After British Gas owner Centrica (CNA) released a trading update for the first four months of 2018, Morningstar equity analysts are reiterating the fair value estimate for the company to 160p, above the current share price of around 148p a share.
We will not change our earnings forecasts following this update. Our fair value estimate implies a 7.5% dividend yield, with the current yield above 8%. The premium to the sector average is justified by regulatory uncertainty in the United Kingdom, in our view, and Centrica's shares look slightly undervalued.
Churn in the UK energy supply business slowed down. The number of UK energy supply accounts fell by 110,000 over the first four months of the year, implying a fairly limited 0.8% churn. Annualising the latter would point to a 3.2% churn rate, well below our 9% full-year estimate and 4.4% churn in 2017. Moreover, energy demand was supported by colder weather than last year. In line with the guidance, the firm's UK and North America business activities are on track to deliver increased profitability after a very tough 2017.
On the negative side, profitability for UK Home Services activity was hit by increasing costs due to a high number of central heating boilers breaking down, owing to extreme cold weather in February and March. With regard to exploration and production, the group now guides for the lower end of its targeted 50-55 million barrels of oil equivalent in 2018 due to unplanned outages at Morecambe, in line with our 50 mmboe estimate.
UK Regulatory Risk
Centrica revised its strategy in 2015 to focus on customer-facing activities and downsize upstream activities after a new CEO was appointed. The company disposed of its combined-cycle gas turbines, wind farms, and exploration and production assets outside Europe and is acquiring small, light-capital-intensive companies involved in innovative energy services linked to digitalisation, efficiency, and distributed energy. We appreciate management's willingness to embrace markets linked to new energy while intending to leverage its large customer base. Still, we believe those businesses have no moat and uncertain structural profitability.
Retail energy supply in the United Kingdom is the largest activity, contributing about 40% of 2016 operating profit. Historically, Centrica has been able to deliver higher margins than its competitors thanks to the scale provided by its large market share.
Political risk has dramatically increased since late 2013. In October 2017, watchdog Ofgem was instructed by the UK government to set up a price cap mechanism on default tariffs, so-called standard variable tariffs, or SVTs, by the end of 2018. The impact on Centrica should be lower than for some of it competitors, since its standard variable tariff is below the market average. Still, Centrica decided to drastically reduce the number of its SVT customers by offering them fixed tariffs. We believe that will reduce the average revenue per user and profitability of the business.
