Description

New Position: Centrica (CNA LN)

After several years of tough competition and dithering management, new CEO Chris O’Shea plans to rapidly transform the group from a directionless conglomerate to a UK focused energy supply and services business by divesting upstream, nuclear and international operations and focusing on the core business.  The shares should more than double over the next 12-18 months as a consequence of asset divestitures and cost-improvement initiatives with further upside from a post-COVID rebound in commercial/industrial electrical demand.  We believe this opportunity mirrors the NRG opportunity in February 2017 when John Wilder joined the Board to expediently ensure the divestment of several non-core assets, aggressively cut costs and return cash to shareholders.  In an ironic twist, NRG just announced the purchase of Centrica’s US energy supply business (Direct Energy) that should soon catalyze a massive re-rating in Centrica shares once people appreciate the pro forma balance sheet and earnings power of the business.  Further, on our estimates, pro forma for the announced sale of Direct Energy, the shares trade at just 5.6x and 3.0x 2021 P/E and P/FCF despite substantial cash flow visibility and balance sheet flexibility.  Peers trade at a multiple of these multiples (see below), but even it trades at just 8x free cash flow for a defensible business with structural growth, the stock will nearly triple from here.

The Complexity of Centrica

The Core

·   British Gas (“BG”) / UK Residential is the 800lbs gorilla for retail gas supply in the UK with 23% share in a fragmented market with leading brand recognition. However, this business generates a slim 3% margin as regulatory and competitive pressure have not been offset by cost-cutting and Service bundling.

·       BG/UK Services is the best business within Centrica, generating mid-teens margins via a subscription model to repair and replace gas and electrical appliances (mainly boilers) via ~8k engineers.  Homeserve is the best comparable business whose value implies that Services is worth the entire market value of Centrica today.

·       Centrica Home Solutions is a relatively new business comprised of EV installations, smart meters, etc. and should lose less each year and drive growth for the overall business IF well-managed.

·   BG/UK Business is an industrial gas supply business with >30% share that generates steady, albeit low margins (2% consistently) on a cost-plus basis.

·       Energy Marketing & Trading possesses a strong competitive advantage given intel from its sister company that is the largest gas supplier in the UK, enabling double digit ROIC annually.

·       Business Solutions is similar to Home Solutions, growing fast, but losing a lot of money.  This is a collection of businesses that help clients save on energy and shrink their CO2 footprint.

Non-Core Assets to be Monetized Expediently

·       NA/Direct Energy is the third largest energy supply business in North America.  In July, Centrica announced the sale for >GBP2.8bn / $3.625bn – 40% higher than consensus, reflecting significant scarcity value. The deal should close by year-end.

·       Spirit Energy is 69% owned by Centrica and is a North Sea O&G producer.  The market does not expect this asset will be sold in the near future given the downturn in O&G prices.  We believe that the asset is likely to be sold over the next few months (~$0.7-$0.9bn) as the asset can generate >$150M of free cash flow at $45/BOE.  The market does not appreciate that this asset is responsible for >60% of total capex, which will unmask how little capex Centrica Core requires once this asset is sold.

·       Nuclear comprises a 20% minority stake in the UK’s nuclear fleet purchased from EDF in 2009 for £2.3bn (current market cap of all of Centrica).  We believe these assets are likely to be sold for £500M.

·       Storage is a misnomer for what is largely a gas field in run-off and irrelevant to the overall business.

Assumptions: (1) Divestitures impact 2021 and 2022. (2) All Upstream assets are sold for £800M. (3) Divestiture proceeds and cash flow used for debt and pension paydown. (4) EV multiples include pension deficit, but we don’t add back pension costs (service and interest) to estimates to keep them comparable to Consensus.

Public Market Comps (based on Bloomberg Consensus for ALL)

How Did We Get Here?

The shares are down 54% YTD and are now below the 1997 IPO price.  Our diligence calls suggest that previous CEO, Iain Conn, was the wrong person for the job.  During his five-year tenure, Conn failed to aggressively cut costs to compete with new asset light entrants in the UK energy supply business and failed to leverage Centrica’s (legacy British Gas) massive scale advantage.  Instead he made 12 acquisitions for £1.4 billion that generate <£100mm of EBIT against a market cap today of just £2.4bn.  Additionally, he burned ~£500M of cash creating Home and Business Solutions that likely would never break-even under his leadership.  In 2015 Conn said that the two aforementioned businesses would be break-even by 2018, but instead they lost >~£180M that year. Instead of moving on Conn doubled down on his investment and moved his break-even goal to 2021.  He also tried to convince the Board to allow him to open an office in Silicon Valley to be closer to the “nexus of innovation.”  Fortunately, the Board refused to acquiesce.

In addition to poor management, Centrica also encountered a hostile regulatory environment.  Over the past 5 years the UK Consumer business (BG) has seen EBIT cut in half driven mainly by major cuts in regulated price caps.  Domestic energy supply margins were cut in half from 9% in 2014 to 4.8% in 2019 as costs per customer were 23% higher versus. top quartile players.  Additionally, Centrica has an E&P asset called Spirit Energy whose EBITDA declined by 77% between 2014 and 2019 due to lower oil and gas prices.  Finally, COVID modestly impacted the UK Services Businesses.

Why Will This Work?

New CEO Chris O’Shea is the perfect leader for Centrica.  Chris joined Centrica as CFO at the end of 2018.  All of our checks indicate that Chris and the previous CEO were at odds on cost-cutting, capital allocation and strategic direction.  In addition to fantastic checks from Royal Dutch Shell, BG Group and Smiths, we also knew Chris personally when he was CFO of Vesuvius from 2012-2015.  Chris is young, ambitious, hard-working, meets or exceeds his targets and is exceptionally focused and confident on delivering at Centrica.  He already delivered positively on his first financial period as CEO and sold Direct Energy faster and at a higher price than anyone believed possible.  We believe that over the next several months Chris will continue to simplify the group.  Additionally, he has already announced further cost cuts, which will a) move the UK Retail business into the top quartile within its sector and b) generate massive upside to earnings versus consensus expectations in 2021.  Ofgem, the UK gas and electricity regulator, publicly announced measures to assure the health of the industry due to COVID and regulatory measures for the next couple years will now provide more of a tailwind than a headwind.  Finally, there will be another leg up in 2021 as the UK industrial energy supply business saw volumes fall 20%+ temporarily because of COVID-19. 

Conclusion

We believe Centrica offers a fantastic risk-reward given the fortuitous confluence of a) COVID-19 crushing sentiment and the share price, while only impacting the business short-term, b) a great largely unknown new CEO who knows the business extremely well and will rapidly divest non-core assets and cut costs, c) an improving regulatory environment from which Centrica already began growing UK retail customers for the first time in five years in 2019, d) rebounding oil and gas prices, which will enable divestment of the most hated asset (Spirit) over the coming months and e) improved communication surrounding capital allocation and earnings power over the next few months as the new management team starts meeting more investors.  Risks to the downside include the new CEO moving too slowly on asset divestitures and cost-cuts and the UK business facing increasing regulatory pressure.  In addition to multiple calls with Chris since he joined Centrica and confirmatory reference calls, we have a long history with Chris from Vesuvius and have little doubt that he will move quickly and do what is necessary to create value.  Recent policy statements from Ofgem make it clear that it does not want to harm the industry further as that would lead to smaller players going bankrupt, generating more customers and higher returns for Centrica.

Catalyst

• Completion of NRG-Direct Energy deal
• Results
• 2021 guidance, capital allocation policy and increased communication from new management
• Divestitures of Upstream and possibly Ireland