Two minute speech: Centrica

Peter Lynch, in his seminal book "One up on Wall Street" says that when you buy shares in a company, you should always do a "two minute drill".

This is a short monologue that "covers the reasons why I'm interested in it, what has to happen for it to succeed and the pitfalls that stand in its path...Once you're able to tell the story of a stock to your family, your friends or the dog...and so that even a child can understand it, then you have a proper grasp of the situation."

This can't be what many crypto-investors or speculators will use as some forced justification of it (eg "the stock is going down!" "I got a hot tip from Bob in the pub!" or "Elon Musk just tweeted about it, it's going to be huge!"). The monologue needs to set out, as best as you can, a proper reasoning for making an investment.

Centrica

Centrica is better known in the UK as British Gas (Scottish Gas in Scotland). It has three key operations: retail supply of gas and electricity, Centrica business solutions (teaming up with large businesses to provide renewable energy and electric vehicle charging points) and energy trading. It also owns 20% of British Energy (formerly part of EDF) which generates nuclear power. Centrica does not own any power plants itself. Centrica's main base of operations is the British Isles.

The speech

Category: Ordinarily Centrica would be a stalwart (one of Peter Lynch's categories for a company), particularly as it was once part of British Gas. I would say that Centrica is still probably priced as a turnaround stock. Its share price was once 691p per share whereas it has reached lows of below 31p per share. It is currently going through a restructuring having had high debts.

P/E ratio: 4.91.

Tell me about the market the company operates in: Centrica is an energy supplier. Gas prices have risen in Europe due to cold weather, geopolitical tensions between the West and Russia, proposed new sanctions on Russia, Belarus being incredibly difficult and delays in the building of the Nordstream 2 pipeline. Prices have gone from 56.4p per unit on 31 December 2020 to 344.9p per unit on 17 December 2021.

Despite the drive to renewables and net zero, natural gas currently accounts for 31% of UK energy supply and is set to increase to 33% by 2023. In short, natural gas is still a vital part of our energy mix. 

Centrica's share price peaked in 2013 at a share price of 391p per share. Today it is 66.50p per share. Part of this is due to the UK government encouraging competition in the energy supply sector. Until 2013 the "big six" (British Gas, EDF Energy, E.ON, npower, ScottishPower and SSE) dominated the energy sector and British politicians even called for an energy price freeze.

Once the energy market started to open up in 2014, several new energy suppliers came into the market who competed with the big six in terms of price. It also became much easier for consumers to switch suppliers.

Now, with rising gas prices, the margins of the smaller energy providers has become squeezed to such an extent that in 2021, 28 energy suppliers went bust.

When energy suppliers go bust, Ofgem (the UK's energy regulator) arranges for replacement suppliers to supply the insolvent supplier's customers. So far, Centrica, has taken 554,200 new customers from insolvent suppliers since 2019. Whilst Centrica will be forced to abide by the price cap and it is much easier now for customers to switch supplier and the market in energy supply has widened since 2013, Centrica is benefitting from an increase in customers all of whom needs gas and electricity.

So what about the company itself?: Centrica is in quite a stable financial position and is in the process of a large restructuring. In 2020 it planned to reduce 5,000 jobs (particularly at management level), simplifying the employment contracts and creating a flatter, less bureaucratic and more simplified corporate structure. It has sold off parts of its carbon focused business (including the Norwegian assets in Spirit Energy for a around £800m, around £560m of which should go to Centrica) and aims to find £100m in efficiency savings. It has also disposed of other divisions such as Direct Energy (based in North America) for $3.6bn in order to focus on core markets of the UK and Ireland.

Centrica has a healthy financial position. Net debt has been reduced from almost £3bn in December 2019 to £93m in June 2021. 

Based on its interim reports published in June 2021, Centrica has used some of the money generated from its restructuring to clear out debt. Its overdraft borrowing has reduced from £543m at the end of 2020 down to £93m in June 2021. Further, Centrica has reduced its borrowings under a bank loan from £144m to £137m. These types of debt are not great for investors as they can be payable on demand. Also the interest rates on loans are often (though not always) made with reference to an interest rate (such as LIBOR or SONIA - the rate that banks lend to each other, this is different to the Bank of England's base rate but when one goes up there is likely to be a correlation between the two). When interest rates go up, this will increase interest payments and act as a drag on earnings.

Centrica has also raised debt through note issues. Peter Lynch would argue that this is good debt for a company to have because Centrica would only need to pay interest (rather than interest and capital) and such notes are often not repayable on demand. Looking through the notes, the interest rate for most notes is set at a fixed rate although one set of notes has interest at a floating rate. 

Further the deficit in its pension scheme has been reduced from £471m to £130m. 

In terms of the balance sheet, the current asset based on the interim results is £9.8 billion whereas current liabilities are £6.8bn. This is very good and it means that the Company is more than able to cover its liabilities that are due within 12 months.

The only downside is that its forecasted earnings growth (2.9%) is low. 

Insiders have been purchasing shares in December and November. This is ordinarily seen as a good thing but these are purchases through the Company's share incentive plan so I am not sure whether this is necessarily a positive indicator. That said, it should not be a negative one. Centrica has not been buying back its own shares.

Before 2020, Centrica would issue consistent dividends which between 2016 and 2018 would amount to 12p per share per year. Centrica stopped issuing dividends in April 2020 (shortly after the first lockdown) presumably due to its financial position and Covid 19. Perhaps once the restructuring is completed hopefully dividends can once again resume.

Verdict

So, that is more than 2 minutes! 

I have bought Centrica. The success in the restructuring process of paying down debt and selling off divisions that were not profitable have impressed me, so too has the improvement of Centrica's debt profile. The sheer scale of debt reduction and attempts to reduce the pension deficit and the strong cash position have impressed me. 

On the other hand the forecasted earnings growth and the lack of dividends would work against the company. 

I will also purchase Centrica on the basis that it is in a strong position to increase its position in the market for energy supply.

Disclaimer: This is not financial advice.