Morningstar | Centrica's vertical integration mitigates regulatory pressure.
Centrica revised its strategy in 2015 to focus on customer-facing activities and downsize upstream activities after a new CEO was appointed. The company disposed of its combined-cycle gas turbines, wind farms, and exploration and production assets outside Europe and is acquiring small, light-capital-intensive companies involved in innovative energy services linked to digitalisation, efficiency, and distributed energy. Management's bet is to leverage on the group's large customer base to embrace markets linked to new energy. Still, we believe those businesses have no moat and uncertain structural profitability.Retail energy supply in the United Kingdom is the largest activity, contributing about 45% of 2017 operating profit. Historically, Centrica has been able to deliver higher margins than its competitors thanks to the scale provided by its large market share. Political risk has dramatically increased since late 2013. In September 2018, as instructed by the government, the watchdog Ofgem unveiled the features of a tariff price cap to be implemented in early 2019 on default tariffs, so-called standard variable tariffs. This tariff cap implies a 5% tariff cut for around 35% of British Gas customers, which will squeeze margins and lower the structural profitability of the business, in our view. Centrica also operates as an energy supplier in the United States. The November 2017 profit warning reflects the fact that the structural profitability of the U.S. business supply activity is below what the market had assumed and that short positioning implied by the lack of upstream assets drives high earnings volatility.Altogether, profitability slide of the retail supply business will be offset by increasing E&P and nuclear margins on account of high gas and power prices. That calls into question the strategy of reducing vertical implementation, which has been implemented since 2015. Non-risk-averse income seekers could be enticed by the 8% dividend yield as of late September 2018.Centrica is an energy and services company. Co.'s segment are: Energy Supply and Services, which supplies gas and electricity in the U.K. and North America; Connected Home, which supplies energy solutions and technologies to residential customers; Distributed Energy and Power, which supplies energy solutions, generation and technologies to commercial and industrial customers; Energy Marketing and Trading, which trades and optimizes energy; Exploration and Production, which produces and processes gas and oil and develops new fields; Central Power Generation, which generates power from combined cycle gas turbines, wind and nuclear assets; and Centrica Storage, gas storage in the U.K.
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