Centrica PLC Is Working Itself Out of the Value Trap

Owning Centrica shares over the past several years has been an unhappy experience. However, management says it is determined to fix that and has undertaken a wide ranging restructuring program to slim down and reboot growth.

Chart 1

Centrica PLC (LSE:CNA, Financial) (CPYYF) is an energy distribution, services and solutions company based in the UK. It supplies electricity, gas and related services to over 9 million residential and business customers, mainly in the UK and Ireland, through brands such as British Gas, Bord Gáis and Centrica Business Solutions, supported by around 7,500 engineers and technicians. It also owns a 20% stake in the UK Nuclear generation fleet. It has a market cap of 3.16 billion British pounds ($4.42 billion) and in 2020 generated £685 million in free cash flow from continuing operations. It has net debt of £2.76 billion.

Slimming down

Centrica has now sold Direct Energy, its North American energy distribution and services business, to NRG Energy (NRG) for $3.6 billion cash. Houston-based Direct Energy provides electricity, natural gas and home services to consumers and businesses in North America. It operates in all 50 U.S. states and six Canadian provinces. NRG's (NRG) purchase of Direct Energy closed in January earlier this year.

The transaction will allow Centrica to focus on its core home markets of the UK and Ireland and to deleverage using the proceeds from the sale.

Centrica also wants to unload its stake in the UK's nuclear generation fleet and its upstream oil and gas business. By divesting itself of this capital intensive commodity-price dependent division and focusing on the UK and Ireland, Centrica hopes to bring more predictability to its business.

Centrica is also making a push towards EV adoption and is a leader in installing EV charging stations in the UK. It is keeping this part of its business, as this area could be a source of good growth in the future as the transportation sector goes green.

Below is chart depicting Centrica's balance sheet:

Chart 2

Here, we have a chart of the company's net income and cash flows:

Chart 3

While net earnings are inconsistent from year to year due to depreciation and large non-cash charges (pink bars below), operating cash flow and free cash flow remain much more consistent. The company manages to generate about a billion pounds sterling of FCF a year, which is remarkable for the company with a market cap of £3.16 billion.

Compared to cash flow, the long term debt is manageable. The proceeds from the Direct Energy sale will further reduce debt.

Dividend

The company has paid out a large portion of its free cash flow as dividends in the past. It cut its dividend last year to cope with the Covid-19 crisis but plans to reinstate as the company's financial conditions improve. I expect the dividend to be reinstated in some amount in the second half of 2021.

Valuation

I used the GuruFocus discounted cash flow (DCF) calculator to value Centrica shares using a starting FCF value of 0.157. This is consistent with GuruFocus data for the last five years and is on the conservative side.

I used a 9% discount rate and minimal growth projections. The derived value of £1.65 per share is fairly close to the value of £1.80 per share provided by the GuruFocus Projected FCF method. Either way, there appears to be wide margin of safety and multi-bagger potential for the stock.

However, investors should note that due to the one-star predictability rating of the business, these valuation models are less reliable.

Since the intrinsic value calculations based on Discounted Cash Flow, or Discounted Earnings is difficult to calculate for companies without consistent revenue and earnings, GuruFocus developed a valuation model based on normalized Free Cash Flow and Book Value of the company. The details of how Gurufocus calculate the intrinsic value of stocks are described in detail here.

Chart 4

Conclusion

As the UK-Irish economy reopens, demand for Centrica's products and services is expected to increase. The industry itself has begun the process of consolidation, and Centrica will be a leader in the consolidation process. In time, the industry pricing is expected to become more rational and oligopolistic.

British Gas is the largest natural gas distributor in the UK. Unfortunately, it has developed a poor reputation for customer service and has been accused of coasting on consumer inertia. It is critical that the company overcome that reputation as the UK has highly competitive energy markets.

To some extent, this is just part of the business environment as consumers in deregulated markets love the lower prices but become unhappy when exposed to the resulting lower-quality service and unbundled pricing plans, which can result in unexpected high prices when there is a big enough demand spike.

The erratic financial performance and continual non-cash impairments over the years have taken a heavy toll on the stock price as shareholders have lost confidence. However, we cannot ignore the fact that the company's stock price is extremely beaten down.

It is now divesting itself of non-core operations and deleveraging. Importantly, Centrica has continued to generate a lot of cash. As the hockey great, Wayne Gretzky once said: "Skate to where the puck is going, not where it has been."

Looking at GF Value diagram below, it is obvious to me where the puck is going.

Disclosure: The author does not own shares of Centrica PLC but is considering buying.

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