With a dividend yield of 8% and a share price that's at a 15-year low, British Gas owner Centrica (LSE: CNA) is an obvious bargain. Or is it a value trap? It's hard to tell.
The utility group's share price collapse is certainly a little worrying. And dividend yields of more than 6% are often at greater risk of being cut.
On the other hand, it's when companies are priced for disaster that the greatest bargains can sometimes be found. As billionaire investor Warren Buffett famously said, we should seek to be greedy when others are fearful.
My personal portfolio contains a chunk of Centrica stock. In this piece I'll explain why I believe the shares are too cheap to ignore at the moment.
Priced for failure?
The Centrica share price has fallen by 60% over the last five years. This suggests that the market expects the firm's future to be much less profitable than its past.
Is this fair? The company certainly faces some headwinds. Political price caps and threats of renationalisation have spooked investors. And British Gas customer numbers fell by 10% -- or 1.4m -- to 12.8m last year. Those customers who are still with the firm aren't using as much electricity or gas either. Energy consumption per UK home customer fell by 5% last year.
However, it's worth looking at these figures in context. British Gas still has nearly twice as many domestic customers as FTSE 100 rival SSE. And Centrica also has an additional 7.5m customers for services such as boiler repair and maintenance, plus a North American business.
The numbers are better than you think
Centrica's profits have halved since 2013. Adjusted operating profit has fallen from £2.6bn to £1.3bn over this time, while adjusted earnings have dropped from 25.9p to 12.6p per share. It's a gloomy picture.
But dividends and other expenses aren't paid out of profits. They're paid from cash flow. And cash generation has improved massively over the last five years. The group's last annual report shows that "cash flow before cash flow from financing activities" -- a measure of underlying free cash flow -- has risen from £589m in 2013 to £1,872m last year.
This has mostly been achieved through a big reduction in capital expenditure. What it means for shareholders is that the group's dividend is now supported by ready cash in a way it wasn't back in 2013, when the shares were worth twice as much as they are today.
The $50m question
Chief executive Iain Conn is targeting adjusted operating cash flow of £2.1bn-£2.3bn per year and capital expenditure of up to £1.2bn per annum for the next three years.
This should leave enough money to support the dividend, which at 12p per share will cost around £675m a year. Management hopes that a £500m cost-cutting plan will offset the expected impact of the government price cap, although the timing of this isn't yet certain.
The shares now trade on about 10 times forecast earnings, with a dividend yield of 8%. The big risk is that it's not yet clear how Mr Conn will return the business to growth. But given the group's leading share of the UK market, I rate Centrica as a contrarian buy at current levels.
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Roland Head owns shares of Centrica and SSE. 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.