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10 iconic UK shares: Centrica

The second in our series of articles using fundamental analysis to examine the prospects of 10 iconic FTSE companies.

Gas hob
Source: Bloomberg

Reasons to watch

  1. A strong yield for income investors
  2. A competitive forward earnings valuation
  3. Increasing importance of the North American operation helping to reduce reliance on UK-focused operations.

History

Centrica is a utility company with operations in the UK and around the world. Its main activities are the supply of electricity and gas to homes and businesses, primarily in the UK and North America. It also maintains a nuclear power division and engages in exploration for and production of natural gas.

The roots of Centrica go back to the privatisations of the 1980s and British Gas. Centrica itself was formed from the demerger of British Gas into three separate companies, with responsibility for gas sales and trading, along with the retail business and gas production in the North-West. A diversification strategy from 1998 saw the company acquire, among others, AA, and also move into the North American market.

From 2003 the strategy changed, with a focus on consolidation and the removal of operations deemed ‘non-core’ to the business. Since then Centrica has aimed to confine expansion to energy technologies, gas fields and partner arrangements with oil and gas firms.

Fundamental analysis*

The past year has been full of turmoil for Centrica and its investors. September 2013 saw the shares hit an all-time high just above 400p, but history repeated itself as the share price found resistance around this mark just as it had done around 2007 and began a steady descent.  For now the price has found a floor above 300p but this 25% decline means it has lagged behind the FTSE 100.

Headline news has played its part here. As a firm supplying energy to UK domestic customers, Centrica is an easy target for British politicians wishing to burnish their consumer-friendly credentials by attacking energy price rises. Some have even called for the firm to be broken up, and an investigation by the Competition and Markets Authority was begun to look into practices in the broader energy sector.

Management issues have played their part too. The chief financial officer left in January, and the newly-promoted head of the firm departed in May to head up power supply firm Aggreko. This is not the kind of environment that makes for stable leadership, especially given the long-term declines in margins and continuing political pressure.

Nonetheless there is reason to be optimistic about Centrica. It has the biggest market share in provision of energy and heating and is firmly ahead of its rivals in this sphere, with 38% of natural gas market share and 24% of electricity supply. This puts it comfortably ahead of its peers and provides a clear stream of dividends for shareholders.

At a yield of 5.6% the firm clearly falls into a very attractive bracket for income hunters, although the fall in the share price has done much to boost the yield. The firm has already stated that it plans to maintain its commitment to increasing dividends, which will go a long way to reassuring those bruised by the lack of capital growth over the past twelve months.

With costs in its North Sea operations rising and UK taxes a burden, Centrica is shifting its focus to the North American division. It continues to make new acquisitions in this area, with Alberta being the latest area to see investment. In addition, its nuclear unit in the UK is something that no opponent can match, giving it another dependable revenue stream.

As earnings recover we should see the forward PE drop, to around 13, making it more attractive versus the FTSE 100 itself, which trades on a forecast PE of around 16.5. So long as the shares hold above 300p, investors can look to Centrica with a greater degree of confidence, even if political troubles threaten to flare up ahead of the 2015 General Election. 

*What is fundamental analysis?

Fundamental analysis seeks to examine a security by measuring its value through the use of financial and qualitative factors. Essentially, fundamental investors believe that each share is a piece of a company, and that the company can be analysed to determine whether the current share price indicates whether the company itself is undervalued (trading at a discount) or overvalued (trading at a premium).

The overall objective is to determine the underlying value of a company, and use comparisons with similar companies to determine if the business is likely to be successful or otherwise. Crucially, a company cannot be overvalued or undervalued in isolation. Instead, fundamental analysis compares a company to its peers in the sector, to the broader market, and to past valuations, to determine whether the current valuations are appropriate. 

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