The Centrica share price is up 65%. Here’s why I sold

Saucepan on a gas hob

The past year has seen an improvement both in the business fortunes and valuation of British Gas-owner Centrica (LSE: CNA). Over the past 12 months, the share price has boomed 65%.

That is impressive. Even now, the firm trades on a price-to-earnings ratio in the single digits. At surface level that may look like a bargain. But I decided to sell my holding rather than buy more. Here, I explain why I decided to sell.

Strong business outlook

Before getting into some of the risks I see, it is worth looking at the company’s current business performance and outlook.

Over the past several years, Centrica has trimmed its business significantly. That has had several benefits, as I see it.

An obvious one is giving the firm more strategic focus. But another benefit has been a marked improvement in the company’s balance sheet. Last year, net debt of just under £3bn gave way to net cash of £680m. That puts the company in much better financial health.

But the sharpened strategic focus could turn out to be a double-edged sword, I reckon. That is because it is now heavily focused on areas where I see significant risks to future profitability.

I am particularly concerned about its heavy exposure to the gas business. But I also think the nuclear business could turn out to be problematic, as that industry has long had problematic economics, with high investment requirements.

Centrica’s gas problem

Why do I see the gas business as a risk to Centrica Well there are a couple of key longstanding issues – and a newer one too.

The main longstanding issue is the decline of gas as an energy source in the UK. Environmental critics have led to an increasingly hostile reception to use of gas as an energy source.

Indeed, a planned ban on gas boilers in new-build homes is indicative of the way the wind is blowing. In itself that might not be a big issue for a gas company like this, as millions of existing homes will likely continue to have gas boilers. But if current political trends continue, I expect the UK to see declining gas use in coming decades.

Centrica is a key player in a market I think is set to shrink. That is not a great business model.

A second challenge is that its key brands have built poor reputations for customer service. Last year, Centrica’s level of energy complaints per customer jumped by over a third. That has hurt revenue potential.

Although the number of residential energy customers increased last year by 5%, the long-term trend has been a sustained decline. Even with the increase last year, the number of residential accounts shrank by 54% over the past decade. That is a huge fall.

I think that partly reflects the company’s struggle to compete with brands that customers feel offer better customer service or more attractive pricing. Although last year’s improvement was good news, I remain concerned that Centrica’s service standards will lead to further declines in customer numbers down the road.

Soaring gas costs

The newer risk I see for Centrica is a surging gas price. At first glance, that may seem like good news for a gas company. Indeed, it probably partly explains the recent strong performance of the Centrica share price. But, in reality, I think things are more complicated than that.

Due to its energy trading division, moves in energy prices could hurt profitability at Centrica, depending on what trades its dealers have made. Indeed, last year, the company’s total adjusted operating profit in its energy marketing and trading division fell 60%.

The bigger risk I see to the share price from gas cost increases concerns the dividend. My satisfaction with the Centrica board fell this year when it failed to reinstate the company’s dividend despite a strong business performance.

Now I see considerable political risk when it comes to gas prices, which could make it tougher to pay a meaty dividend even if profits could enable it.

Imagine that Centrica decides to pay its first dividend since 2019 just as millions of households and businesses are grappling with expensive energy bills. I think that could increase the risk of tighter price caps, something that might hurt profits in the long term.

But the already slow resumption of dividends has made the investment case less attractive to me. Indeed, that was one motivation for me to sell the shares.

Is the Centrica share price a bargain — or a value trap?

Despite what I see as sizeable risks, I recognise there is a strong case to be made that the share price is a bargain, even after increasing by almost two thirds over the past year.

The P/E ratio continues to look low. A far healthier balance sheet means the company can now generate earnings and pay them to shareholders, if it chooses, without the burden of debt payments hanging over it.

Whatever problems brands like British Gas may have, Centrica continues to have a large customer base. Even if declining gas use and customer losses are bad in the long term, the gas business could be a cash cow for the company in years to come.

My concern though is that this stock could be a value trap. For many years it has had the makings of a very profitable business, but it has never really realised its full potential, in my view. Instead it seems to limp from one piece of disappointing news to another, obscuring its achievements when it does well.

The company is largely focused on a business that is in structural decline. Its brands are problematic, the dividend remains cancelled, and political risks are growing.

I see more attractive investment cases elsewhere, which is why I recently took advantage of the growing Centrica share price to sell my investment.

The post The Centrica share price is up 65%. Here’s why I sold appeared first on The Motley Fool UK.

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Christopher Ruane has no position in any of the shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.