Centrica (CNA) has been downgraded by Morningstar analysts in the light of last week’s profit warning, which knocked 20% of the British Gas owner’s market value.
We have slashed our fair value estimate for Centrica to 150p per share from 250p because of a deterioration in profitability – the shares are currently trading around 140p. We have cut our 2017-21 earnings per share estimates by 46% on average due to more bearish assumptions for the UK home, UK business, US business, and storage divisions.
We forecast a flat dividend though 2021 involving a high 8.2% dividend yield. Though we do not factor it in, the risk of a dividend cut on account of a rise in the pension deficit is real.
We've downgraded our narrow moat rating to none, which means the company has no competitive advantage against its rivals, chiefly due to mounting political and competitive pressure. The brand recognition of British Gas and cost advantage provided by its leadership position historically provided some moat, in our view. This moat has disappeared due to mounting political pressure, which should result in a tariff cap squeezing margins.
In October 2017, the British government instructed energy watchdog Ofgem to set a price cap by the end of 2018. As costs continue to rise, this could squeeze margins. That would imply a reregulation of the sector that was liberalised in the 1990s.
Also, the likely merger of SSE's and Npower's retail arms will create a powerful competitor supported by cost synergies – and mean that Centrica is about to lose its leadership position in electricity retail.
Centrica also operates as an energy supplier in the United States. The profit warning in November reflects that the structural profitability of the US business supply activity is well below what the market had assumed.
For UK home, we factor in a tariff freeze over 2019/20 followed by a tariff hike, which would partially recoup lost margins. For the US business, we reduce our long-term profitability assumptions as we believe the issues highlighted during the November profit warning are structural.
Under the British Gas brand, Centrica is the biggest retail supplier of gas and electricity in the UK. This is the group’s largest activity at around 40% of 2016 operating profit. This business typically has no moat due to fierce competition caused by 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.
Still, historically, Centrica has been able to deliver higher margins than its competitors thanks to the large scale provided by its leadership position. Therefore, we thought the British Gas brand name and established position provided some moat. However, in the current political climate, we believe the value of this moat has materially diminished.
