Despite surging profits investors should avoid Centrica shares

Profits in the energy sector are booming but Centrica shares are struggling. Rupert Hargreaves explains why he’d avoid the stock.

The European energy market is in crisis, but for some companies, profits are booming. That’s the position British Gas owner Centrica (LSE: CNA) finds itself in today. 

The group, one of the largest energy suppliers to households and businesses in the UK, is seeing profits at its generation business surge, although its retail arm is feeling the heat. 

It’s thanks to this tug of war that Centrica shares have struggled to move higher this year. 

The stock is up around 6% in 2022 and it doesn’t look as if this underwhelming performance is going to change anytime soon. 

Are Centrica shares a good investment for the energy crisis? 

As the group’s CEO, Chris O'Shea wrote in the company’s half year report, the past 12 months has “demonstrated the importance of well-funded, well-run energy companies".

While other companies both at home and across Europe have collapsed under the strain of rising energy prices, Centrica has been able to navigate the storm. Its vertical integration across the energy supply chain has been key to its success.

For the six months to the end of June, the company reported an adjusted operating profit of £857m compared to £140m last year. Higher revenues from its oil, gas and nuclear assets accounted for most of this growth. 

Centrica’s profits would have been much higher if the group had not already inked the sale of Spirit Energy Norway and the Statfjord field. Including the impact of these two oil and gas assets, adjusted operating profits would have been in the region of £1.3bn for the period. 

However, after divesting the assets the group has one of the strongest balance sheets in the sector. It had net cash of £0.3bn at the end of June 2022 having reduced net debt by £4.2bn over the past three years. 

With a strong balance sheet and surging profits, management has been able to restore the dividend at 1p per share (to begin with). The total payout is worth £59m. 

Profits are booming, the dividend is back and the company has one of the strongest balance sheets in the business. 

So, why is the market seemingly giving Centrica shares the cold shoulder? 

Market and political challenges make it hard to gauge the company’s prospects

For a start, Centrica has a poor track record when it comes to growth. 

British Gas’s share of the retail gas market dropped from almost 44% to 28% between 2011 and 2021. Its share of the electricity market also fell from 24% to 19% as the number of suppliers surged from 14 to 70. 

This wasn’t entirely the company’s fault. Ofgem’s drive to create a more competitive energy supply market (which has now backfired spectacularly) encouraged a wave of smaller players to enter the market and undercut the so-called big four suppliers. 

Management couldn’t have stopped the influx of competitors. Still, British Gas could have tried harder to fight for business. The group lost market share because it was taking customers for granted. 

Customers are now returning, but that’s mainly because there’s a lack of other options.

There’s also the issue of volatility. As we’ve seen over the past year, the energy market is highly unpredictable. Centrica’s upstream businesses are raking in huge profits due to surging power prices. However, there’s absolutely no guarantee this will continue. Since 2011 it has earned an average net profit margin of 1.47% across the business.

And it’s not as if the energy supply arm will pick up the slack if revenue drops from generation. In the first half of the year on average Centrica made just £6 per UK household it supplied mainly as a result of the energy price cap.

On the topic of the energy price cap, the biggest elephant in the room for Centrica shares is the threat of government intervention. Last year, British Gas Energy reported £118m of adjusted operating profit, down a staggering 87% from 2016, the year before the retail energy price cap was introduced. 

The windfall tax on oil and gas producers, or the “Energy Profits Levy” to give it the official name will have an impact on Centrica’s finances, although its full impact is not yet known. 

Centrica shares look attractive but there are better ways to invest in the energy market 

There’s no denying that Centrica is fulfilling a vital role in the UK energy market, and unlike other large suppliers across Europe, the business has not asked for a bailout. It’s also acting as a backstop for the energy supply market, absorbing customers from other defunct energy suppliers. 

Nevertheless, as an investment, Centrica shares do not have many attractive qualities. The threat of further government intervention in the energy market is a huge, unpredictable risk, that’s without even considering the volatile nature of the energy market as a whole and the razor thin margins the group earns from its supply business. 

Even though Centrica’s profits are booming, I think it’s unlikely this growth will translate into high returns for investors.

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