Centrica Outlook is Positive but Analysts Hold Fair Value

Morningstar equity analysts are reaffirming their fair value estimate of £2.50 per share for British Gas parent company Centrica

Charles Fishman 19 December, 2016 | 11:09AM
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British Gas parent company Centrica (CNA) now expects 2016 adjusted earnings per share to be approximately 16.5p versus Morningstar analysts’ estimate of 15p and the consensus estimate of 15.4p. Although the favourable outlook is positive, it is driven by strong energy marketing and trading, a business with no moat and one where strong results can be temporary.

As a result, analysts are reaffirming our narrow moat and stable moat trend ratings and our £2.50 per share fair value estimate after Centrica increased its 2016 earnings guidance and confirmed operating cash flow will be well above management's initial guidance exceeding £2 billion. Centrica will report full-year actual results on February 23, 2017.

It was also positive to see that British Gas residential accounts, now part of UK Home, were flat since the first half of the year after declining 3% in the first half of 2016. Centrica did not comment on margins, but we suspect they could have been modestly squeezed due to leaving the variable energy tariff unchanged with recently higher wholesale natural gas prices.

What is the Source of Centrica’s Economic Moat?

We believe the combination of moaty nuclear and natural gas storage businesses and the no-moat retail energy supply business results in an overall narrow moat rating for Centrica.

In our opinion, the retail energy supply business does not warrant an economic moat. Retail power and natural gas markets are highly competitive, with virtually no barriers to entry and low switching costs. Retailers mostly compete on price, given customers' guaranteed service through the delivery utility and the commodity product that eliminates quality differentiation.

In the U.K., Centrica's retail energy sales are partially hedged by the ownership of North Sea oil and gas assets and power plants. Although the hedging strategy has recently proved to be successful, we do not believe it creates an economic moat.

Centrica's British Gas brand name has significant value, but brand loyalty to a commodity product can be fleeting, as the decline in Centrica's share of the residential U.K. gas market illustrates. Although British Gas remains the dominant market share leader, its share of natural gas retail customers has steadily declined, but still remains over 35%.

In Texas, Direct Energy faces intense competition, which has also compressed margins. However, Centrica does not have the natural gas or power generation assets to hedge its retail business effectively in the U.S.

Centrica's 20% ownership stake in eight nuclear plants deserves an economic moat. Nuclear power plants are the lowest-cost emission-free base-load power source. Existing nuclear plants face virtually no substitution threat because no other carbon-free power generation source can match the low operating cost or large scale of an existing nuclear plant. High capital costs for new nuclear construction create a very high barrier to entry for new nuclear plant developers.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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Securities Mentioned in Article

Security NamePriceChange (%)Morningstar
Rating
Centrica PLC123.00 GBX2.16Rating

About Author

Charles Fishman  Morningstar Equity Analyst, Equity and Credit Analysis

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