When I wrote about energy and services company Centrica (LSE: CNA) in March last year the share price was close to 132p, just as it is today. However, it went as high as 164p in the summer before falling back.
Dividend-collecting investors wouldn’t worry about such fluctuations in their capital. After all, the firm is yielding around 9%, which is a robust income to collect and you could compound it into a tidy sum over the years if it proves to be a sustainable annual payment from the company. However, if the share price drops by, say, 50% from here and stays there, the loss of your capital could wipe out years’ worth of gains from the dividend, and I think that would be a big problem for most investors.
This trend is not your friend
Centrica has form when it comes to a collapsing share price. Since the late summer of 2013, it’s down around 66%, and the chart shows a relentless downtrend with no obvious sign of an end in sight. Movements like that don’t often happen without good reason, and Centrica’s record of declining annual earnings and operating cash flow over the past few years reveals a worrying decline in the business.
But high dividend yields tend to arise because of operational setbacks and lacklustre trading. When growth evaporates, firms often fall out of favour with investors. But I reckon the best type of setback is a temporary one. Or, even if trading is flat year after year, consistent cash flow could still lend decent support to a company’s dividend. But Centrica has yet to prove that the decline in its operations can be arrested.
In a November trading update last year, the firm described some of the actions it has taken aimed at turning around the business, saying it is making good progress “introducing new propositions for customers,” and in “re-positioning the UK Home energy supply business in advance of the introduction of a default tariff price cap.” But trading conditions are competitive, and I can’t see that problem evaporating. Nevertheless, the firm expects to maintain the full-year dividend at 12p, which means the gigantic yield is safe for now.
The risk from thin cover for the dividend
But I see yields above 7% as more of a warning than an attraction. Indeed, earnings cover the payment just once and cash flow from operations has been on an undeniable downward trend for years. Meanwhile, the dividend payment has been flat since 2015 and some City analysts expect it to fall a little in the next trading year. That’s not the scenario I look for with a dividend-led investment. My preference is for cash flow, profits and dividends that rise a little each year. Centrica is struggling to hold all those things flat, and all the pressure is to the downside, in my view.
The company mentioned unexpected operational challenges, fierce competition and regulatory changes that all contribute to difficult trading. The directors also describe their focus on financial discipline and, I reckon, one of the obvious moves for them to make in the face of the firm’s high debt load and challenging trading is to trim the dividend to restore comfortable cover from earnings and cash flow. If that happens, the share price will likely drop further. I see the shares as risky.
