Centrica plc (LON:CNA)
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Trading Update
Nov 23, 2017
Good morning, everyone, and thank you for joining the call this morning. I'm joined here by Jeff Bell and Martin Espli and Rebecca Triffith. And after a few introductory remarks by me, I will then go straight to your questions. I'll provide some headlines at the beginning and try and set the scene. And the first thing to say is that performance in the second half has been disappointing after a solid first half, but largely in Energy Supply in Centrica Business.
And as we've outlined in the release, North America Business has been impacted by four things. Firstly, and actually they're all largely relating to the Retail Power book, which is one of our books in North America business. So the first thing is that unit margins have been compressed throughout this year as a result of competitive intensity, particularly as a number of individual power producers have moved in downstream, and we've seen significant competitive activity. The second thing is volatility has been very low. And as a result, we've been unable to capture additional margin.
Thirdly, and very importantly, the shape of the energy curve has been such that the business that we've been booking has resulted in the net margin that we have been booking in sales being compressed in the near term, even though it is likely to the remainder of the margin will be booked in subsequent years. And then we have announced today a one off non cash charge of £46,000,000 relating to a reassessment of the historic recognition of unbilled power revenues, and this goes over a five year period, and Jeff will be able to take you into more detail on that. So the North America business results that we are forecasting is significantly down for those four reasons. Some of it will come back in later periods. In UK business, we saw a recovery in the second quarter, but have continued to see difficulty in our retention of existing customers, although that is stabilizing, and we are improving in acquisition and the number of the operating parameters are improving.
But these factors plus the factors we had in February, which we announced in the middle of the year and warmer weather this year mean that we expect U. K. Business to be broadly breakeven. Those are the two principal impacts that have resulted in our forecast of around 12.5p per share EPS. This is obviously subject to weather, commodity prices and operations for the remainder of the year.
The second thing is that we remain on track despite this to hit our 2017 targets, which we set in February, around adjusted operating cash flow of £2,000,000,000 cost and headcount target and our efficiency program is running ahead of plan. And we are forecasting savings of approaching £300,000,000 on top of the £384,000,000 we delivered last year. Our other targets are on track, including capital. And our net debt is forecast to be well within the 2,500,000,000.0 to £3,000,000,000 range, which we set at the beginning of the year. The third message is that our balance sheet has been materially strengthened as a result, and Phase one of the portfolio repositioning of the company will be completed at the end of this year, including the £946,000,000 of divestments against our 500,000,000.0 to £1,000,000,000 range.
And we expect our credit metrics to be at or above our thresholds by the end of the year, and Jeff will answer questions on that too. Notwithstanding our disappointment, particularly in North America business, there are encouraging signs of momentum and stability. And I just want to outline a few of those. We signaled that in The U. K.
Home, the outcome is likely to be broadly in line with 2016. And this is despite customer headline customer losses of 800 and 23,000 since the middle of the year. But the majority of these losses relate to, as we outlined, collective switch customers, books of those rolling off. And I'm able to tell you that we no longer have any on the books. The white label fixed price customers rotating in the very intensely competitive fixed price market and the loss of some prepayment tariff customers.
Customer numbers are therefore down, but the core customer numbers trading between standard variable tariff and our fixed product under British Gas are down $150,000 and that's the competitive impact that we focus on and worry about the most. Because of our cost efficiency program, we have offset the decline in gross margin so that U. K. Homes results will be resilient versus last year. And in fact, as we've indicated, therefore, I think slightly ahead of consensus.
We're developing a number of new propositions and services for our customers, which are being well received. And in the services area, we have seen in recent weeks customer accounts stabilizing. So U. K. Home encouraging progress.
In the Consumer division as a whole, we've seen gross margin decline offset by cost efficiency. In Connected Home, we continue to see some significant growth rates around hubs and products. And as you know, we announced the ENI partnership, this month. In Distributed Energy and Power, site growth continues and we continue to build capability. And as you know, we have established a new joint venture Spirit Energy and E and P and that will begin in December subject to regulatory approvals.
So that's the fourth message. Notwithstanding the disappointment in NAB, there are encouraging signs of momentum in other parts of the group. I won't go through all the other business units. The fifth message from earlier this week is clearly, I'm well aware that the political environment and uncertainty around The U. K.
Energy supply market has been an extremely difficult situation to assess and predict. We announced earlier this week a comprehensive package for the improvement of The U. K. Energy market. The early indications that I've had from the government are that this has been cautiously well received.
And we believe under any circumstances, whether it's a price cap or the scenario resulting from some of our interventions, we believe we can deliver an attractive and sustainable business in U. K. Energy Supply, whatever the outcome. And finally, a word on the dividend. We provided two messages in the trading update today.
The first one is that the twenty seventeen full year dividend is underpinned both by cash flows and by our earnings. And the second, very importantly, is that for a period of time, as we transition the portfolio and until The U. K. Market situation settles down, we are willing to operate with dividend cover below historic levels. And obviously, recently in the last couple of years, we have had dividend cover levels of about 1.4 in 2015 and 2016.
This year, clearly, if you do the math, we are looking at dividend cover of 1.04. And what we are assuming is that we will need to operate for a period of time with cover below historic levels, and we are confident in being able to manage the group at those levels of cover while we transition the portfolio and implement the strategy. I'd now like to hand over to questions, Natalie, if that's okay. Thank you very much.
Thank you, Our first question is from John Musk from Royal Bank of Canada. If you'd like to go ahead, John.
Hello, John. Good morning, everyone.
Really just a question to try and understand how things have deteriorated so significantly in the past couple of months since the half year results. I mean, were there no warning signs or no visibility on this when we were all speaking back in July? And then secondly, following up on the growth that you're indicating in the Connected Home market, Are you going to be able to achieve your targets there around the product sales of $1,500,000 for this year? And then you're still confident in the longer term breakeven target for 2019?
Thank you, John. So let me start on the visibility point and the Connected Home point, and then I'll ask Jeff to expand on the North America business situation because I think it'd be good if we just had one fulsome answer to that right upfront. So first of all, gentlemen, it was not fully visible to us in July at all. We were we had had a successful first half in North America business and we were booking good net margin. But the guys were signaling the competitive pressure, but we have not seen the low volatility over the coming months, which has arisen.
And we had not seen the impact of the shape of the curve as we were continuing to sell margin in the Power book. And clearly, this resulted in a final review with our recent performance reviews. We have very intense performance reviews each quarter. And our conclusion was, as a result of that, that this would materially impact 2017. We did see this in our third quarter review, and we did see it in our fourth quarter review, which completed last Friday.
And we concluded not only will it impact 2017 materially, but obviously there will be some continuing impact of that given the shape of the curve going into 2018. In the matter of the revenue recognition accounting issue, which I'll ask Jeff also to cover, we did not know about this until this last week. And we have been intensely evaluating it to make sure that it is an open and shut case and that we understand when and where it arose, how it arose, why it arose and that it is completely bounded and contained. And that is the case. But I'll leave Jeff to expand on both of those because I think it's important you understand where we are in NAB.
I should say that the other three books that we operate are operating to plan. In Connected Home, I am very encouraged by the results. Specifically on your question, will we hit our targets? We have a very important month and a bit coming up. We're right in the middle of the one of the heaviest trading weeks in the year.
And we are we have significant momentum, which appears to be accelerating. I think it's likely that we will be very close to, if not hitting the target for products for the year. We're at over 1,200,000 products cumulatively. Our target is 1.5. We are selling a much higher ratio of products to hubs than we were in 2016.
And I'm very encouraged by progress there. On the million hubs, it looks difficult for us to hit the million hubs from here, But we have got to 150,000 hubs so far to this point. And the growth rates versus last the end of last year of 42% on hubs and 59% on products are very material. The second part of your question is, are we confident still about our forward projections, that we have absolutely no reason to change the GBP 1,000,000,000 revenue by 2022 target. And the important development of the ENI partnership tells us that we can go beyond our own customer channels and that there are third parties who want Hive and want to offer it to their customers on our terms, and it's very important on our terms.
So I remain very encouraged by Connected Home. And yes, we are on track for the long term targets. I'd now like to hand over to Jeff to go into more detail about the North America business situation and including the revenue recognition point.
Thanks, Ian. I mean, maybe just to start with the one off accounting charges. As Ian has said, it is a one off post tax non cash impact of GBP 46,000,000 pre tax and operating profit level GBP 76,000,000. And it's an issue that as we've been consolidating our billing systems and doing our continued balance sheet and financial process improvements as we look to generally improve within North America overall. This issue has come up as Ian said, dates back to 2013 and is a small differences in unbilled revenue estimates that have are tiny proportion of revenue, but have built up over the last few years.
So clearly disappointing, but we are confident that we've sized that and that it exists in just one of the billing systems that we have. I think in terms of North American business overall, clearly from a go forward perspective to this year's results, you would have to add back the one off accounting charge. We don't clearly can see that going forward. So that our projection of about GBP 80,000,000 this year without that charge would have
been in the GBP 150,000,000
to 160,000,000 range. I think John to your point, we were seeing to Ian's earlier points about the four areas of pressure that we've seen in North American business. We did see and signaled at the half year that we were seeing unit margin pressures in North America. But in reality, it's only since we've come into the awesome period and you don't see this as much in the summer because volumes are so low. That as we've come into that, that we've seen both the full extent of the competitive pressures, But again, compounded by warm weather such that we haven't been able to start the winter season as we would normally with gas volumes and gas volatility.
We do obviously consider that it does happen from time to time, but we wouldn't assume that would normally happen every year under normal weather. We see a much more normalized flow of volatility and optimization revenue around that. And the same would be with the backwardation of the curve. Clearly, the unit margin pressures, we expect to continue on at least into next year, but typically has a cyclicality to it within the industry overall.
Thanks, Jeff. The only other thing to say, John, is that other market participants have seen the same impact, particularly Exelon as I understand it and Just Energy are also seeing similar particularly the impacts of the forward curve. John, thank you very much. Let's go to the next question please.
Our next question is from Sam Ahri from UBS. Sam, your line is now open.
Good morning, Sam.
Good morning. Thank you for the presentation and very helpful explanation just now of what you've announced this morning. I've got just two questions. And the first one is just thinking about the earnings expectation for this year at 12.5p or 13.3, excluding the one off charge. That looks to be about 2p below consensus.
And when we sort of run some quick back of the envelope here, we kind of roughly estimate that 1p out of that is probably, you know, further one off effects that you've described, and the other half would be recurring. And I just wanted to check if that makes sense to you as a sort of high level summary. In other words, excluding the North America one off accounting charge, is about half of the rest of the miss nonrecurring and half recurring? And then secondly, on operating cash flow, well, obviously, it's very positive that you're still expecting over €2,000,000,000 this year. But can you just tell us where that leaves us in terms of your target of adjusted operating cash flow growth of 3% to 5%?
And I think last time we were speaking, was some speculation that the scrip element of the dividend might be neutralized in the future. Does that still seem like it would be viable? I think the scrip take up was about 40% this year. Or is that now something that looks more difficult with the earnings coming in a bit lower than expected? Thank you.
So thanks, Sam. I mean, first of all, there are a number of other parts of the portfolio that are performing well as we've just indicated. And obviously, we've got other things that will not be recurring next year that have impacted us this year such as the exploration and production outage at Morecambe for nine months in order to improve the asset integrity and safety. So there are lots of moving parts in the portfolio. But I think broadly, assertion of about half other than the accounting impact from the revenue recognition item, about half nonrecurring and half recurring would be about right, that would be my judgment.
And as far as the forward projections of the company are concerned, I recognize that this is a particularly difficult time for people to judge, Centrica in the context of the uncertainty, particularly the political uncertainty that is going on around us. But no part of our financial framework is currently changed, and we don't intend to change the financial framework. The judgment we have to make about the cash flow growth is it's a medium term target and the judgment is when will we see enough of it and be able to see it through all of the political uncertainty and interventions potentially so that we can be confident in it. We have no reason to change our view of what this company is capable of. And we have just gone through a long annual planning process with our Board where we've been looking ahead for the next five years, and it remains the medium term target.
And it's also true that our dividend philosophy in the financial framework is also unchanged. But we have to recognize that we given the uncertainties of a potential price cap and or other interventions in the market in The U. K. And despite our view of how we can drive efficiency and there will be further efficiency announcements that we will be updating you on in February, despite that, we currently recognize we will have to operate potentially with a dividend cover that's below recent years, and we're willing to and able to do that. Thank you very much, Sam.
Can we move
on to next
question, please?
Our next question is from Dominic Nash from Macquarie. If you'd like to go ahead, Dominic.
Dominic. Hi, there. Good morning. Two questions, please. Quick one on 823,000 customer losses does appear quite a high number, but you say 650,000 of those are from sort of block trades.
How many other blocks are there in your book that we should be aware of that could be sort of coming out in the coming months? And secondly, do you have a view for the consensus going forward in the North America business is in the sort of the financial community? And do you think sort of following up from Sam's question is that what we see this year on an underlying basis is more representative of that business going forward?
Okay. Well, me start and then I'll pass on to Jeff on North America business. But in terms of customer numbers, clearly 823,000 is a very large number. But as we indicated at the middle of the year, we are very much customer segmenting this and looking at the standard variable tariff base, which obviously we're now going to be trying to encourage to move to other fixed term products. And indeed, we are seeing successfully our interventions moving customers from the standard variable tariff to the fixed term contracts without losing the customer.
And we have seen, therefore, net net with standard variable tariff customers losses and people moving on to fixed products, this 150,000 customer impact. So in terms of the really high value customer base, we are still seeing relative stability. Now on your specific question of books, customer books that roll off where we've actually acquired customers in a block, As I indicated earlier, we have no more on the books in The U. K. At all.
So you will not be seeing that. And we have seen some very significant movement in that area. So there are no more in that regard. As far as North America business is concerned, I mean, you have to add back the one off impact to the $80,000,000 But let me pass on to Jeff to talk about expectations from that business going forward.
Yes. I think Dominic, as we were saying earlier, you add back, you had GBP 150,000,000 to 160,000,000. If I took as an example, the comparison to last year, where the business made about $220,000,000 I think the differences we've seen partly that difference is related to unit gross margin pressures, in power, Ian talked about merchant generation. We wouldn't until we see that easing up, that looks like it's a part of the market structure, at least in the short to medium term. On the other hand, we are seeing things like much warmer than normal weather to start the fourth quarter in North America, which has impacted volatility, impacted our ability to optimize, impacted the supply margins themselves just through lower volume and this issue of a higher sort of front part of the curve and input costs for the power book because of the backwardation in capacity markets.
So we would see of that difference half to two thirds being unit margin pressures. The other third or so is probably more phasing just in this year because of the way weather and its impact on the business has been.
Thank you.
Thank you very much. Can we go to the next question please, Natalie?
Next question. Not a problem. The next question is from Mark Treshny from Credit Suisse. If you'd like to go ahead.
Good morning, Mark.
Morning. Can I ask two questions, please? Firstly, on connected homes, it seems that you've got a lot more hives out there. But I think one of your retail outlets, Amazon, is very heavily discounting that right now. And I know that once you cut the price of something in The U.
K, it's very, very difficult to put the price up. So I was just wondering as to what the gross margin contributions from those incremental sales is looking like. Secondly, Distributed Energy and Power. It seems that, that business is performing well. NAEAS won a very, very large contract.
Can you talk more I don't think you specifically mentioned profitability there, but that seems a business that's well on track to reaching that $1,000,000,000 revenue aspiration by 2022.
So thank you very much, Mark. I mean, firstly, on the first one, we're right in the middle of the Black Friday week. It's one of the traditional weeks where lots of products are discounted. That's why you're seeing discounting this week. I can assure you that gross margin and holding on to the right levels of gross margin as we grow Connected Home is our guiding light, which means that we will not just chase volume for the sake of volume.
That's very important. But we are seeing attractive gross margins and we have ensured that in the ENI partnership, which we really haven't spent much time talking about, where we are looking at the access to 8,000,000 customers in Italy. And those customers will experience Hive. They will experience the Hive brand, and it will be our relationship with the customer and our customer data, which we will then share with E and I. And we have a schedule of measures in there where we will obviously share some of the growth more of the gross margin upfront at the very early phase.
But the unit margins are extremely attractive. And that is also true with all the manifestations of Hive that we are selling today. So I'm very encouraged by that. And you mentioned Amazon. The relationship with Amazon is very good.
I've had a long meeting with the senior guys at Amazon talking about how Echo sells Hive and Hive sells Echo and whether we need to think about how we go to market together. So I'd say Connected Home is it's a difficult business to be absolutely certain about precise deliverables in any short period of time, but the acceleration is very encouraging. On Distributed Energy and Power, just want to correct one thing that it doesn't change your conclusion, but NIAS Energy is actually reported as part of our Energy Marketing and Trading unit. You're right, NIAS is doing very well. In fact, I'm pleased to say that all of the acquisitions we have made so far are doing really well, NIAS and EM and T.
And there are some capabilities, which I think is what you're alluding to from NIAS that are helping us in Distributed Energy and Power. We also have seen very good results from Energy Cogent. And as you saw very recently, we've just purchased ReStore, the leading European aggregator business. And when you build all these into the Distributed Energy and Power business under the brand that we're now going to market with, which is Centrica Business Solutions, we now have a complete set of capabilities, which we are now integrating into a platform. You saw some of that in the Capital Markets Day, which we believe will mean that we can offer things to business customers that other people cannot.
But we are also on track for the £1,000,000,000 revenue target for that business in 2022. Can we go to the next question please, Natalie?
Our next question is from Marcus Atanas from Agency Partners. If you'd like to go ahead.
Hi, guys. Questions, One is, any read across on competitive pressures, particularly in regard to activity by generators moving downstream into residential markets? Secondly, do you think you should be now considering improving your reporting on North America? A few years back, you did combine your heavily loss making services into residential supply, we lost visibility there. You stopped reporting on regional customer numbers.
And I think now there is a need to split out reporting and business between supply and brokerage optimization. So any comments on that, please?
So we're not seeing power players currently moving into the residential market in any of our geographies. I think we've got to be very awake to competitive pressures, but that is not something we're seeing. And I think generally speaking, from talking to people in the market, I think power players really don't know how to deal with residential consumers. I think the where you get the battleground is in the wholesale markets and into access to large industrial and commercial customers where you're clearly seeing large power players in North America in particular looking at that. And you're also seeing some of the large traders like Gazprom and Total and others using those industrial books to trade around and complete their supply chain and their risk management.
So no, we're not seeing that. On your point about disclosures in North America, given the impact that we've just reported today, we need to take that on board. And I think that your point is totally valid. We've been trying to balance a lot of disclosure in a lot of business units with there's a never ending demand for more detail. But given what's happened, we will take that on board and we will report back to everyone in February.
Next question please, Natalie, if there is one.
Our next question is from Martin Barrow from Deutsche Bank. If you'd like to go ahead, Martin.
Hi, Yes, it's following really from Lakis' comment. Given that you've highlighted that there are IPPs now in The U. S. That are looking to access the route to market directly downstream to customers, whether they be residential or business customers, Do you think that there's a case for looking at exits of retail in North America if there's more strategic value to some of the other players in the market that have upstream generation that perceive a route to market value? Do you really need the full scale of the retail business that you've got in North America?
If somebody came along to you and made you an offer, would you consider that?
I believe that our business in North America is core. And the capabilities that we have are exceptionally good in my view in North America business. I regret deeply the performance that we have delivered in the last part of this year, but that is not a business without risk. We clearly operate to serve very large numbers of customers with very sophisticated products against the backdrop that is complex and can be volatile. I can absolutely assure everyone on the call that we did not expect this scale of impact this year.
And there are questions that we've got to ask about the product suite that we're offering and whether we are sharing risk adequately between us and the customer. We and other market participants faced with this phenomenon in the second half of the year have been starting to change the product. The market has been operating with a pretty standard period, I. E, about three year fixed price deals where the supplier takes the risk and takes the risk of a number of markets and regulatory instruments as well. And we need to review whether we are prepared to take that share of the risk exposure relative to the customer.
It has served us very well until now. And this business, although it has had a couple of very volatile periods, one just before I arrived, the Polar Vortex, which everyone remembers, and this situation this year. But this business delivers very high returns, and we have unique capabilities and market positioning relative to our competition. So I believe it's absolutely core. But clearly, we do not want to be delivering this type of result on any frequency at all and ideally never again.
But it's a very core business to us. Okay. Thanks.
Our next question is from Chris Leybart from JPMorgan. If you'd like to go ahead,
Good morning, Chris. Good morning. Just two questions. The first, on The U. S.
Business, there's been quite a lot of M and A activity in The U. S. And I think your business would be very attractive in that market from an M and A perspective. Would you consider selling it as a way to lower the volatility of your earnings? And perhaps that may not hamper your aspirations to grow Connected Home if you could sort of sign agreements with the new owners to partner up on the Connected Home front?
And secondly, just in terms of the 650,000 customers in that block, Could you give us an idea of how many were in the block? How many were prepayment? And how many fixed?
So first of all, Chris, could you just clarify the previous question from Martin obviously was about selling our North America business and I answered about North America business I. E. NAV. Is your question referring to the Home business? Or are you asking the same question?
My apologies if I am. I was doing two things at once. But in terms of partnering specifically, would that hamper your ambitions to partner?
So first of all, our strategy is to have a portfolio of businesses that are, taken as a whole, resilient. And we believe that exposure to different geography and different customers is very important as we believe, we need to balance and rebalance the exposure from commodity energy exposure to other services and propositions. We believe that that will result in a stable and resilient portfolio overall, but recognizing in energy supply, there will be regional differences and volatility. We will consider partnering clearly. And one of the options as the Italy contract demonstrates is to expand some aspects of our Connected Home business and other services we offer through other partners.
We do not need to be doing it through our own energy customer relationships. And that does not immediately say what we should do is get out of energy and try and replace it with pure services. We see it very much as a balance. Does that answer your question, Chris?
It does. Thank you. And on the 650,000 customers
I'm sorry. Yes. So we're not giving a split. What we will do in February is give the look back bridge of customer count changes as just as we did in the middle of twenty seventeen, showing the categories that we are either deemphasizing or are ones where in the highly competitive market people have rolled off. As I said to an earlier question, we don't have any more of these large books.
But I can tell you that approaching half of that number roughly was the collective switch book roll off.
Thank you. If I could just ask one follow on, which is on that theme. The some of your competitors, particularly innogy, have started to focus on keeping their customer numbers flat. You have appeared to start to focus on margin. Is that a deliberate ploy?
Or is that just the nature of your pricing in this period? Could you give us some color around that, please?
Well, I think we indicated, and we have done a number of times, that we want to focus on customer segmentation and giving those customer segments what they value and need. And that does not mean a pursuit of numbers as a driver. It means numbers as an outcome. And we have seen, as we've analyzed The U. K.
Market more intensely over the last couple of years, we realized some of the activity in the market not only appears to be but is sub economic. And so acquiring customers at really aggressive levels, unless you're going to flip them on to a really high standard variable tariff when they're not looking, which is a practice that we have decided we do not support. Unless you do that, and it's quite unsustainable, we believe, especially in the face of a government price cap intervention potentially, we believe that is sub economic. And what we are not prepared to do is acquire customers who we believe within a reasonable period of time we are unable to cross sell or upsell to create NPV. And some of our customer segments, if we were to pursue them for the basis of customer numbers, they would be value destructive quite significantly.
And so we don't think that's what any of you would want us to do. It's not what we ought to spend our time doing. I can't comment about some of our other competitors, but I do believe that there's a degree of papering over the cracks to some degree if you pursue that and it's quite a distraction.
Okay. Thank you very much.
Our next question is from Jenny Ping from Citigroup. Jenny, your line is now open.
Hi, thank you. Morning, gentlemen. Just want to, if I may, pin you down a bit on your reference to the willingness to operate the dividend cover for a period of time. Can you talk a little bit more about your thoughts on the definition a period of time, is it connected homes growth related? Is it looking at the SVT cap impact?
Just a bit more color on that, that would be great. And then second question on the block of customers, you said there weren't any more in The UK. Can you disclose what the blocks are in The U. S? And then just thirdly, in terms of the impact on the SCT cap, presumably in your five year plan that you mentioned earlier, you've had some working through as to what the potential impact would be if the SBT cap followed a similar methodology to the PPM cap.
Can you comment a little bit on that as well? Thanks.
Well, Jenny, great questions. Difficult ones to answer with full disclosure today, but let me go through them one by one. First of all, on the dividend, I mean, we are clear how important the dividend is to our owners. We are also clear that, that dividend is very important to our owners at a time when we are having to shift our own portfolio and at a time when the market is also changing dramatically. We therefore are signaling that there is a period of time that we recognize contains uncertainty, uncertainty about our ability to net grow.
We're seeing some pretty important green shoots. We're focusing quite a lot on stabilizing services with the intent to grow services. And you've seen how services over a run of years have been very stable, but it hasn't yet been able to grow. We're getting quite excited about that. The Connected Home growth, the proposition development and customer segmentation in Energy Supply, which we've just been talking about, all of these things are capabilities and route to market changes that are required, which we are developing and making significant progress in, but that will take a bit of time.
We also have got a we've shrunk the balance sheet of the company significantly. And, the question is, can we start to re expand it? Not necessarily dramatically, but we clearly need to look at options which would allow us to deepen in the areas where gross margins are high and where we have the requisite skills to compete. And then the third component that you mentioned is clearly the political backdrop around The U. K.
Energy market. I hope we've demonstrated by the trading update that we are able to offset gross margin decline despite these dramatic headline reductions in customer numbers with cost efficiency and the new propositions to the customer segments we are targeting. What this all means is that we believe we will have an attractive and sustainable business in U. K. Energy supply.
However, the end game of the marketplace over the next if I take the time frame that governments talked about, two to three years as they talk about a price cap, if it's going to come into being in place at the 2018 or early twenty nineteen, there's quite a lot of uncertainty that we've got to steer Centrica through. And we are signaling that over a period of time, we are prepared to operate with dividend cover from earnings below historical levels. And clearly, the only way you would do that is if you're confident about a subsequent period where dividend cover returns to more healthy levels. And that's what we're signaling. In terms of well, then I should say, we will obviously give a bigger update, a more extensive update on that and our dividend policy in February.
In terms of blocks of customers in The United States, I don't have the data on that today. But let me just ask Jeff if he does. I don't think it's particularly significant. No, I'm going
to add to that, Ian, that like The UK, and to a smaller extent, we've historically been involved from time to time with aggregation or collective switch type deals in The U. S. But as we've also in The U. S. Like The UK been much more focused in the businesses around value of customers, we've largely pulled back from The U.
S. In that as well. So that has become and will be a fairly small part of the business over there.
And on your last question, Jenny, the standard variable tariff cap, if there is one, and I don't know whether there is going to be one, but even if there is one, the announcements that we've made this week on proposals for The U. K. Energy market, we believe, are good for all seasons. Of course, we've tried to model scenarios in our planning. It's quite difficult to do.
And therefore, what because it is quite uncertain. But what we've been able to do is model our own response capability and model the types of scenarios that we envisage given the government's guidance so far, because the government has been very clear that a cap needs to be set at a level, which still encourages investment, still drives efficiency and drives competition, but doesn't remove competition and still allows programs like the smart meter program to continue. Now that's a pretty complicated formula. But if you analyze that, where we start with our standard variable tariff below 85% of the market and the fact that the government is signaling that they are not intending to make the market completely fail, we believe we can model a range of scenarios around that. And when coupled with our own interventions, both in terms of the customer segments we're targeting, the propositions we now have, the systems and processes we now have in place and the efficiency program, which we are pursuing, we're confident we can give the sort of guidance we've given today and on Monday, really whatever the outcome.
You can never say never, but we believe we can create a very sustainable and attractive business, whatever the final outcome is. I have spoken to the government about our plans and proposals, and I have received cautious, warm reception about a step in the right direction. And I think we're going to be able to initiate more constructive dialogue now with the government. These proposals have been seen as comprehensive and very, thorough. And I think they've given the government serious pause for thought about how many of these they should incorporate.
Thank you, Jenny.
Thank you.
Our next question is from Ajay Patel from Goldman Sachs. Ajay, if you like to go ahead.
Good morning. I just have three questions, but they're relatively short. The first thing is just looking at the business as a whole, America and UK. And I know that some of the impact today is weather related, but just thinking about margin pressure going forward, what makes you confident that this isn't a beginning of just increased competition, reducing margins and that we're not rebounding on to a maybe slightly reduced margin level, but actually you just have a structural theme of those margins getting more and more compressed as the competition increases. The second question was on the dividend comment about a period of time.
Clearly, you're a company and a lot of change and there is a lot of work being done with growth businesses and changing the business model and the proposition. When do you think when you talk about a period, when do you think that transformation is complete? And then would it be when the growth business is breakeven? Or would it be when you begin to actually see a view to attaining the revenue and potentially the profit targets that come from the growth division? I'm just trying to get a feel for that.
And then lastly, in the customer side, where you talked about the $650,000,000 the block trade, it kind of gives me the it gives you the well, it's clearly that they are lower margin customers that you've lost, so it's not as negative on that profit as you would expect. But it doesn't kind of tell us that there is decent amounts of profit dispersion as in your profit margin on your cost to your customer base is very different. And just looking at the gas customer base where there's a 15% EBIT margin, how much could that dispersion be? Are you making somewhere between a 2010% EBIT margin? Or is it wider?
Or is there any sort of feel for this? Because I'm just thinking if the pressure is on default tariffs and they may be some of your higher profit margin customers, is there a stronger downside on that than maybe you could just see from the headline average number?
Thanks, Ajay. So firstly, on margin compression, I've been in commodity energy businesses for thirty two years. There is always a need to be agile and be highly capable in managing commodity risk. And there is always a trend towards commoditization, albeit, that there are limits to that commoditization and there always remain risks associated with managing commodity market exposure, which clearly means that commoditization cannot go to the ultimate extreme where there is zero margin, even though some people talk about blockchain eventually removing the margin altogether, which I don't fully subscribe to. But I would accept that there is a tendency towards commoditization in commodity energy markets, so the clue is in the name.
And I think, therefore, very strongly that a lot of it's about capability and offering customers things that they are willing to pay for. To do that, you have got to be experts at managing risk. You've got to be expert at managing and providing risk services. You've got to be able to use scale in aggregation to, allow you to optimize and create a return. And on top of that, you've got to offer non commodity services around the commodity.
And I think those trends are absolutely happening, and that is what our strategy is based upon. We are driving towards two themes. One, the distributed nature of the energy system increasingly becoming apparent. And the second thing is that people don't just want energy. They want more than just energy.
So it's a very important observation, but I'd also say that the theory of pure commoditization of energy markets has been around for fifty years or so, they're still alive and well. But we need to be expert in our capability if we're going to play. When is the transformation going to be complete? Look, I don't think there's a magic date, but we are clearly going to need to get to a place where we have the portfolio we want to have. We've done a lot of that, most of it.
In terms of the asset businesses, we have not yet completed the build out of the customer facing skills and capabilities we need in the five pillars of each of Consumer and Business that we have outlined earlier this year. I'm not prepared to give a date, but clearly a very important indicator will be when we can demonstrate sustainable gross margin and net cash flow growth and deliver attractive returns. And those are the objectives that we've set out, and we should be able to see that within the next few years, but I'm not prepared to tie it down to a particular date. On customer margins, yes, there is a dispersion of margins. And I just want to be clear, of these books that have rolled off are worth zero NPV, so they have no impact on the company's financials.
In terms of EBIT margins, everyone quotes our high EBIT margin on gas. I just want to remind everybody that our absolute gas price within the bill is highly competitive despite us having high EBIT margins. So I we do have a dispersion of margins. We don't expect them all to be the same. We are more aggressive on electricity than we are on gas.
We are trying to rebalance that a bit, as you saw earlier this year, but not particularly worried about that and there will be a dispersion of margins always.
Our next question is from Nick Ashworth from Morgan Stanley. Nick, your line is now open.
Hello, Nick.
Hi, good morning, everybody. Two questions from me. Firstly, just on the dividend, just for clarity. So are we talking about a 12p dividend for this full year? And then is the assumption that, that will remain flat over the next few years given the headwinds and uncertainty that we're talking about?
So I just want some clarity around what you're actually saying on the dividend level over the next couple of years. And then secondly, when thinking about Connected Home, because you've obviously talked a lot about the green shoots and the positive growth that we're seeing in that business. How do you think about that growth and how aggressive you want to be in that business given all the uncertainties elsewhere? Because it feels like with North America today, that adds on to the political uncertainty in The U. K.
Does that make you any less keen to be more aggressive on connected home growth? Does it make you keener to get these products out faster? Or does it not change? I just want to get a sense of how you feel about these growth businesses given it feels like the uncertainties in the core businesses are sort of mounting up.
Well, thanks, Nick. I mean, I know there have been lots of different ways of asking the same question around the dividend. I mean, we have been clear that the full year dividend at the current level is underpinned. So you can assume that a 12p dividend for this year is underpinned. We're not giving guidance about the absolute level of dividend going forward.
What we are saying is we're prepared to operate with a level of dividend covered from earnings that is lower. You'll need to draw your own inferences from that. But clearly, we are prepared to operate with the dividend slightly less covered than it has been. And that's the thing you should draw from this. And it is a signal of confidence that we can steer Centrica through a period of difficulty, no question about it, and uncertainty associated with particularly the evolution of the energy market in The U.
K. Without our investors becoming concerned. In terms of the Connected Home growth, this situation doesn't make me keener. I am I remain very keen to grow Connected Home. I was out with customers yesterday morning.
I was sitting in someone's living room talking about Connected Products. And they were saying, it would be really good if we could get our connected products and energy. They didn't know who I was, by the way. And I was saying, well, some companies are able to do that. Would that be interesting to you?
And they said, absolutely. So we were talking about that. Another customer was talking about monitoring of an elderly relative in their home who needs constant care. And I'm absolutely sure that the connected spaces that we have chosen to direct our attention at, peace of mind, home energy management and home automation, are growing areas of real interest to customers. And if you can combine them with energy or sell them on their own, it is giving customers what they absolutely want and need.
And I'm very encouraged that other companies are now seeing our positioning in the Connected Home as sufficiently attractive to ask us if we would exclusively give them access to it, such as we've had with E and I. So I'm very keen to grow Connected Home. We're very conscious, however, that the S curve shouldn't be so deep that the company can't afford it. We believe we can manage that. And we can come out the other side of that S curve with some quite attractive, very attractive gross margins and attractive gross rates.
Thank you very much.
Our next question is from Fraser McLaren from Bank of America Merrill Lynch. Fraser, your line is now open.
Good morning, Fraser. Good morning, Fraser. Hello. Hi, Are you able to
hear me? Hey, good morning. Just a few questions, please. First of all, on UK business supply, this has been a difficult division for a long time. I mean, how confident are you that you'll be able to get a grip of it?
And secondly, I hear your message about cash and debt still being within the range, but there's clearly less headroom now. And together with the potential impact from UK supply intervention, I'm wondering about the extent to which this reduces your flexibility for acquisitions and the growth in your chosen areas of development. And then just finally, does lower cover for a while include a number less than one given that there are scenarios where U. K. Supply caps could nudge earnings materially lower while growth kicks in elsewhere?
Thank you.
Jeff, do you want to talk about U. K. Business? I'll come back on the other two.
Yes.
So Fraser, your question, yes, we are seeing continued competitive pressures in the B2B business here in The UK, pressures from large sort of large suppliers, like the likes of sort of oil and gas majors, etcetera, coming into the more and more into the C and I space and it being a highly brokered business and pressure from brokers currently. So we are experiencing that here of late as the business continues to drive costs out. However, we do expect and do believe the business will grow from here and that those margins will return. Our full year results have been held back a bit by issues from earlier in the first quarter this year. So we would expect it to grow going forward.
Clearly, it won't return to the profitability levels we had a number of years ago when of course the business model was quite different in there. There was the whole auto rollover segment of the market. But it's just taking a bit longer than we had anticipated here in the second half.
Fraser, on the other two questions. So cash and debt levels cover acquisitions. We will always only do acquisitions if they are core to the strategy and are attractive for the shareholder and economically attractive in the near term as well as NPV accretive over time. We have flexibility within our financial framework and as we've been demonstrating to do small acquisitions that would build capability. We are we do not feel prohibited from looking at acquisitions at this time even with this performance.
But clearly, I recognize that the bar obviously is high at the moment for doing any acquisitions other than small infill acquisitions. That shouldn't stop us looking for them if we believe that they would be potentially important for our strategy. But I want to emphasize performance comes first, and that is our focus. And it's not we're not going to be distracted by the pursuit of get out of jail free cards, if that's, the type of acquisition people have in mind because that's not what we do. But we are prepared to do and demonstrating a track record in doing acquisitions that build out our capability for the longer run.
On the your version of the question about dividend, look, lower cover for a while, in theory, obviously, includes lower numbers than one. But I want to be clear that I don't want to be running a company where it has dividend cover from earnings that is below one. There are circumstances in a commodity exposed company where you get kicked into that territory, but I can assure you we have no plans to deliver for any period of time dividend cover that is unsustainable like that. And our job is to operate so that we get to more sustainable dividend cover levels. And I'm confident we can do that.
And I don't think dividend cover from earnings should be the only metric that you look at a company through. There are plenty of companies that operate for periods of time with dividend cover below one. It's entirely possible to do so. It's not something that I want to plan to do, and I don't think we need to at this stage.
We have a follow-up question from Mark Treshni. If you'd like to go ahead, Mark.
Hi. A question again on the balance sheet. I know that I ask you this every time I see you, and I'll ask you it again. You've got gross debt of GBP 6,000,000,000. The market value of that debt is somewhere above 7,000,000,000 to buy out.
You're only using about $2,500,000,000 and I guess that could well go down even next year with things like the scrip. Clearly, it's a very big drag on earnings. I was just wonder I know you keep it constantly under review, but is it possible you can do anything to right size the balance sheet or if your thoughts have changed since I last asked you the question in September?
So Mark, it's Jeff. I'm going to give you the same answer I did in September, conscious that that may not be sort of as fully satisfying as you might like. Listen, very conscious as you'd imagine on the difference between gross debt and net debt. And we are looking at ways in which we might be able to manage that as efficiently and as effectively as possible. And we not only keep that under review, but we actively look at opportunities to make that more efficient.
And when we see the chance to do that, then obviously we'll we would announce that.
Thank you.
Next question is from Andrew Mulder from Credit Suisse. If you'd like to go ahead.
Hello, Andrew. May be on mute. Natalie, is Andrew's line open?
Andrew, your line is now open. Okay.
Maybe we should come back to him. Are there any other questions, Natalie?
We have a question from Ingo Becker from Kepler. If you'd like to go ahead, Ingo.
Yes. Thank you. Good morning.
Hello, good morning. I had a question on your U. K. Home business. Hopefully, you didn't answer that already.
Can you give us an idea about the impact of the customer losses that you experienced? And apparently, you had not absolutely favorable weather. You're losing quite a lot of customers, but you're still expecting this business to be flat. Is it possible to give some kind of breakdown how efficiency gains, how the different customer value segments that you have been categorizing at the C and D play into here, where you're losing what and where you might just not lose that much and what the related costs are? And a related question might be pre any cap on the SVT or otherwise next year, which I guess we all have to work out for ourselves.
If the market would just continue as it did lately with your experience customer losses and what you can do against that, assuming normalized weather, just conceptually so I'm not talking you into giving us a guidance at this stage, but conceptually so pre EKF given normal weather, would you think it is plausibly assuming you can defend that roundabout EUR 800,000,000 profit figure over, say, the next twelve months at UK Home? Or those impacts, the first part of my question, are suggesting a somewhat different outcome? Thank you.
So, Inge, we're going to give you guidance on the company for 2018 in February. And therefore, not prepared to give you specific steers on individual business units at this time. However, let me just recap. I mean, what is going on in U. K.
Home is that the market is highly competitive and we are seeing customer segmentation become more and more extreme where you've got some customers that continuously shop around and they are only interested in price, only interested in the cheapest price, and they don't care where they get it from. Those customers are very unlikely to generate material value when you acquire them, and they're very unlikely to want to buy any other goods or services from the company. They're just interested in energy, only energy, the cheapest energy, and they don't care who it's from. Those customers are extremely unlikely to be attractive to us. There are, however, plenty other customers who are who do care who they get it from.
They do want other goods and services. Some of them actually do want the standard variable tariff, which is going to be a challenge for us as we try and persuade them to come off it because they just want someone to manage the product through time. And therefore, we are being much more focused on individual customer segments, and we're offering reward programs for loyalty. We're offering boiler servicing and energy. We're offering connected home and energy, which by the way, these are sources of gross margin that our competitors are unable to offer.
And so we are starting to see the stabilization of our gross margin. That's really important, and we expect to be able to stabilize it and grow on a unit basis. Now the question is, can you ultimately stop the customer losses as well because there are proportions of the customer, the higher value customers who decide that they are just going to become a price oriented customer, and we're seeing a roll off of some of those, not at as higher rate as the headline numbers would suggest. That means we've got to drive efficiency in order to deliver net margins over the period until our customer base settles down. And we're confident we can do that.
We have demonstrated we can do that. Clearly, a very large proportion of the approaching 300,000,000 of efficiencies that we've indicated today is in U. K. Home. And as the world goes more online and more digital, we are going to pursue those trends, which are obviously going to result in bringing our cost base down as well.
So we are confident, it's a core part of our strategy of creating a sustainable and attractive business in U. K. Home, but that's as far as I can go. Okay. I think we're nearing the end of time.
We'll take a couple more questions, Natalie, and then I think we should call it a day.
Okay. Our next question is from Deborah Swanson from Bernstein. If you'd like to go ahead.
Thank you. That's Deepa Venkateshwaran from Bernstein. I had three questions. So firstly, your U. K.
Home performance for the year is maybe better than where we were expecting it. Could you just say how much of this was cost cutting or what is the source of that? Is it services? Is it energy? Is it cost cutting?
Second question, Ian, you were mentioning that you've done some work on different scenarios of where price cap needs to come and if it needs to meet all those different objectives laid out in the draft bill. How far do you think it could be from where, say, the prepayment cap, which is also applicable now to the vulnerable customers, that's roughly at $10.30 per customer for this average consumption. So how far do you think the cap needs to be above that to satisfy all those conditions? And my last question, it's a clarification. I know, Jeff, through various calls, you have talked about it.
But what do you think could be an underlying level of profitability for both the North America business and The UK business combined going forward, given that this year effectively adjusting for the one off, is $126,000,000 or so for those. So any view on where your current thinking is on a steady level of profitability for the two business units combined? Thank you.
Well, look, in The U. K. Home, the performance has been good. We're not I'm not prepared today, Deepa, to give you any breakdown of performance, but we will be able to do so more in February. I'm very encouraged by the way the organization is adapting to a more and more competitive market.
There is clearly a significant amount of cost efficiency as I as we've indicated that in the Consumer division, cost efficiency has resulted in us being able to offset gross margin degradation to deliver a stable result year on year. In terms of the price cap level for, standard variable tariffs, which I think is your question, there are lots of ways of there's been lots of speculation about this. If we get a price cap, the methodology to calculate it, I'm afraid, has been thrown at Ofgem and the variables that they have to deal with are huge. And it's really complex. And my assertion would be they're going to have a real job trying to do it if the government go ahead with it.
The government keeps talking about this $1,400,000,000 detriment, which we completely refute. But however, if you did take that number, and I don't agree with it at all, and you divide it by 17,000,000 households, you get about GBP 80 per household. But the assertion is that people are being overcharged. We do agree that the market could be made more efficient and therefore there is definitely some tens of pounds per customer efficiency improvement, but we don't think it's automatically £80 But clearly, if there's some proportion of that GBP 80 that should result in efficiency, the average standard variable tariff is about GBP $11.40. And you could imagine a scenario where the changes, whatever they are, result in £40 or £50 coming out of the standard variable tariff.
That would mean that it would actually end up exactly where our standard tariff is today. And so at that level, we wouldn't see significant impact today. Obviously, prices can move up and down depending on what happens from here. But it's difficult to really calculate where the government would rationally put a price cap if they did or Ofgem were asked to. But I don't think it's going to be at levels that will stop us making a healthy gross margin.
And when you add the cost efficiency, I think it's quite probable that we will continue to be able to make a healthy net margin as well, which is what we intend to do. And that is why we're making the statement that we are today and indeed on Monday. Jeff, would you cover the how should people think about the underlying level of profitability in the business division energy units from here?
Yes, I mean, fair question, Deepa. I think I've given a fairly extensive answer on North American business, which I won't repeat. I think on UK business, I mean, obviously, it's a business that we made GBP 50,000,000 in 2016. We did have one off issues earlier in the first half in UKB. We are seeing more competitive pressure currently, but that is a level that we would expect to return to in that business and then ultimately grow from there.
The business has lost some additional customers in the second half. But now that the operational issues are behind that business, it has been very focused on new customer products, launched an online only product recently that's very competitively priced and has a lower cost to serve that goes with that. So see we the business being able to return to those levels of underlying profitability and grow with momentum from there would clearly be the target. So obviously, within the rest of the business division, there's the Energy Marketing and Trading business. As we said at the half year, we continue to be of the view that profit will be heavily weighted towards the first half of the year, primarily due to the phasing of the historical long term gas supply contracts that are in that business that do phase between periods and including within a year.
And we would and do expect to come back with more visibility on the impact of those versus the underlying growth in the Marketing and Trading business, including the areas like the knee as business, which has been continuing to perform very well and give a bit more clarity on that in February.
Okay. To repeat, you're saying that maybe around $50,000,000 for The U. K. Business and I think earlier you said maybe around 150,000,000 for North America business would be a general underlying expectation.
I mean, I think what clearly what I said is that we would expect to get back to twenty sixteen levels in UKB. That's clearly the target. And then ideally have the business continue to grow from there. In terms of North American business, I made the observation earlier, just to reiterate it, that we've said around $80,000,000 this year. If you add back the one off, you get 155,000,000 And then I've made some comments about how much of the difference of that between that number and last year's number of two twenty.
We see as related to weather and phasing and a bit of backwardation versus the unit margin pressures, which may take longer to sort themselves out in the Power business in The U. S.
Thanks, Peter. And one last question please, Natalie.
Our next question is from Andrew Mulder from Credit Suisse. Andrew, your line is now open.
Yes, great. Thank you. Sorry, I cut off earlier. I just really had one question, and I just wanted to know about how you see your credit metrics evolving over the next couple of years. It just strikes me this talk about low dividend cover potentially going below one.
You've already done most of your divestment programs, so there's not much due to more to come from there. And it just strikes me that with all the pressures we're seeing, you're going to have worse credit metrics for the next couple of years, at least until this transition is done. And I just wonder if you agree with that and whether you see that pressuring your ratings?
So let me start with just reiterating what I said about the dividend. I did not say that we're targeting or expecting a dividend cover below one. I simply said that if operating at a lower level of dividend cover, which we are signaling we're prepared to do for a period, you clearly in a commodity exposed business could end up in a situation theoretically where you get below one for a very brief period of time and lots of companies operate that way. I do not intend that Centrica operates that way. We need to plan for dividend cover, which is obviously above one.
And we need to plan that if we are operating under dividend cover that is below historic levels, that it is not permanent and we can see our ways to restoring healthy dividend cover. And that is what we're signaling today. Jeff, on metrics.
Yes. So as we said at the half year, we remain confident and on track to achieve the rating metrics, the financial metrics that the rating agencies have set us and expect to be at or above those come the end of the year. And with the strong cash flow generation in the underlying businesses, notwithstanding Ian's point about where that is in the future. We expect to continue to be above those rating metrics going forward as well. Having the financial metrics that underpin the element of our financial framework of a strong investment grade credit rating, we see as very consistent with where the business will continue to perform in the future.
And as always, we have a lot of flexibility in the investment we're able to deploy into the business on a year by year basis. So I continue to see us being having financial metrics consistent with our target rating.
Thank you, Andrew. Well, listen, everyone, thank you very much for joining us. I just want to say one thing at the end. I am deeply disappointed with our performance in the second half. And obviously, therefore, I am deeply disappointed with performance, particularly in North America business.
We didn't expect this dramatic shift in the outcome at the middle of the year. We were seeing competitive intensity on Power margins, but we did not expect the magnitude of impact. Although we booked healthy net margin in the second half of the year, quite a lot of it will appear in our P and L in 2019, not 2017. And therefore, we are reviewing the products that we are offering. And I really regret for our investors and those who follow us having provide news like this today.
Having said that, I don't want you to believe therefore that the whole portfolio is unreliable. And I think you've through the questioning, I think we've talked about the rest of the portfolio and how it's performing. I also do not believe that this year's outcome in North America business is the long term outcome. And I reiterate what I said earlier, it is an attractive business, and we've got very highly skilled people. The issue that we are wrestling with is during 2018, unless the curve shifts, we are going to see this type of pressure on the P and L.
And as Jeff said, therefore, I think it's a reasonable expectation that adding back the one off item and possibly seeing some recovery, but not back to historic levels in 2018 is the right place to be positioning this business. We are absolutely focused on driving performance, and I regret what's happened simply because the performance everywhere else outside of these two business units is actually encouraging. And I'd just like you to know that we will leave no stone unturned to drive performance such that you will see the outcomes that we have indicated this strategy will lead to. Thank you very much for taking the time to join us today, and we look forward to speaking with you and updating you in February. And we would very much welcome your calls through IR if there are any follow on questions.
Thank you very much.