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Strategic review sparks interest at Centrica

Equities recovered from losses earlier in the week, as strong corporate earnings offset intensifying concerns about the outlook for the Chinese economy.

Growth uncertainties were heightened by news that industrial profits in China were down, while manufacturing activity contracted for a fifth successive month. In Shanghai, the composite equity index tumbled 8.5%, its biggest fall in eight years, defying renewed government vows of support that analysts warned were not enough to soothe nervous investors.

Meanwhile, concerns that China’s economy could suffer as a result of the slide in equity prices continued to reverberate through commodity markets. Brent Crude Oil traded a six-month low, copper hit its lowest level for six years and gold sank to a five-year trough, weighing on the heavy-weight mining sector.

Some economists, however, argued that China was undergoing a transformation, moving away from heavy industry and manufacturing-based exports, towards a more inward looking consumer based economy. As the world’s second largest economy, many argue growth momentum should trend lower in the coming years and be on a more stable footing as a result.

Some in markets have suggested that continued uncertainty about China could persuade the US Federal Reserve to delay raising interest rates. Yet the latest policy statement suggested that the US central bank remained on track to raise interest rates later this year. The Fed said it was seeing solid job gains and maintained its view that economic activity was expanding “moderately”, with the risks to the outlook nearly balanced, reinforcing market expectations that lift-off could occur in September.

News of a steep drop in US consumer confidence also eased fears of an imminent hike in interest rates, while the recent weakness in commodities could also delay any monetary tightening. The Conference Board said its index of consumer confidence plunged to 90.9 in July from a revised 99.8 in June, as households became less upbeat about the outlook for the economy, employment and their finances.

On a domestic front, British economic growth gained traction in the second quarter, although the strong pound hurt manufacturers. The economy grew by 0.7% in the three months to June, following an unexpected slowdown in the first quarter. The figures showed an increased reliance on domestic demand, with business and financial services powering ahead, while factory output suffered a rare quarterly fall.

British mortgage lending picked up strongly in June, with the value of mortgage lending rising by the largest amount in almost seven years, adding to signs that the housing market is regaining momentum. Retail sales, however, slowed in July, despite a large rise in clothing purchases. The CBI disruptive trades survey’s retail sales balance fell for a second successive month after hitting a five month high in May, while the outlook for August indicated further weakness.

Technical analysis of the FTSE 100 illustrates renewed buying after the euphoria from the Greek debt-deal faded. After trading a double-bottom at 6510 the index appears to be forming a new upward trend and the escalating oscillators indicate momentum is building. A close above 6800 is needed to confirm the trend, while support is seen at 6510 and 6414.

In conclusion, equity volatility in China has intensified fears about the economy, yet monetary and fiscal easing should help China manage a controlled slowdown, as it migrates from an emerging economy into a developed market. Strong corporate earnings and a burst of bid and merger activity in Europe helped improve sentiment among investors, while global deflationary pressures, supports the case for equities as an asset class.

As one of the bellwethers to report this week, Centrica (LON:CAN) said it has completed its strategic review of the business, which will see it shift investment away from its upstream production and towards British Gas and its other consumer businesses.

The FTSE 100 listed electricity and gas provider reported a £1.20 billion pre-tax profit in the first half of 2015, up from an £890 million profit a year earlier, despite revenue experiencing a 2% drop to £15.45 billion from £15.74 billion. Earnings before exceptional items was down 3% to £1.0 billion from £1.03 billion, after higher profit from customer facing businesses was more than offset by lower profit from upstream gas and power businesses.

Centrica’s new management team has conducted a six-month review of the business "in light of significantly changed circumstances", concluding that it must focus on meeting the needs of its customers and to deliver long-term shareholder value through both returns and growth. The company has decided to divert £1.50 billion of capital from its upstream business that focuses on exploration, production and central power generation, towards its consumer business, such as smart “connected home” technologies.

That further £1.50 billion investment will be split into several areas between 2015 and 2020. The company will spend an additional £250 million over the next five years growing its service business in the UK and in North America. An extra £700 million in the same period will be spent on its energy and power distribution, while a further £500 million will be used to improve the capacity of its connected homes segment. Another £150 million has been set aside for marketing and trading activities.

Centrica currently trades on 15x earnings, while its strengthened balance sheet and rebased progressive 4.5% yield should appeal to shareholders. Net debt fell 6% year-on-year to stand at £4.90 billion at the end of June compared to £5.19 billion at the end of June 2014 and Centrica aims to make £750 million in cost savings between 2015 and 2020. Around 6,000 jobs will be cut from its upstream segment by 2020, however, it will also increase its headcount in some areas resulting in a net reduction of 4,000 staff.

Chief Executive Iain Conn said: “With Centrica delivering solid financial and operational performance in the first half of the year and making good progress in strengthening its balance sheet and reducing net debt, the group is well placed to compete materially against the emerging long-term trends in global energy markets.”

 

The chart of Centrica shows the recent range-bound trading between 260p and 284p, with the shares nearing both the medium-term trend line and support. The bullish divergence evident from the oscillators suggests little momentum behind the recent weakness, indicating that 260p could provide a base.
The new management team retains a clearly defined focus on the balance sheet, while the shift away from high-risk upstream operations will lead to reduced business risk and enable the company to evolve.
At the time of writing the share price is 266.6p, which I believe is an enticing entry level, with targets seen at 279.9p, 289.3p and 320p. Traders might consider a tight stop-loss below technical support at 258.2p to minimise risk.

This report was written by Mark Allen – Head of Derivatives at SI Capital Stockbrokers. The writer does not hold a position in Centrica, but client accounts may. The material in this report has come from SI Capital’s internal data sources and Centrica’s corporate website.


 

 

 

 

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