Company Reports

European utilities have reversed their outperformance in the fourth quarter of 2023 because of a fall in wholesale power prices in the wake of gas prices after a very mild winter, and a pickup in interest rates due to inflation receding more slowly than expected. The former led to some of the companies, most exposed to power prices, cutting their guidance for 2024.

Centrica is the leading retail energy supplier in the U.K. operating under the brand British Gas. It also has upstream and midstream operations including oil and gas production in the North Sea and a 20% stake in EDF’s U.K. nuclear plants. Thanks to its upstream operations, Centrica was historically positively exposed to soaring commodity prices. Accordingly, the fall of the latter drove a 90% collapse in adjusted EPS between 2013 and 2020, leading to the cancellation of the dividend in 2020. Conversely, the rebound of commodity prices, driven by the energy crisis, boosted profits in 2022 and 2023.

We confirm our GBX 180 fair value estimate after no-moat Centrica released 2023 EPS slightly above our and FactSet consensus estimates. The full-year dividend is set at GBX 4 per share, one third above last year and in line with the interim dividend hike. The group mentioned that distributions on top of the dividend will be reviewed against a revised capital allocation framework. This opens the door to additional share buybacks, in our view. Shares are materially undervalued.

European utilities are up by 14% year to date, slightly underperforming the broader European markets. Since the end of September, the sector strongly outperformed thanks to the rally in government bonds and solid third-quarter results that drove multiple guidance upgrades although growth slowed down from the second quarter due to higher comps. All in all, companies that are the most exposed to commodity prices are set to exceed their 2022 record profits in 2023. Meanwhile, firms with big retail businesses that were hit by a margin squeeze because of the energy crisis in 2022 will post a significant rebound in earnings.

European utilities have underperformed the European market by 4% year to date with most of the underperformance occurring in the third quarter because of the rise in interest rates. This overshadowed strong second-quarter results driven by the easing of the energy crisis, persisting commodity price volatility, and the hedging improvement. These drivers have persisted in the third quarter. Moreover, some power price clawbacks expired at the end of June like in Germany and Belgium. On the flip side, the comparison basis will be tougher as of the third quarter.

We raise our fair value estimate for no-moat Centrica to GBX 180 from GBX 140 on: 1) the material one-off of the first-half of 2023 from the recoupment of incremental costs in 2021-22 related to customers who flocked to standard variable tariffs amid the energy crisis, 2) the postponement of the closure of Heysham 1 and Hartlepool nuclear units from 2024 to 2027, 3) the increase in the available storage capacity of Rough from 30 billion cubic feet to 54 bcf, and 4) the GBP 450 million increase in the share buyback plan. Our new fair value estimate involves a 2023 P/E of 5.6, free cash flow yield of 16%, and dividend yield of 2.2%. Shares are undervalued.

Centrica is the leading retail energy supplier in the U.K operating under the brand British Gas. It also has upstream and midstream operations including oil and gas production in the North sea and a 20% stake in EDF’s U.K nuclear plants. Thanks to its upstream operations, Centrica was historically positively exposed to soaring commodity prices. Accordingly, the fall of the latter drove a 90% collapse in adjusted EPS between 2013 and 2020, leading to the cancelation of the dividend in 2020. The rebound of commodity prices since 2021 has boosted the group’s profits.

No-moat Centrica released first-half results well above expectations thanks to a material positive one-off. The group increased (again) its share buyback plan by GBP 450 million. Further, it increased its interim dividend by 33%, involving a full-year dividend of GBX 4. Last but not least, Centrica raised its growth investments and provided medium-term guidance for its retail and optimisation businesses. We commend this as Centrica has always stood out from other utilities by its lack of visibility. Our fair value estimate is GBX 140.

Centrica is the leading retail energy supplier in the U.K operating under the brand British Gas. It also has upstream and midstream operations including oil and gas production in the North sea and a 20% stake in EDF’s U.K nuclear plants. Thanks to its upstream operations, Centrica was historically positively exposed to soaring commodity prices. Accordingly, the fall of the latter drove a 90% collapse in adjusted EPS between 2013 and 2020, leading to the cancelation of the dividend in 2020. The rebound of commodity prices since 2021 has boosted the group’s profits.

We don't plan to materially change our GBX 140 fair value estimate after no-moat Centrica released its highest annual earnings since 2013 and announced a new GBP 300 million share buyback. This reflects good stewardship given the current material undervaluation of shares. Also, share buybacks suit Centrica's high-earnings volatility. The full-year dividend will amount to GBX 3.

We maintain our GBX 140 fair value estimate after no-moat Centrica released a brief trading statement in which it said it expects 2022 adjusted EPS above GBX 30, the highest level since 2013 and above our and FactSet consensus expectations. This confirms that Centrica is the most favorably exposed utility to soaring commodity prices in the short term. Amid a big energy affordability crisis in the U.K., those skyrocketing profits could fuel a public backlash. Nonetheless, we don't expect further political intervention after the increase in the energy levy on oil and gas companies and the implementation of a levy on low-carbon power producers announced last November. On the downstream side, that is Centrica's retail energy business, the wave of 2021/22 bankruptcies of small suppliers serving millions of customers will prevent the government from intervening in tariffs, in our view. Overall, shares are materially undervalued.

Most of the European utilities are well positioned against high inflation due to rising wholesale power prices and the indexation of most networks' revenue to inflation. However, the sector is down by 7% year to date, in line with the market, because of two headwinds: rising government bond yields and political risk. The former makes the sector's dividend yield less attractive. Further, it will increase the cost of debt, which will weigh on European utilities' bottom lines as the sector is the second-most-leveraged in Europe. Renewable developers and southern diversified utilities will be the hardest hit. Political risk varies greatly across countries. As in the European sovereign debt crisis, it is highest in Italy and Spain, and lowest in Germany. France and Belgium stand in the middle and the U.K. power windfall tax was milder than expected. Overall, political risk is stabilizing.

Previous Centrica CEO Iain Conn, appointed in 2015, embarked on a strategic U-turn by downsizing upstream activities to focus on customer-facing ones. The company sold its gas power plants, wind farms, and oil and gas assets outside Europe and redeployed part of the capital in small, capital-light companies involved in innovative energy services linked to digitalization and efficiency.

On Nov. 17, U.K. Chancellor Jeremy Hunt presented a new budget aiming to restore the country's financial credibility. As expected, the levy on oil and gas companies implemented last May will be raised to 35% from 25% and extended from the end of 2025 to March 2028. In addition, a levy of 45% will be applied to low-carbon power producers as of January 2023. According to Reuters, this 45% levy will be applied to revenue made over GBP 75 per megawatt-hour.

We plan to raise our GBX 130 fair value estimate by a high-single-digit rate after no-moat Centrica announced it will buy back 5% of its shares and sharply raised its 2022 guidance for the second time in a row. Shares are still materially undervalued after the high-single-digit jump at the time of writing.

We maintain our fair value estimate of GBX 130 per share after no-moat Centrica announced it reopened its Rough gas storage facility on Oct. 28 after being granted a 10-year license. This should boost short-term profits. On the other hand, Centrica confirmed its willingness to ultimately convert Rough to store hydrogen, which could be value-accretive should the firm get a regulated remuneration scheme. Shares are materially undervalued.

Previous Centrica CEO Iain Conn, appointed in 2015, embarked on a strategic U-turn by downsizing upstream activities to focus on customer-facing ones. The company sold its gas power plants, wind farms, and oil and gas assets outside Europe and redeployed part of the capital in small, capital-light companies involved in innovative energy services linked to digitalization and efficiency.

In a state of the union speech on Sept. 14, President of the European Commission Ursula von der Leyen confirmed all proposals made on Sept. 7 to tackle the energy crisis, except a price cap on Russian gas. Proposals include a mandatory reduction of electricity use at peak hours with the aim of reducing overall electricity demand by 10% until March 2023 and a power price cap at EUR 180/megawatt-hours on "inframarginal" electricity producers, that is renewables, nuclear, and lignite. The commission also intends to reform the electricity market design.

According to Bloomberg, new U.K. Prime Minister Liz Truss has drafted plans to freeze retail energy tariffs at current levels whereas the default tariff cap is due to increase by 80% next October. This involves a repeal of the current tariff regime implemented in 2019, with U.K. energy regulator Ofgem setting the default tariff cap (twice a year previously and quarterly since August) to allow suppliers to cover their procurement costs while capping their EBIT margin to 1.9%. Given the wholesale soaring gas prices of recent months, a freeze this October would create a huge shortfall for energy suppliers. According to Truss' draft plan, this shortfall will be fully compensated by the U.K. government, which will guarantee financing to cover the difference with what suppliers would have charged under the previous system. This plan would cost GBP 130 billion over the next 18 months, according to Bloomberg.

We don't plan to materially change our GBX 120 fair value estimate after no-moat Centrica released solid first-half results, guided for 2022 EPS above our expectations and those of the consensus it polled, and reinstated its dividend payment. The firm will pay a GBX 1 interim dividend implying a total of GBX 3 for 2022, below our GBX 5 and consensus' GBX 4. We don't contend this prudence, which we believe is driven by the need to avoid political noise as the energy affordability issue is all over the news. Over time, the company targets to progressively reach a 50% payout ratio. Shares appear significantly undervalued.