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Why I’d buy this superstock before Centrica plc

Iron ore pellet producer Ferrexpo (LSE: FXPO) displays an attractive blend of quality, value and momentum and I think it looks a better option than buying shares in British Gas-owner Centrica (LSE: CNA) with the uncertain outlook the utility operator faces.

Ferrexpo’s full-year results today report a strong market environment for high-grade iron ore pellets, which led to an increase in premiums during 2017. The figures reveal that even though total pellet production declined 7% during the year and sales volumes eased back 11%, revenue rose 21% compared to 2016. That led to a 6% gain in net cash from operations and a 109% uplift in diluted earnings per share.

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A positive outlook

In a sign of the firm’s gathering financial strength, net debt declined by 32% to $403m, and the directors expressed their confidence in the outlook by pushing up the total dividend by 150% — when the economic sun is shining, cyclical firms such as Ferrexpo can really deliver for investors. And the firm thinks there’s more to come, saying it expects to benefit from higher pellet premiums during 2018, “reflecting agreements with customers and strong demand for high-quality pellets.”

Non-executive chairman Steve Lucas said that a quality upgrade programme completed in 2015 enabled Ferrexpo to fully capture the increase in market premiums for higher quality iron ore.”  Looking ahead, he expects further rationalisation of steel capacity in China in 2018, “which should support global steel margins, and in turn encourage a continued focus on iron making productivity.”

Meanwhile, it’s hard to describe the company’s valuation as expensive. The recent share price close to 296p throws up a forward price-to-earnings (P/E) ratio just under 10 for 2019, which compares to Centrica’s forward P/E ratio of a little over 10 for 2019. But that’s where the similarity ends. Centrica’s share price has been in a downtrend since the summer of 2013, driven by generally falling earnings, while Ferrexpo’s shares have risen spectacularly on the back of robust earnings growth.

Looking for a turnaround

Centrica’s chief executive Iain Conn was direct in February’s full-year report saying: “Our financial result in the second half of 2017 was weak.” He put the outcome down to poor performance in the firm’s business energy unit and in the North American business arm. It seems that a combination of political and regulatory intervention in the UK energy market, concerns over the loss of energy customers in the UK, and the performance issue in North America “created material uncertainty around Centrica.”

So, investing in Centrica today is all about looking for a turnaround in the company’s fortunes. City analysts expect earnings to lift 7% during 2018 and to decline by 5% in 2019, so no one is expecting a rapid reversal here. Maybe that’s why the valuation looks cheap. Today’s share price of 132p throws up a forward dividend yield above 8% for 2019, but I consider any yield above 7% to be more of a warning than an opportunity. Anticipated forward earnings cover the proposed payment just once.

Any further slip in operational performance could see the dividend under threat. I don’t want ‘investing in Centrica’ to end up being one of the worst  mistakes I make, so I’m avoiding the firm’s shares.

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Kevin Godbold 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.

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