PG&E: Is It Worth the Expense?

Large Cap Watch List member PG&E (PCG), through its Pacific Gas & Electric subsidiary, is the largest power utility in California. With a 2.9% yield and the revenue and earnings stability of a regulated utility, it would seem to be an interesting diversifier in current market conditions. That thesis, in fact, is borne out by recent market activity. Given that the benefits of a utility are fairly well known, we focused our 10K review on the issues that may fall below the radar screens of many investors. We are not presenting these as reasons not to buy the stock, so much as things investors should be aware of when making a decision.

Risk Factors (as we see them) for PG&E:

Pensions are $1 billion underfunded. Expense reported on the income statement is based on an assumed return on $640 million, whereas the actual return was just $154 in 2006. Given that 2006 was generally a decent year for investments, the assumed return may be aggressive.

Doubtful accounts – company has consistently been underreserving (see image) for doubtful accounts, depleting the existing reserve. The difference was approximately 2% of net income, which equates to perhaps $0.05 per share.

The regulation of the utility industry is a double-edged sword. Against the benefit of earnings predictability investors should weigh the regulatory risks. FERC, Nuclear Regulatory Commission and State regulators all have a say. In addition, the power generation business is subject to extensive current and potential regulations over air and water quality, including possible regulation of greenhouse gases. The company is engaged in lawsuits over cooling water discharge at Diablo Canyon nuclear plant, its holding company structure and faces possible penalties for missing records related to California Air Resources Board.

Finally, while the price/earnings multiple is in line with that of the overall market and the company generates strong cash flow from operations, most of the cash flow is consumed by additional investments in plant. On an enterprise value to free cash flow basis, the company appears somewhat expensive.

PCG 1-yr chart

Full Disclosure: Author has no position in above-mentioned company at time of writing.