Centrica Plc

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THIS REPORT WAS PREPARED BY TOMÁS GAIVÃO RIBEIRO, A MASTERS IN FINANCE STUDENT OF THE NOVA SCHOOL OF BUSINESS

AND ECONOMICS, EXCLUSIVELY FOR ACADEMIC PURPOSES.THIS REPORT WAS SUPERVISED BY ROSÁRIO ANDRÉ WHO REVIEWED THE

VALUATION METHODOLOGY AND THE FINANCIAL MODEL. (SEE DISCLOSURES AND DISCLAIMERS AT END OF DOCUMENT)

See more information at WWW.NOVASBE.PT Page 1/29

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ASTERS IN

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INANCE

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§ In an effort by governments to create energy retail markets more fair to customers and due to the low commodity price environment, utilities markets have observed a rising number of competitors that have been pressuring Centrica’s international downstream businesses, British Gas (UK) and Direct Energy (US), who saw client’s escaping to smaller players during the last years. § With a commodity prices rebound scenario on the horizon and the sterling depreciation against dollar, will benefit Centrica’s operating scenario and increase its competitive advantage in relation to smaller players.

§ In the past, the same Centrica’s hedging strategies, ca. 12-24 months, that hampered the company relative to most smaller suppliers when energy spot prices were at record low levels, will now be favourable to the company.

§ Also, through its growing new product and services portfolio on smart technology, Centrica is leading the shift to energy saving solutions for customers and building a solid revenue stream for a greener and less energy consuming future.

Company description

Centrica Plc is an integrated energy company. The Company operates through three segments: International Downstream, International Upstream and Centrica Storage. It offers smart thermostat solutions and its International Downstream segment includes the operations of British Gas, Direct Energy and Bord Gáis Energy in the UK, US and France, respectively.

C

ENTRICA PLC

C

OMPANY

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EPORT

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TILITIES

6 J

ANUARY

2017

T

OMÁS

G

AIVÃO

R

IBEIRO

14658@novasbe.pt

Betting in size and smart “tech”

Overcoming the rise of small competitors and low

commodity prices

Recommendation: BUY

Price Target FY17: 270.44 GBp

Price (as of 30-Dec-17) 234.00 GBp

Reuters: CNA.L, Bloomberg: CNA:LN

52-week range (GBp) 182.50-248.00 Market Cap (GBPm) 12,846 Outstanding Shares (m) 5,488 Source: Reuters

Source: Reuters

(Values in GBP millions) 2015 2016E 2017E Revenues 27 971 27 987 28 769 British Gas 12 303 11 550 11 313 Direct Energy 10 587 11 796 13 003 Centrica Energy 4 242 3 764 3 536 EBITDA 2 395 2 745 2 879 Net Income* 832 1 105 1 272 Energy sales (TWh) 497 464 507 Gas production (mmboe) 78.6 74.7 71.5 Electricity Generation (TWh) 19.3 21.7 21.5 EBITDA Margin % 8.6% 9.8% 10.0% Source: Company data; Analyst’s estimates;

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CENTRICA PLC COMPANY REPORT PAGE 2/29

Company overview

Company description

Centrica’s segments are divided between its International Downstream and International Upstream businesses. Under its International Downstream Business, Centrica operates with British Gas, Bord Gáis Energy and Direct Energy, while under the International Upstream it operates with Centrica Energy. It also operates Centrica Storage, the largest UK natural gas storage facility.

Figure 2 – Centrica Plc organizational structure

British Gas

(United Kingdom)

Bord Gáis Energy

(Republic of Ireland)

Direct Energy

(North America) Centrica Energy Centrica Storage

Centrica Plc Residential Energy Supply Residential Services Business Energy Supply and Services Residential Energy Supply Residential and Business Services Business

Energy Supply Gas Power International Downstream International Upstream Midstream

Source: company data

International downstream

British Gas, which represented approximately 44.0% of Centrica’s Revenues in 2015, is the UK’s leading energy supplier and provides energy and services to around 10.8 million homes in Britain, as well as providing energy to over 850,000 UK business supply points. British Gas Services installs, repairs and maintains boilers and heating systems. Recently, British Gas is also helping customers to manage their energy consumption with a range of low carbon, energy efficient products and services, which are integrated in their Connected Home department.

British Gas Residential, the largest operating segment of British Gas (67.0% of 2015 British Gas’s revenues), supplies gas and electricity to residential customers in the UK and provides leading technology in the industry. With the British Gas Residential Services operating segment (13.0% of 2015 British Gas’s revenues), the company provides a range of services from boiler installation and repair to plumbing and drain cover, supported by a national network of engineers and with six engineering academies. Finally, through its British Gas Business energy supply & services operating segment (20.0% of 2015 British Gas’s revenues), Centrica supplies gas and electricity as well as energy-related services to businesses throughout the UK.

Figure 3 – British Gas revenues breakdown

Figure 1 – Centrica revenues breakdown

44.0% 37.8% 15.2% 3.0% British Gas Direct Energy Centrica Energy Others 67.0% 13.0% 20.0% Residential Energy Supply Residential Services Business Energy Supply and Services

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Also in Europe, the Bord Gáis Energy (2.6% of revenues), which has been part of the Centrica Group since mid-2014, is a supplier of gas and electricity in the Republic of Ireland. It has 685,000 customer accounts and offers a wide range of customer, focused solutions including flexible payment options, online account management capabilities and several simple price plans.

Across North America, Direct Energy represents 37.8% of Centrica’s revenues. Through several acquisitions in the past two years, Direct Energy has been expanding its network, which now supplies gas and electricity to residential, commercial and industrial customers and provide energy management solutions. With a similar operating model to British Gas, Direct Energy Residential (20.5% of 2015 Direct Energy’s revenues) supplies gas and electricity to customers’ homes throughout North America, focusing on differentiating its offering by developing innovative bundled energy and protection plan products. Together with its Direct Energy Services (4.5% of 2015 Direct Energy’s revenues), it provides residential customers with choice and support in managing their energy use and cutting costs through its portfolio of innovative products and services, from services as air conditioning, plumbing and solar installations. Finally, the Direct Energy Business, which is the largest revenue driver (74.9% of 2015 Direct Energy’s revenues) supplies gas, electricity and energy management solutions to commercial and industrial customers.

Transversal to all its downstream businesses, Centrica’s Connected Home products and services bet in consumers shift to smart and more rationale consumption of energy. With its Hive smart thermostat and other services, Centrica is helping customers to manage their energy use in the UK, Ireland and North America, leveraging from strong existing sales teams of British Gas, Bord Gáis Energy and Direct Energy, respectively. With strong brands and a fleet of 12,000 engineers and technicians on the ground across its markets, Centrica has the potential to integrate physical with digital and to expand its offering to customers.

International upstream

Centrica Energy, which represents 15.2% of Centrica’s revenues, is one of the leading producers of gas on the UK continental shelf, while also operating a fleet of gas-fired power stations. Its business is divided in 1) exploration and production, which is upstream oil and gas business in the Irish Sea, the UK, Norwegian and Dutch sectors of the North Sea and North America, and 2) power generation, through its own fleet of gas-fired power stations, and a 20.0% share in EDF Energy’s UK nuclear power plants. Centrica Energy also operates the trading arm of the group, while trading gas, power and related commodities,

Figure 4 – Direct Energy revenues breakdown

Figure 5 – Centrica Energy revenues breakdown 20.5% 4.5% 74.9% Residential Energy Supply Residential and business Services Business Energy Supply

78.0% 22.0%

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including the own upstream and power generation operations. Energy Marketing and Trading (EM&T) also sources electricity and gas for British Gas customers. Centrica Storage

Centrica Storage owns the largest natural gas storage facility in the UK (the “Rough” facility), able to meet approximately 10.0% of the UK’s winter peak day demand and representing more than 77.0% of the UK’s current gas storage capacity, according to the National Grid and Oxford Institute for Energy. Centrica Storage also owns and operates the Easington gas-processing terminal, which processes both gas from Rough and from Centrica Energy’s York gas field, which are then distributed via the National Transmission System. In accordance with undertakings given to the Secretary of State for Trade and Industry in 2003, Centrica Storage is legally, financially and physically segregated from all other Centrica businesses.

Shareholder structure

Centrica’s shareholder structure is mainly composed of Institutional Investors that all together are 12,595 and hold 94.5% of total shares (excluding Treasury shares). Of these institutional shareholders, 31.5% are material shareholders as Aberdeen (4.91%), BlackRock (5.88%), Invesco (4.95%), Newton (5.02%) and Schroders (10.72%).

The remaining 301,127,377 shares, which represent 5.5% of total shares are held by 584,986 investors.

Finally, Centrica distributes two dividends: one interim dividend whose established practice is that it represents 30.0% of previous year total dividend and a final year dividend that is determined based on the sustainability of operating cash flows. Historically (from 2011 to 2015) Centrica has distributed both dividends every year.

The utilities sector

Current environment and future outlook

The beginning of energy liberalization

The liberalisation and privatisation of the energy markets in the UK began after Margaret Thatcher privatised British Gas Plc back in 1986. The company remained a fully integrated monopoly, provider of gas to approximately 40 million households, which also required the creation of OFGEM (Office of Gas and Electricity Markets) so the market remained supervised and controlled, to fulfil Britain’s superior interests. In 1996, the gas markets were then opened, which

Figure 6 - Potential gas storage capacity, %

Source: National Grid; Oxford Institute for Energy Studies (2013)

Figure 7 – Shareholder Structure

77.20% 5.70% 5.50% 4.00% 7.40% 1. Rough (Centrica) 2. Hornsea (SSE) 3. Humbly Grove (Star Energy) 4. Aldbrough (SSE and Statoil) 5. Others 68.5% 5.88% 5.72% 5.02% 5.00% 4.95% 4.91% Free floating BlackRock, Inc. Schroders Investment Management Limited Newton Investment Management Limited Schroders plc Invesco Limited Aberdeen Asset Managers Limited

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meant that consumers could choose and change from their gas provider for the first time. Finally, in 1998, the electricity markets were opened and now British Gas was free to take on electricity customers.

During this transition period, OFGEM also structured and demanded corporate restructurings that would intend to segregate the energy generation business, such as gas and electricity, from their energy sales operations unit. This was a much-needed restructuring, since many of the old monopolists, such as British Gas, were fully integrated businesses that would sale as well as product gas and generate electricity.

These important measures from a consumer standpoint, brought many utilities across Europe to reach crossroads that are already requiring new business strategies, as the 80’s model of centralised, constant energy production and consumption is being replaced by a much more modern and dynamic energy market. This can be visible already in Centrica's 2015-2016 strategy, where the company wants to reduce its oil and gas production business, reduce brutally its allocated capex (GBP400-600m in 2016 from over GBP1,000m in 2014) and focus instead on providing better products to its end-consumers, such as the smart technological products and solutions that reached the market in 2016. M&A to push further valuations and consolidation in the UK

From a macroeconomic point of view, Europe and specifically the UK, currently look particularly attractive to abroad seeking to acquire Utilities’ assets. This is especially true for US companies, who have benefited from the Euro’s depreciation against the US dollar since 2014, and more recently, against the Sterling, promoted by the recent BREXIT referendum outcome and from a low interest rates environment. On 2014 the EUR/USD was at approximately 1.40 and the GBP/USD at 1.66, while at the end of the year of 2016 rates are approximately trading at 1.05 and 1.23, respectively. Therefore, UK and European assets might appear relatively cheaper to US buyers.

However, despite the favourable conditions above, actual European M&A activity has been below the levels many predicted for 2014-2016 according to HSBC1. The uncertain geopolitical environment in Europe aligned with continuous weakness in commodity prices appears to have created a situation where buyers are waiting for the market to hit the bottom, though questions are being raised to whether there is room to go even lower. However, as pressure in commodity markets start alleviating, mainly as a result of OPEC’s output cut, it might be a question of time until consolidation and acquisitions get their momentum. A single

1

HSBC: Europe - Plentiful Opportunities (Natural Resources & Utilities;

Source: UK National Grid

Figure 8 - Electricity annual demand UK (TWh/year) 300 310 320 330 340 350 360 370 380 390 2005 2010 2015 2020 2025 2030 2035 2040

Historic High case Low Case Base Case

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high-profile European acquisition could be enough to help setting the market price for utilities’ companies and trigger other deals. These would have a critical role in increasing valuations on the European and UK’s utilities market, special for those with exposure to foreign markets as Centrica that now sees its US dollars’ revenues increasing in Sterling terms.

Besides, as a result of higher commodity prices, some smaller suppliers that do not benefit from long-term hedging strategies, and whose market share growth was derived from low commodity spot prices, are now starting to fail its commitments. GB Energy became the first of these companies to collapse during 2016 winter. This presents an opportunity for market consolidation in the future and to create scale and synergies, which has been a challenge for the big six (UK largest utilities companies).

Access to debt and cost efficiency measures

The increasing risk of investing in this sector is also being reflected in the access of debt – both for operating needs and M&A activity. Raising debt financing to Natural Resources and Utilities companies is now more challenging than in the past, which limits growth and consolidation. Several banks have reduced or stopped providing financing for businesses in the oil and gas sector, for instance – especially in large project finance structured deals. Even integrated companies had to recognize large amounts of impairments and energy contracts re-measurements that ultimately affected their net results and, consequently, their capital levels creating greater pressure in internal liquidity and leverage ratios, as well as covenants agreed with creditors. Centrica, for instance, had to recognize GBP4,032m of impairments and re-measurements (net of taxation) from 2013 to 2015, which impacted severely its capital and reserves level, and even obliging the company to take drastic measures and propose a change in its articles of incorporation (further analysed on the “Valuation” chapter). Therefore, there is a major focus across the sector to reduce leverage ratios, which ultimately is also being driven by rating agencies on ensuring that companies have well balanced from capital structures that enables them to comply with its obligations on the long run and raise debt at the cheapest rates possible.

Also, Natural Resources and Utilities companies’ treasuries globally have had to adapt their operating models to accommodate commodity prices fall. Like Centrica, that has a progressive cost cutting programme in place, many of these treasuries have been encountering the same cost cutting pressures that other sectors’ faced after 2008’s financial crisis. There has been a more general need to streamline processes, increase automation and improve efficiency, that requires time and might jeopardize operations on the short-run. Centrica, for

Figure 9 – Net Income and Impairments and certain re-measurements (GBP bn)

0% 50% 100% 150% 200% 0.0 0.3 0.6 0.9 1.2 1.5 1.8

2012A 2013A 2014A 2015A

Net Income (pre-exceptionals) Impairments and certain re-measurements % of NI

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instance, which is working on different vectors to improve its operating system efficiency, has been facing difficulties while implementing a new Client Relationship Management system (CRM), between 2014 and 2015, that cost them several accounts and pressured the operating profit.

Besides, in an effort by governments to create energy retail markets fairer to customers and due to the low commodity price environment, utilities markets have observed a rising number of competitors. These smaller players have been pressuring the Big Six’s revenues that include Centrica’s British Gas energy supply business. The main problem arises from client’s continuous closing accounts trend and escape to smaller players during the last two years. Since the Competition and Markets Authority (CMA) started its investigation in 2014, the competition in the UK market has continued to intensify; with the number of residential energy suppliers registered growing from 25 to over 40, pushed also by the record low commodity prices.

CMA Investigation

In June 2014 OFGEM announced a Competition and Markets Authority (CMA) to investigate the energy market main players (the “Big Six”) – Centrica Plc, SSE Plc, RWE npower, E.ON, Scottish Power and EDF Energy - and confirm if it could find any adverse effect on competition such as “prevention, restriction or distortion”2 of competition. After two years of investigations, OFGEM referred the energy supply market to the competition regulator, Competition and Markets Authority. The referral was largely supported and the CMA investigation aimed at: § Clarify any doubts relating to tariffs practiced;

§ Help to rebuild consumers’ confidence and trust in the energy providers; § Provide certainty requested by investors.

Recommendations to be implemented and potential impact

Of the different recommendations suggested by CMA in August 2016, OFGEM said that it would implement immediately the following:

§ Suppliers should be required to provide the details of customers who have been on expensive tariffs for three years or more to rival suppliers;

§ Impose an interim price cap on customers using pre-payment meters.

However, though OFGEM is acting at this stage, it is not obliged to take every recommendation by CMA. They are hypotheses to be tested, and to help the

2

OFGEM report

Figure 10 – Operating margins (%) and accounts decrease (m)

4% 5% 6% 7% 8% 9% 10% 11% 17.0 17.5 18.0 18.5 19.0 19.5 20.0

2012A 2013A 2014A 2015A

Accounts decrease Operating Margins %

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market to be more transparent and fair. There may be other measures that might be implemented later.

The impact of CMA’s recommendations at this stage is still very limited and does not have any major recommendations that impair the value of energy supply businesses.

In fact, before this investigation, the CMA has only enforced three small-scale divestments that ended all to be appealed to the Competition Appeals Tribunal, such as the London Hospital, Gatwick and other of Holcim-Lafarge's cement plants. For this reason, CMA might be more reluctant than the past to force any large-scale divestments in the future.

Comparables

Overview

Centrica’s main competitors are the other large integrated energy companies that generate and supply electricity and natural gas, and even trade between different parts of their businesses. They do business in Great Britain, where together supply most of the energy to domestic households, as well as abroad and are called the “big six”. The big six group is comprised of Centrica Plc, E.ON UK, Scottish and Southern Energy (SSE), RWE npower, EDF Energy and Scottish Power. Of all the six, Scottish Power is the only company that is not listed and EDF Energy (parent company is Electricité de France), E.ON UK (parent company is E.ON) and RWE npower (parent company is RWE AG), are listed in other stock exchanges other than the London Stock Exchange – EDF on the Paris Stock Exchange and E.ON and RWE on Deutsche Börse Xetra.

Relatively to the generation business, EDF, which locked one of the largest nuclear projects in the UK during 2016, is by far the largest player, generating GBP602m of profits during 2015, which compares with GBP456m of SSE, the second largest, and with GBP73m of Centrica. Overall the 2014-2015 was positive and allowed the generation business to recover.

Though it has been suffering some account losses to competition (especially to small players), Centrica is now recovering its operating efficiency, enabling domestic supply profits to keep particularly stable when compared to the other players. In this line of business, Centrica is by far the largest supplier, and generated GBP574m of profits during 2015, which compares to GBP248 of SSE, the second largest, and to (GBP21m) of EDF, the largest generation player.

E.ON

Figure 12 – UK domestic supply profits by supplier (in GBPm) Source: OFGEM 2016

Figure 11 – Generation profits by supplier (in GBPm) Source: OFGEM 2016 -200 0 200 400 600

2011A 2012A 2013A 2014A 2015A

Centrica E.ON EDF npower Scottish Power SSE

-200 0 200 400 600 800 1000

2011A 2012A 2013A 2014A 2015A

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Similarly to Centrica, E.ON, a German company that operates in the UK under E.ON UK, used to supply natural gas and generates and supplies electricity. However, during 2016 the company combined the generation businesses to a new distinct company, Uniper, which has been independently listed since September 2016. Its electricity and gas global sales across 8 countries in 2015 stood at 781TWh and 1,722TWh, respectively, achieving sales and EBITDA of EUR116.2bn and EUR7.6bn, respectively. The company current market capitalization (as of 3 January 2017) is EUR13.6bn.

Electricité de France (EDF)

EDF is the world’s largest electricity generator and covers generation to trading and transmission grids. Across the 22 countries globally, where it is present, it generated 619.3TWh of electricity in 2015, from which 78.0% was nuclear (UK Nuclear is 64.3%). In the UK it operates under EDF Energy. Its operations achieved EUR75.0bn (UK EUR11.6bn) of sales and an EBITDA of EUR17.6bn (UK EUR2.2). The company current market capitalization (as of 3 January 2017) is EUR20.6bn.

RWE Group

RWE Group has been extremely active in the markets by exit the oil and gas production in 2015 with the sale of its oil and gas production unit, RWE Dea for USD5.6 billion deal. During 2016 it also split the renewable, network and retail businesses of RWE into a separate entity, Innogy, that is 75.0% owned by RWE (the remaining 25.0%were sold through an IPO). Across the 79 locations, where it is present, it generated 213.0TWh of electricity in 2015, and sold 262.1TWh and 296.7TWh of electricity and gas, respectively. In the UK it operates under npower. Its operations achieved EUR48.6bn (UK EUR9.0bn) of sales and an EBITDA of EUR7.0bn (UK -EUR0.8). The company current market capitalization (as of 3 January 2017) is EUR7.3bn.

Scottish Power

Is the only big six company that is not listed, but it still one of the largest UK suppliers, providing energy to over 5 million households across the UK. In the UK it presented total revenue of GBP9.5bn and an EBITDA of GBP508m.

SSE

Besides being naturally involved in the generation, transmission, distribution and supply of electricity, in the production, storage, distribution and supply of gas and in other energy services, SSE provides also phone and broadband products and services in the UK. The company achieved a PBT of GBP1.6bn and its current market capitalization is GBP15.7bn. 20% 30% 40% 50% 60% 70% 80% 0 10 20 30 40 50

EDF SSE E.ON RWE Centrica

Market Capitalization EV % of EV

Source: Reuters;

Figure 14 – Market Cap. and EV of listed Big Six (£bn)

Figure 15 –Big Six multiples Source: Reuters; company data

0% 5% 10% 15% 20% 25% 0 10 20 30 40 50 60 70 80 90

EDF E.ON RWE Centrica Scottish

Power

Sales EBITDA EBITDA margin %

Source: Reuters; company data

Figure 13 – Sales and EBITDA of Big Six (£bn)

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Centrica’s operations

International Downstream – United Kingdom

Hedging strategy to recover market share

As described before, the liberalized market together with low wholesale prices over the past two years, have been transferring business to the small players. However, their advantage starts now to reverse because of a rebound in commodity markets’ prices, promoted greatly by OPEC’s 30 of November 2016 output cut – Henry Hub Natural Gas spot price appreciated 45.5% between one month before and after the meeting – and depreciation of the sterling (-16.3% against US Dollar during 2016).

The downstream business benefits from low wholesale gas prices, but Centrica’s ca.12-24-month hedging profile did not enable the company to benefit immediately from lower spot gas since 2014, which hampered the company relatively to most smaller players. In return, derived by the same hedging strategy, Centrica is now able to buy its energy at lower prices longer than the small competitors allowing itself to maintain a sustained margin of approximately and stabilized prices for customers - electricity and gas estimated price for Centrica CAGR 2016-2022 of 1.9% and 1.0%, respectively vs.2.5% and 4.4%. Besides, Centrica has been also implementing the changes by the Retail Market Review launched by OFGEM and CMA, including an increase in the number of tariffs offered), that allows UK Home customers to optimize their plans. Additionally, benefiting from its hedging strategy, Centrica was the first to announce, that it would freeze tariffs during 2016/2017 fall, which will also further pressure competition and smaller players in the UK that do not have the capacity to enter long-term hedging positions. For gas’s tariffs, Centrica went even further and reduced tariffs by 5.1% from March 16, which shows how the company is committed to gain back control of its market share and stabilize the number of clients.

Accounts decrease vs. operating efficiency

The UK home business of British Gas still saw the number of customer accounts to fall during the first half of 2016 by approximately 3.0%, which represents 399,000 energy supply accounts. This reduction continues to reflect a competitive environment and a significant roll-off of long-term contracts during the first months of 2016.

30 35 40 45 50 55 60

2011A 2012A 2013A 2014A 2015A 2016E 2017E Weighted average wholesale gas cost (GBp/therm) Weighted average wholesale electricity cost (GBP/MWh) Source: UK National Grid; U.S. Energy

Information Administration (EIA);

Figure 17 – UK natural gas and electricity wholesale cost

(18-month hedge) 50 60 70 80 90 100 110 120 130 140 150 Henry Hub Natural Gas Spot Centrica Source: Reuters;

Figure 16 – Henry Hub Natural Gas Spot and Centrica evolution 1 month

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Additionally, as a result of some unpredicted issues during the implementation of the new Client Relationship Management systems across different business units, the British Gas Business adjusted operating profit3 was negatively affected during 2015, presenting a loss of GBP 22.0m (compared to a profit of GBP 114.0m in 2014). However, with some of these issues being rectified in the end of 2015, British Gas Business returned to profitability, with a profit of GBP 31.0m in the first half of 2016, despite of the number of account decrease (30,000 accounts loss). The recent evolution creates openness for further margin optimization and Centrica’s UK Business segment to stabilize and recover on the current market environment.

Centrica’s cost cutting programme, has specific measures allocated to its British Gas segment, Centrica aims to increase its operating cash flows and reward investors based on its efficiency and cost control, instead of accounts number total recovery – proved extremely difficult in the current competitive environment. On figure 18, it is visible that since 2014 and especially during the first half of 2016, Centrica complied rigorously with its cost goals. This was a result of operations consolidation into fewer locations and reorganisation of its sales channels and services product lines. This enabled British Gas to cut the number of roles by over 2,000 in the first half and other 2,000 cut is planned up to 2020, which was reflected on the valuation. Besides, changes to pension terms of employees were suggested, with a clear majority voting to accept the proposals. Finally, to benefit from internal synergies, Centrica is combining under “UK Home”, its British Gas residential energy supply and services segments (in addition to UK Business). So far these actions, together with expenditure control will generate at least a saving of 5.0% on controllable costs in 2016.

International Downstream – North America

Trouble with margins

Centrica has been struggling in the North American market to achieved better and sustainable margins. Though it has been growing Direct Energy’s revenues at 14.9% a year (in dollar terms) through acquisitions since 2011, it only achieved volume and market share in North America.

From figure18 and 19, it is clear that after 2013/2014 acquisitions, Direct Energy increased its sales volume from 197TWh to 355TWh, but in contrast it decreased its margin from 3.8% to 1.3%, which was even higher in 2012 (5.5%). After improving its margin in 2015 to 3.10% and duplicating its operating profit in 2015 with lower revenues (from GBP150m to GBP328m and GBP11.8bn to

3_{Adjusted operating profit is operating profit before exceptional items and certain re-measurements, before taxation} Figure 18 – British Gas adjusted

operating margin1

Source: Company data;

Source: company data; 0%

2% 4% 6%

2011A 2012A 2013A 2014A 2015A 1H2016

North America Home North America Business Direct Energy

Figure 19 – Direct Energy adjusted

operating margin1_(%) 0% 2% 4% 6% 8% 10% 12% 14%

2011A 2012A 2013A 2014A 2015A 1H2016

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GBP10.6bn, respectively), Direct Energy suffers a significant backdrop during the first half of 2016, and presented an adjusted operating profit margin of 1.9%. There are several reasons that could justify Direct Energy’s margin resilience: § Similarly to the UK, the North American markets remain highly competitive; § More favourable credit conditions on trading businesses, allowed competition

to finance at cheaper rates – also promoted by record low interest rates; § Record high energy prices in 2013/mid-2014 still affected Centrica’s ability to

decrease tariffs charged to clients due to its 18 rolling hedge strategy; § The implementation of a new Client Relationship Management system during

2015, that cost 223,000 residential accounts to Centrica;

§ Record warm weather in North America in comparison to extreme cold weather a year before, during the first half of 2016;

Positive outlook for margins

However, the outlook for the second half of the 2016 and the next years remains positive and there is room to margins expansion because of:

§ Efficiency improvements at the solar operations level;

§ Growth in paid protection plans, cost efficiencies and favourable foreign exchange movements;

§ Stabilization of Direct Energy’s number of accounts - in the first half of 2016 residential accounts increased by 7,000 while business account remained unchanged – entering into 42 new franchise territories and 3 new states; § 45.5% weaker natural gas prices since the beginning of November;

§ Internal synergies while combining under “North America Home” its residential energy supply and residential services;

§ Differentiation of product mix offered and bundling of products, through the integration of Connected Home business, as well as its own smart thermostat – 51% of Home sales are already bundled with a protection plan or smart thermostat (which so far was developed by other companies.

GBP/USD favourable impact for Centrica

Finally, it is worth pointing out that the conversion of Direct Energy into sterling in 2016, and the years going forward, will have a positive impact in its results and, ultimately, its valuation. Much influenced by Brexit referendum results, the US Dollar appreciated 16.3% against Sterling.

Source: Reuters; 0 100 200 300 400 Direct Energy total sales (TWh) Gas sales (TWh) Electricity sales (TWh)

Figure 20 – Direct Energy total sales (TWh) 2.5 2.9 3.3 3.7 4.1 4.5 4.9 5.3 2017 2018 2019

Figure 21 – Henry Hub Natural Gas forward prices $/mmbtu Source: company data; analyst’s forecasts

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Therefore, though 2016 was a slower year for Direct Energy, it will certain benefit from the current foreign exchange rate environment, enabling the company to grow its revenue base in sterling terms. Besides, except Centrica’s outstanding USD bonds (37.4% of total debt), Centrica does have any investment hedge that can offset this impact.

Connected Home

Growing the business

In order to quickly grow its Connected Home business and keep a pioneer status as a smart technology and solutions provider, Centrica has been extremely active in the M&A market. In March 2015, Centrica completed the acquisition of AlertMe, which gives control over the platform that supports the Connected Home activity, and strengthens the capability to launch products across the group. Besides the acquisitions, Centrica has also plans to invest GBP500 million of operating costs and capital expenditures in this division up to 2020, to both increase its capacity and capability.

Recent developments and Centrica’s plans for Connected Home

The connected home business launched 5 new products in the first half of 2016 and added over 360,000 hubs in the UK. The increasing focus on technology was traduced in revenue growth of 52.0% in this segment, relating to the first half of 2015, though it remains expressively small for Centrica’s scale. In North America, after selling already 200,000 smart thermostats, Connected Home launched its own smart thermostat there.

These movements into more efficient and greener solutions for customers, emphasizes Centrica effort to build a sustainable a new revenue stream going forward. In the current highly competitive market and with energy consumption levels decreasing, it is important to create areas of business that will diversify the company and minimize revenues downturns.

International Upstream

Centrica Energy portfolio

The natural resources portfolio decline and the current commodity prices environment made Centrica’s upstream unit, Centrica Energy, to see its production decrease by 7.0% during the first half of 2016. However, as Centrica will have a first contribution from the large-scale Cygnus development in the fourth quarter of 2016, the negative impact observed during the first six months of the year will be minimized (+2.0% was considered).

Figure 23 – Connected Home key figures

Source: Reuters;

Source: company data; 1.2 1.25 1.3 1.35 1.4 1.45 1.5 1.55 1.6 1.65 1.7 1.75

Spot Forward 1y Forward 2y

Figure 22 – GBP/USD spot and forward curves

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The Cygnus gas field, in which Centrica Plc owns a 48.8% interest, has started production in December, meaning that it is on course to be the “largest producing gas field in the UK North Sea by 2017”, according to energy specialists. At peak, the gas field, which has estimated 2P reserves of 636 billion cubic feet of gas, will have a share of 5.0% of UK’s gas production, which it is enough to serve 1.5 million British homes. Additionally, while the first gas from the field comes from the Cygnus Alpha platform, works are already underway to explore and increase the field even further via other wells that are being drilled at the Cygnus Bravo platform.

Also on the committed developments, there is the Maria project that remains on track to produce its first oil in 2018, with drilling operations scheduled to start in 2017 per Centrica’s latest interim report.

Conversely, following Centrica’s recent policy in relation to upstream assets, the company starts now closing and selling some of its fields and wells that are not performing as expected or where they are not being able of generating enough cash flows.

One of these assets is the fourth production well located in York (UK), which due to reservoir quality issues failed to deliver commercial volumes and has been shut-in. This consequently impacted the first half of 2016 results with a pre-tax impairment of GBP53m.

Finally, Centrica proceeded with the disposal of its interest in two oil and gas assets, the Skene and Buckland, which are subsea developments fields, 230km north east of Aberdeen, with production of 1.2mboe net per day. Skene is a gas condensate field, while Buckland is an oil-producing field. Centrica Energy held a 33.3% share in both fields and the surrounding acreage. Centrica recognized a GBP51m gain on the disposal and a profit on disposal after tax of GBP30m. For 2017 Centrica already announced that will sell its Trinidad and Tobago assets to Shell, which represented 2.1% of its 2P reserves in 2015.

Capital Expenditures (CAPEX)

Centrica’s CAPEX has been historically driven mainly by expenditures in Centrica Energy, which have been on average (2011-2015) 61.4% of total CAPEX. It even reached 80.0% in 2012 but ended 2015 at a much smaller level, 45.4%, as a result of Centrica’s cutting cost program, especially in the upstream business while the commodity price environment remains at record low levels.

This CAPEX control plan has been successful and in the first half of 2016 it remained at GBP292m – representing 42.4% of total CAPEX - which keeps the door open to close 2016 spending approximately GBP500-600m in the full year,

Source: company data;

0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100% Total On Property, Plant and Equipment

Figure 25 - Centrica Energy’s CAPEX as % of Total CAPEX

Source: company data; analyst’s estimates; Figure 24 – Centrica Energy assets

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approximately 20-30% lower than 2015 level (GBP737 million) and within the GBP400-GBP600 million range that Centrica considers that is necessary to sustain production between 40-50mmboe per annum (below the 78.6mmboe level in 2015).

CAPEX expected cut of 23%

The falling commodities seen from 2014 to most part of 2016, obliged Centrica to keep cutting its target CAPEX. Entering 2016, it is expected that Centrica reports a CAPEX cut of 23.0% at Centrica Energy level, revealing the steps the company is taking to scale back its upstream operations, while they keep underperforming, and focusing on its current position both in the UK and North America. In a situation of stabilization and expected recovery of commodity prices during the following years will minimize the need of further actions. Still worth to note is that the new strategy will cost Centrica a decrease in revenues, mainly driven by natural gas exploration as show on figures 26 and 27.

Centrica Storage

On its storage business, Centrica was impacted by low seasonal gas price spreads, and reduced operating pressure following a decision in 2015 to conduct testing and verification works on its wells. As a result of theses tests, and as analysed in detail later in this report, Centrica Storage announced in July 2016 that it had ceased all injection and withdrawal operations following the identification of an issue with one of the wells during testing, raising also potential uncertainties regarding the untested wells. During 2017 it will carry out an enhanced testing programme, which is expected to last until March or April 2017, although some of its wells came back to service in the end of 2016. A GBP144m post-tax charge related to an impairment of the Rough gas storage asset was considered in the first half of 2016 Centrica accounts and no more impairments were expected by Centrica during the second half of 2016.

Valuation

For the valuation of Centrica, a discounted cash flow model was employed, where the horizon period has 6 years. For the terminal value, a perpetuity growth rate was used. British Gas, Direct Energy and Centrica Energy were the businesses where the valuation was focused – together they represent 96.5% of Centrica’s revenues.

Revenues

Figure 26 - Centrica Energy’s revenues vs. CAPEX (GBP bn)

Source: company data; analyst’s estimates;

Figure 27 - Centrica's Energy production levels

Source: company data; analyst’s estimates; 0.0 0.5 1.0 1.5 2.0 2.5 3.0 3.5 4.0 4.5 5.0 5.5 Revenues CAPEX Gas revenues Power revenues 0 10 20 30 40 50 60 70 80 Centrica Gas prodution (mmboe) Centrica Power generated (TWh)

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International Downstream – United Kingdom

Centrica’s UK energy supply business used to be the largest revenue driver, accounting for 54% in 2011 but ending 2015 accounting for 44.0%. Together with higher competition in the UK, that lowered British Gas’s revenues, Centrica’s effort to increase its North American Business, that now sees its revenues gaining value due to sterling depreciation, are the main reasons of change of Centrica’s revenue breakdown. From 2016 onwards, British Gas operations will be the second largest business unit and will account for 41.5% (38.3% in 2022). From 2011 to 2015 Energy (Natural Gas and Electricity) consumption in the UK has been decreasing at 3.0% a year and it is expected to continue this trend from 2016 up to 2022 but at a smaller annual rate (-1.1%). This was mainly affected by high prices of natural gas for the years before 2014. Naturally, assuming a constant market share for the future, all the players will sell less energy. However, due the reasons mentioned before, as lower prices, British Gas is expected to recover some market share (to 16.0%) in relation to 2016 (15.1%) and keep it constant throughout the next 6 years.

As described before, relatively to prices, British Gas is expected to benefit in 2016 and will benefit in 2017 of lower wholesale energy prices when compared to the spot market due its 18-month rolling hedge strategy. That allowed the company to announce a 5.1% drop in natural gas tariffs and to freeze prices in 2016/2017 winter.

The residential business will maintain its current number of accounts while the business will manage to increase approximately 0.8% annually due to the efforts put in place by British Gas to increase this segment.

Finally, since clients are consuming less energy than before and spending less due to tariffs decrease, the average amount spent per account its expected to decrease at 1.2% a year. However, with the increasing products and services offer mainly to residential clients described before, the average spending per residential client on services will grow at 3.5% year until 2022, which was the same rate seen from 2011-2015. Just in 2015, the average spending per client grew 12.5%.

International Downstream – North America

Centrica’s North America grew its volume from a series of acquisitions especially from 2013-2014, explaining the share of revenues growth presented in figure 28 – that led the company to finish that year with almost the same share as British Gas (37.8%). However, due to the reasons already pointed out the company ended 2022 as the largest expected revenue driver, accounting for 45.6%. As

0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%

British Gas Direct Energy Centrica Energy Others Source: company data; analyst’s estimates;

Figure 28 - Centrica's revenue breakdown evolution 13% 14% 15% 16% 17% 18% 500 600 700 800 900 1 000 1 100 1 200 UK energy demand (TWh) British Gas share %

Figure 29 – Forecasted Energy demand and British Gas's margin

Source: company data; analyst’s estimates; UK National Grid

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opposite to the UK, Direct Energy Business is the busier for Direct Energy, though the company is taking actions, by expanding its product and services portfolio, to supply more residential clients.

From 2011 to 2015, Energy (Natural Gas and Electricity) consumption in the US has been increasing at 2.4% a year and it is expected to keep constant after 2016 up to 2022 (annual growth of 0.1%). This energy consumption historical growth was a result of the economical recovery that the US has been experiencing until today, after 2008’s credit crunch.

After completing a group of acquisitions in 2014, Direct Energy reached a share of 3.0% of total consumption in the US, which is expected to decrease in 2015 to 2.6% mainly because of accounts loss due to problems with the integration of a new client relationship management software. However, due the reasons presented before, as lower commodity prices, stronger USD, and entrance in new states, Direct Energy is expected to recover some market share (to 2.8%) and keep it constant throughout the next 6 years.

As it happens with British Gas, Direct Energy is expected to benefit in 2016 and 2017 of lower wholesale commodity prices than the spot market, which will improve Direct Energy margins.

The residential segment number of accounts it is expected to increase 1.0% annually while the business segment will keep growing at a lower annual pace, 0.4%.

Finally, since energy demand will keep practically constant, the average amount spent per account it is expected also to increase (at 1.6% a year) over time, accompanying the expected commodity price rebound. Besides, with the increasing products and services offering, as the smart thermostat and protection plans, the average spending per residential client on services is expected to grow at 3.7% year until 2022 (in sterling terms), which is justified by the increasing number of residential accounts forecasted and the average amount spent. Just from 2014 to 2015, the amount spent in services grew from 27.5% to 33.1%, in relation to households’ expenses on energy.

International Upstream – Centrica Energy

As Centrica started growing its downstream business and as commodity prices started decreasing, Centrica Energy unit started losing expression, moving from 20.0% of total revenues to 15.2% - expecting to reach the 12.1% level in 2022. Centrica management is progressively decreasing the investment in the upstream business, and as a result, its share of Natural Gas production in the UK will move from 26.6% in 2015 (having reached 29.2% in 2013) to 24.7%. Overall

Source: company data; analyst’s estimates; UK National Grid

Figure 30 – Forecasted Energy demand and British Gas's margin

0% 1% 2% 3% 10 000 10 500 11 000 11 500 12 000 12 500 US energy demand (TWh) Direct Energy share %

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in the UK, production is expected to decrease 3.4%, due to current unfavourable conditions.

Relatively to electricity, both UK demand and Centrica’s generation levels have been considerably constant over the last 4 years with the average generation representing 6.5% of UK’s demand (in a range from 6.6% to 5.8%). This share is expected to be carried forward.

Others

Bord Gáis and Centrica Storage remain expressively small compared to the other businesses described, and its revenue share will move from 3.0% to 3.9% mainly due to Bord Gáis business growth, since revenues from Centrica Storage were kept constant.

Expenses

Operating costs

As an energy supplier company, with its downstream business accounting more than 80%, it is natural to find commodity costs as the largest line in the income statement. Commodity costs are expected to represent on average 54.5% of the group revenues, based on 2015 levels. Which will traduce in an average cost per energy MWh sold of GBP31.97, below the GBP32.12 average between 2011-2015, reflecting a lower wholesale commodity price environment for Centrica. Transportation, distribution and metering costs constitute the second largest expenses line, which have been extremely constant historically and are forecasted based on average of 16.0% of Centrica revenues.

Finally, employee costs remain as one of the most important cost lines, both because of its size and because of Centrica’s cost cutting plan that aims to reduce its staff base by 4,000 employees until 2020. A reduction of 2,000 was made during 2016 and a following adjustment of other 2,000 employees will be made, ending 2020 with 34,948 employees. The salaries will remain its historical average annual growth rate of 3.1%.

Debt

Centrica’s Articles of Association limits the Group’s borrowings that until the end of last year, limited the debt to a maximum of GBP5.0bn and three times Centrica’s adjusted capital and reserves. When approving the Group’s consolidated Financial Statements for the year ended 31 December 2015, there was a technical breach of the Article 94, predominantly due to asset impairments in the Exploration and Production segment of Centrica Energy, which resulted in a reduction in capital and reserves. Later, at the annual general shareholders

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meeting held in April 2016, a resolution suggesting new limits was presented and approved by Centrica’s shareholders. Borrowings are now restricted to a maximum of GBP10 billion and three times adjusted capital and reserves. This resolution entered as effective from April onwards and will bring room to further debt control over the next years.

Centrica currently holds 87.6% of its debt in the form of senior bonds and unsecured bonds issued mainly in Sterling and US dollars. On average its debt its 86.0% financed by long-term instruments and its amortization schedule it is based on bonds maturity dates. Due to its highly leverage situation and an equity placement of GBP700m during 2016, it is assumed that no more bonds will be issued and the overdrafts and term loans, that correspond to the 12.4% remaining debt, will be refinanced at their maturity.

Finally, on average Centrica financed its operations at a historical rate of 4.45%, that is below 2015’s level of 4.49% and which is in line with the current interest rate landscape both in the UK and the US.

Depreciation and Amortization

The cost cutting plan also envisages the scaling back of Centrica’s upstream business, which is the most CAPEX expensive business, with the goal set out at an annual CAPEX of GBP400-600m. This is expected to be reached by year-end 2016, representing a drop of 23% from 2015. However, from 2014 to 2015, CAPEX had already dropped 41.9%, even though the D&A was only reduced by 16.3% during the same period. Considering the resilience of the D&A value, it was assumed that Centrica must maintain a fixed maintenance CAPEX policy with these assets, investing a percentage of the assets’ depreciation.

Taxation

For the tax expense, it was assumed that the statutory corporate tax rate would be constant at 30.0% throughout all periods, which is below 2011-2013 39.0 level but above the 27.0% average between 2014-2015. This tax rate also has in consideration UK’s Government decision in enacting Finance (No.2) Act 2015 that will impact:

§ UK corporation tax from the current 20.0% level to 18.0% level in 2022 (in 2011 the rate was fixed at 26.0%);

§ UK Oil and Gas corporation tax rate from 62.0% to 50.0%; § Petroleum revenue tax from 50.0% to 35%;

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Though Centrica is a UK corporation, it operates under different jurisdictions with different tax regimes that will affect the effective tax rate. An approximation of the tax rate was made having has proxy its businesses’ different revenue weights. It also considered the following rates besides the expressed above:

§ Republic of Ireland supply of energy and services: 12.5%; § United States supply of energy and services: 35%;

WACC

To get Centrica’s WACC, the Capital Asset Pricing Model (CAPM) was used, as it is the industry’s practice. Centrica it is a British company that concentrates its operations in the energy sector and after its privatisation back in 1986, the company opened its doors for every investor desiring to participate in the business. These investors are assumed to be able to invest in every sector and company where they find most fit, meaning that they can hold a diversified portfolio. As such, instead of using a benchmark index specific of utilities, a broader benchmark was used, as the utilities sector should be already reflected in the cash flows forecasting exercise. Therefore the proxy for the market portfolio chosen was the FTSE 100 Index. Moreover, the benchmark for the risk free interest rate considered was the UK 10 year sovereign bond. As, the UK lives in an interesting abnormal time, after the BREXIT referendum back in June 2016, it is important that both the interest rate and the index benchmark reflect the new risk environment.

To improve the consistency of the Centrica’s beta estimate, the calculation used a rolling period of 2 years of daily data, which allows the comparison of the betas evolution. A 97.5% confidence interval for the Betas was also calculated and the graph below shows the results.

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It is observable that the whole sample is consistent and does not display any significant differences in their 97.5% confidence intervals, maintaining a narrow interval. This means that with a 97.5% degree of certainty, the graph above provides an estimate of the Beta. Considering this result, the beta considered for Centrica was the average value of the betas from September until the most recent data point: 1.015.

As for the Market Risk Premium, it was used the value calculated by NYU professor Aswath Damodaran for a developed equity market as of January 2016, since Centrica is exposed to different markets. The value of the Market Risk Premium considered is then 5.75%.

Finally, since 87.6% of Centrica’s debt is traded bonds, it was possible to derive its cost of debt through their current amounts outstanding and current yields. Together with the targeted capital structure – 27.7% and 72.3%, debt and equity at market value, respectively – a 3.35% cost of debt was achieved.

The resulting WACC using the above assumptions is 5.87%.

Results and sensitivity analysis

Finally, considering all the assumptions above and assuming Centrica’s ability to stabilize its clients number, increasing the portfolio of products and services offering, refocusing the business on the downstream side of its operations while scaling back its upstream business, reducing both the CAPEX invested and the overall company’s costs, the expected share price as of 2017 year end is GBp 270.44, which presents an upside of 15.6% in relation to Centrica’s 30 of December of 2016 price, GBp234.00.

Important to note is that this value includes a perpetual growth rate of 0.84% for the terminal value, which represents the weighted average CAGR of future gas and electricity demand between the UK and US, based on Cenrtica’s future sales.

Through the sensitivity analysis below the fair value of Centrica can be analysed, according to different WACCs and different views on the perpetual growth potential of Centrica.

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Figure 32 – Centrica’s valuation sensitivity analysis Growth Rate 0.24% 0.44% 0.64% 0.84% 1.04% 1.24% 1.44% WA CC 5.27% 278.01 290.26 303.57 318.07 333.95 351.40 370.68 5.47% 264.23 275.46 287.62 300.83 315.22 330.98 348.30 5.67% 251.47 261.80 272.94 285.01 298.11 312.40 328.04 5.87% 239.62 249.14 259.38 270.44 282.42 295.42 309.61 6.07% 228.57 237.37 246.82 256.99 267.96 279.85 292.76 6.27% 218.26 226.42 235.15 244.52 254.62 265.51 277.31 6.47% 208.61 216.18 224.28 232.94 242.25 252.27 263.08

Source: company data; analyst’s estimates

The main conclusions are that the possibility of a downside in the price is exclusively attributed to the bottom left square of the table, especially between a growth rate below 0.64% and a WACC of 6.27%, which is still remarkably below than the projected GDP growth rates for the UK even after the BREXIT vote, according to IMF – 1.7% and 1.3%, 2016 and 2017 respectively. In relation to the WACC, considering a higher rate might be considered too conservative as 5.87% compares with Professor Aswath Damodaran’s utilities WACC of an already lower rate of 4.14%.

Relative valuation

To support the DCF valuation and achieve a more solid consensus, a relative valuation with Centrica’s most direct comparables, which are all energy suppliers and generators with operations in Europe (including UK’s big six), was performed. It was considered the EV/Sales, EV/EBITDA ad P/E multiples for the 2017 year end, which are the most generic and widely used multiples.

We started by analyzing the average P/E ratio multiple for the comparables which gave as a range of [11.5-16.3]x, representing an implicit valuation of Centrica’s share price between GBp[231.9-329.1], with its inferior limit in line with current share price and confirming the DCF output, which has an implicit metric of 13.6x. This suggests an undervaluation of Centrica and an underestimation of its future earnings.

As for the EV/EBITDA multiple, it provides a selected range of [5.6-9.4]x, which results in an implied share price range of GBp[196.7-294.8]. The implicit DCF multiple is 6.2x, which is above both the current market average multiple 5.6x and Centrica’s 3.6x. These differences reveal that the market is penalizing Centrica’s ability to grow and to generate higher results in the future, when compared to other European utilities.

Finally, the EV/Sales was the most scattered multiple, since it presented a multiple range between [0.5-0.9]x, which translates into an implied share price

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range of GBp[161.4-369.7]. However, the average implied share price in this specific case is GBp279.6, with a multiple of 0.8x, which in line with the DCF GBp270.44. This difference with the current price can be a result of Centrica’s current perceived inability to transform its revenues scale into operating results and improved margins, while other larger European utilities are expected to be more efficient.

In the figure below, Centrica’s football field is presented. By approaching the intervals’ tails, we reach an approximate implied share price interval of GBp[250.0-300.0]. Therefore, considering the analysis below, investors might be underpaying for Centrica in 2017, if the current market valuation is approached as correct.

Figure 33 – Centrica’s football field

50 100 150 200 250 300 350 400 P/E [11.5-16.3]x EV/EBITDA [5.6-9.4]x EV/Sales [0.7-0.9]x DCF 5.27% - 6.27% WACC 0.44% - 1.24% g Share Price (GBp)

Source: Reuters data; analyst’s estimate

Risks and threats analysis

Although the above valuation already reflects the expected evolution of the economies where Centrica is present and other non-controllable issues, there are uncertainties looking forward not only in relation to the economy itself but also in relation to Centrica’s future. These risks might influence and deviate the current estimations and ultimately affect the target price.

Rough storage facility in the UK

At the beginning of the year, Centrica saw its storage unit, Rough, in England’s east coast to stop operations as the facility entered through emergency maintenance to prevent gas leaks. Expected to be back on regular operations in mid-December, Rough’s halt has left the Centrica Plc facility with less than half

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the gas it typically holds going into the peak heating season. That also means less pressure than normal in the rock underground that holds the fuel, so when the gas is extracted from 20 of its wells to meet demand from homes to hospitals, it will flow at a slower pace.

Coupled with a shortage of liquefied natural gas (LNG) supplies to northwest Europe, Rough’s halt will increase the risk of price jumps during freezing weather. This is visible through a 5-year volatility high in September after Centrica extended works at Rough. However, warnings of fuel shortages are more relevant for later this winter. During a peak demand situation, the lower flows from Rough and other U.K. storage facilities operated by SSE and EDF Energy will create some challenges.

For Centrica, the consequences might be meaningful as it is pumping less gas. In fact, Centrica already took an impairment charge of GBP176m in the six months to June 30, to accommodate Rough’s situation. Under current conditions, it can withdraw about 33 million cubic meters of gas a day, approximately 77.0% of what it usually extracts by the end of each year, according to withdrawal curves provided by Centrica. Continuous weakening of the facility, and thus even lower pressure, means that by the end of the winter, withdrawals will fall to less than 20 million cubic meters a day.

Additionally, this might not be the last time that an intervention in Rough will be needed. While it’s unlikely Rough should be closed permanently at this stage, it might be an expensive problem to fix in the long-term. Since the current leak problem is age-related, this might not be the last time that intervention will be required. At some point, Centrica might even have to consider if the cost of moving to a new facility is not lower that constantly repair the older one. Although it is not expected, this situation adds the possibility of Centrica to take further impairments, but also to violate its targeted CAPEX level of GBP400-600 million range. Though its CAPEX levels has been decreasing at 14.2% per year, the model will hold 2015 levels (GBP32 million) to accommodate eventual further investments.

BREXIT

In June, the BREXIT referendum resulted in a vote for the UK to leave the European Union. The direct impacts on Centrica specifically are limited in the short term to those felt by businesses in general, such as consumer confidence, interest rates and foreign exchange, that for Centrica would even potentiate revenues from the North American downstream business unit. However, the result creates general uncertainty, which adds challenges for UK businesses in

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all sectors, with implementation plans yet unclear and investment in the country on hold.

For the energy sector, where Centrica operates, the BREXIT impact is still difficult to analyse, and the focus now should be on energy regulation impact and how the changing involvement of the UK in the EU would impact the competitiveness of the European energy markets. Nowadays, the UK is still a major energy importer, while importing 43.8% of its Natural Gas, and what happens in the European energy market will also impact the energy sector and its consumers in the UK. It is critical to keep engaged with the UK Government and the European Commission to work on sustainable solutions to every party involved and that will shape the sector for the years to come.