Is it time to buy Centrica for its huge dividend?

published 27 November 2017

171127-centrica-b — Centrica shares currently yield 8%

British Gas owner Centrica issued a major profit warning towards the end of last week.

The share price fell hard and it hasn't rebounded as yet. The "boring" utility company now pays a dividend yield of more than 8%.

Now I know our readers well, and I know that there's one obvious question that springs to your minds when you see a dirty great dividend yield like that.

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"Should I buy now or later?"...

The British Gas owner has already had a pretty poor year. Sentiment towards the sector has not been helped by the fact that the utility sector in the UK is caught between the deep blue sea of Theresa May (who promises to cap energy prices) and the devil of Jeremy Corbyn (who promises to nationalise everything).

And certainly, in the UK, things are not looking great. The company lost 823,000 customers in the quarter to the end of October. That was driven partly by a decision to raise electricity prices by a staggering 12.5% at the end of September.

However, as Lex in the FT points out, the problems are not in fact, on the UK side. The loss of more than 800,000 customers might sound like a lot, and it was certainly more than many analysts had expected. But, according to Lex at least, these are relatively unprofitable customers who the company might be better off without.

The chief executive, Iain Conn, also argued that cost cuts meant that the earnings of the UK domestic business would stay pretty much the same as last year.

The real issue is across the Atlantic, in the North American side of the business.

Centrica also supplies power to businesses in the US and Canada. Unfortunately for Centrica, competitive pressure is growing over there, which has "put significant downward pressure" on profit margins. As a result, earnings per share are set to come in at 12.5p compared to market hopes for more than 15p a big write-down in other words.

Centrica is not a "buy"

So technically, that 8%-plus yield is "safe" for now.

So what should you do?

Here's my short answer: I don't think Centrica is a "buy" right now. Here's why.

Firstly, when things are going pear-shaped, I like to get a feeling that management knows what it's going do about it. Instead, there's a sense of "fingers crossed" here.

The regulatory regime in the UK could well get worse before it gets better. As we've noted above, the current Conservative government is about as good as it can get for the energy companies. I struggle to see the political mood music changing to make life easier.

The big energy companies might want to shift more of their profits to the servicing side of things. But as most of us know by now, making a decent profit from after-sales services is all about good customer service. And if there's one thing that the big utilities are not well-known for, it's good customer service.

It's very hard to take a business that has grown bloated on customer apathy and lack of competition and then turn it into a sales and customer-service orientated business. Just look at the banks. You can't take a business culture that couldn't care less about its customers and turn it into a "client-centred" business overnight, if ever.

(This is an interesting point to note actually. Businesses are generally run for the benefit of one specific set of stakeholders. Knowing who those stakeholders are can help you to make a decision about whether a company is worth investing in or not that's a topic for another day).

Secondly, competition is only going to get worse in the likes of the US. The utility market is already being "disrupted" there. Renewables, smart cities, localised grids this is not going to go away. If the company doesn't have a plan for dealing with it, then you've got big problems.

Thirdly, the other point I'd make about high dividend yields specifically is this: managements generally don't like cutting dividend payouts, particularly when big fund managers are relying on them. This is one reason why Shell and BP tend to do just about anything to avoid slashing their dividends. It's a pretty good way to find yourself on the fast track to the exit door.

However, there's a point at which a rocketing dividend yield acts as a signal to management. In this sort of environment, a yield of 8%-plus (which is what Centrica is offering now, assuming the dividend remains static) screams: "We don't believe you."

In a way, it gives management permission to cut the dividend to a more sustainable level. But of course, such dividend cuts often accompany rolling heads at the top.

So, in a nutshell: I don't think now is a good time to buy Centrica. There is little visibility on how the company plans to get out of this hole, and there will be building pressure behind the scenes on management to step up or step down. But even then, it's hard to see change at the top being capable of addressing the issues that the company faces.

A dividend cut and management reshuffle might be a "buy" signal, or at least a sign to re-evaluate the stock. But otherwise, I'd expect this profit warning to be followed up by another at some point in the next year.

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John Stepek is a senior reporter at Bloomberg News and a former editor of MoneyWeek magazine. He graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.

He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news.

His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.