, thanks to impairments!  

Centrica debt to assets

Year-End Net Debt Rising

If you look at debt separately it has risen three-fold.

Centrica net debt

Rising Debt to Net Income, a key indicator

Debt to normalised net income multiple has been rising steadily to 7.5 times! The interesting part is the “reciprocal” of Debt to normalised net income multiple and turns it into a percentage.

That percentage indicates a rate, where (if breach) it can’t self-sustain their operations. From 2001 to 2009, this rate averages 35%, but since lower borrowing costs have caused borrowings to spike, that has fallen to 14%. Centrica’s borrowing rate is 5%, but is it able to meet dividends payments in the future? (More on this in my next post, sorry!)

 Centrica debt to income

That kind of hypothesis means you can draw this chart:

Centrica's earnings over interest

A chart showing that normalised post-tax earnings are able to meet interest costs with the amounts left over for taxes, dividends, FX and so forth.

 

Total Debt and Pension deficits vs. Market Cap. and Sales

Liabilities are returning to levels last seen in 2005, in respect to sales. The difference between 2005 and 2016 (or beyond) is back in 2005, investors weren’t concerned about total debt and pension deficit, despite it consuming more of the company’s sales. Now, there is a correlation because of total debt and pension deficit, as % of Mkt. Cap. is approaching 70%, their highest on record.

Centrica total debt and pension deficit

But, isn’t that indicating to investors the undervaluation of Centrica?

 

Centrica’s basic valuation

One easy valuation measure is EV/EBIT.

Centrica's ev ebit

Given the huge impairment write-downs, earnings would return back to normal, which is why I used normalising operating earnings as EBIT. At this moment, it looks like valuation is on the cheap side. But, with Centrica disposing of large amounts of assets, this would affect their revenue stream and profits going forward.

Another way of looking at Centrica’s valuation is to combine debt, share price and their adjusted EPS into this:

centrica debt per share

The details give us a startling indictment of Centrica’s business performance. So, by converting total debt into “per share”, we see this grew from 34 pence in 2001 to £1.16 by 2016. And, what has Centrica had to show for by incurring huge amounts of debt?

An increase of 4.7 pence in adjusted EPS!

Putting it into context, debt per share grew by 241% vs. adjusted EPS growth of 39% growth.

Meanwhile, the share price remains unchanged in 15 years!

 

Summary

Putting this together, we know Centrica’s share price is struggling because

-Investors are becoming sensitive to Centrica’s level of debt;

-Adjusted EPS is at a 10-year low;

-The aftereffects from their over investment in gas storage means a loss in reputation;

-Low Capital Turnover + Mediocre EBIT margin = Lower ROCE;

-Their business cycle is still at a trough.

 

Thanks for reading, the next Centrica’s post will look into their cash flow statement, market valuation and much more.

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