Why I’m Avoiding Centrica PLC & AO World PLC For 2016

G A Chester explains why he’s steering clear of Centrica PLC (LON:CNA) and AO World PLC (LON:AO).

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Centrica (LSE: CNA) and AO World (LSE: AO) are two stocks I’m steering clear of for 2016. Let me explain why.

Centrica

Companies are always evolving, but utility Centrica has made a number of major lurches in direction since it emerged as one of three separate companies from the break-up of British Gas plc in 1997.

The company immediately embarked on diversifying beyond its core British Gas retail and other energy operations by acquiring breakdown company the AA, telecoms operator OneTel and the Dyna-Rod franchise group, as well as developing the Goldfish credit card.

Five years later, Centrica decided it no longer wanted to be a diversified conglomerate and sold off most of the businesses it had bought.

From the mid-Noughties, Centrica focused on developing itself as a “vertically-integrated” energy company, led by new chief executive Sam Laidlaw, who brought significant experience of “upstream” operations. Mr Laidlaw departed at the end of 2014, having been moaning for some time about “unprecedented” political and regulatory scrutiny, including of the relationship between energy companies’ upstream and downstream businesses.

New chief executive Iain Conn, who came from a contrasting downstream background to his predecessor, initiated a strategic review. In July, Mr Conn announced: “The conclusion of our strategic review provides a clear direction for the business .. we will focus our growth ambitions on our customer-facing activities”. The upstream business will be reduced, including by divestments.

City analysts expect Centrica to post an 8% earnings decline for 2015, following a 28% fall in 2014. With the shares not much above multi-year lows hit in December, the price to earnings ratio is an attractive-looking 12 and the dividend yield is a juicy 5.6%.

However, the low oil price will continue to impact on the company. Adverse weather conditions have also hurt in recent times; something that could continue for the next couple of years, if Met Office forecasts are on the button. Political and regulatory risk hasn’t gone away. And, finally, the big question: Will Centrica’s latest “clear direction for the business” deliver?

Given the headwinds, and the early stage of executing on Mr Conn’s vision, I’m avoiding Centrica for now.

AO World

AO World, the online retailer of household appliances, is a company I’ve always been bearish on since its stock market flotation at 285p a share in March 2014. I thought the valuation was “way too high” a year ago at 250p, and still too high at 178p last summer. With the shares now at 150p, is it time to turn bullish?

The table below shows some numbers for today and on a couple of the previous occasions I’ve written about the company. Revenue and earnings are for the established UK business — so exclude the current small sales and negative earnings from the recent expansion into Europe.

  Today May 2015 December 2014
Share price 150p 178p 250p
Market cap £631.6m £751.6m £1,052.6m
Net cash £29.6m £43.9m £43.9m
EV (market cap minus net cash) £602.0m £707.7m £1,008.7m
Revenue (ttm) £502.4m £472.5m* £428.5m
Adjusted EBITDA (ttm) £14.2m £16.5m* £15.1m
EBITDA margin 2.8% 3.5% 3.5%
EV/EBITDA 42.4x 42.9x 66.8x

* Company guidance at the time

As you can see, despite the fall in the share price since May, the valuation of EV (enterprise value)/EBITDA (earnings before interest, tax, depreciation and amortisation) is virtually unchanged.

I maintain that the valuation is way too high for a low-margin business in a highly competitive sector of the retail market, so I will continue to avoid the stock.

Should you invest, the value of your investment may rise or fall and your capital is at risk. Before investing, your individual circumstances should be assessed. Consider taking independent financial advice.

G A Chester has no position in any shares mentioned. The Motley Fool UK has recommended Centrica. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.

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