Drilling Down Into Centrica PLC’s Working Capital

Centrica (LSE: CAN), the owner of British gas, is dirt cheap, the bulls argue. Those in the bear camp, for their part, point out that estimates for the company will have to go down, forcing Centrica to even consider a dividend cut.

Centrica is not an easy call, but much of its fortunes depend on how executives will manage the working capital’s needs of their company, rather than on divestments. Centrica’s net leverage has been constantly rising over the years and stood at 1.5x in 2013 — the highest level on record.

Working Capitalgasring

One Fool questioned the sustainability of Centrica’s payout on Tuesday (May 13), so I drilled down into the company’s cash flow statements. The findings are not encouraging.

Severe cash deterioration from a surge in credits to be collected within a year is apparent. Receivables more than doubled by almost half a billion pounds in 2013 — that’s the largest figure since 2008, when in the midst the credit crunch, uncollected credits sky-rocketed by £1.3bn.

A massive rise in 2013 payables — which almost doubled, surging by about £700m year-on-year to register their biggest rise on record — didn’t pass unnoticed, either. In 2008, cash inflow from a rise in Centrica’s payables was £372m.

All this simply means that credit risk is rising and short-term debts are not being paid as promptly as they should, although the average number of days it takes Centrica to pay its suppliers has markedly improved in the last five years.

On the liability side, a surge in payables makes lots of sense: in a way, more than 80% of the 2013 dividend was self-financed. But it also heightened the risk that those debts won’t be paid in full if financial strains become unbearable. 

Meanwhile, inventories play a minor role in working capital management, and contributed to a cash inflow of £78m.

Hard Time For Utilities

As a result, Centrica’s cash conversion cycle lengthened last year. A further deterioration in its financials could trigger a downgrade from credit rating agencies. Centrica’s credit rating is currently under review by Moody’s. 

Working capital could be a major issue going forward, and management will have to work hard to keep a tight control on swings in short-term liquidity.  

Centrica’s operating cash flow was £2.9bn in 2013. In 2008, when it plunged to the lowest level for 16 years, it hit £297m. Back then, Centrica paid out £500m in dividends to shareholders.

The company can’t afford to cut the payout, even if it needs to take on debt to fund it — and that’s a problem these days.

While debt can be raised on convenient terms in the current environment, and it’s inconceivable that banks will pull the plug on such a key relationship client, higher leverage combined with lower growth prospects for revenue and earnings suggest a distinct possibility for Centrica: value destruction.

The bulls could argue Centrica’s net leverage is lower than that of other European utilities. It still is, but it’s rising fast. A more convincing argument would be that utilities across Europe may need to undergo a significant round of consolidation — but will it occur at a premium to current valuation?

One Question

To reinforce a bearish stance on Centrica, a key question remains unanswered — who will bid up for unprofitable assets knowing that Centrica management must pursue divestment?

Alternatives To Centrica

The way it stands today, Centrica is not the most obvious bet for a private investor. There are alternatives, however, which should be considered by our readers.

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Alessandro does not own shares in any of the companies mentioned.