PG&E Corp: Capital Hungry Name Lagging Industry Margins (NYSE:PCG)

Investment Summary

Regulated energy utilities companies are expected to catch a strong tailwind from the world’s insatiable demand for artificial intelligence (AI). If I think of the American energy landscape, for example, there are large capital outlays required on the infrastructure side. According to Greg Abel at the Berkshire Hathaway 2024 Shareholder Meeting, looking out until the mid-2030s, the underlying energy demand that’s in place with AI and data centres is set to double. If we look beyond the 2030s, Abel says, the underlying demand triples.

The return on equity investment achieved by the electric utilities industry in recent years has been below the general return achieved by US businesses. Mountains of cash have been committed to the space, but only ant hills have been returned. In many instances, it is a case of “throwing good capital after bad capital“.

There is also a large regulatory burden to consider in this space, especially in the proper recovery of underlying assets, including capital, and return on capital. But let’s not forget the main objective here either – to keep the power on. Nevertheless, we are scouring the electric utility space for offerings with durable, recession-proof earnings, that can plough cash back into its business to an advantage.

PG&E Corporation (NYSE:PCG) had originally fallen onto our radar under this top-down framework. Whilst the company has no direct exposure to the theme I just mentioned, its ownership of critical energy assets throughout California is a potential competitive advantage. That was our thinking, at least. On examination, my judgment is the ability to obtain a recovery on our underlying investment is severely hindered by 1) the company’s inefficient capital base, 2) absent free cash flows to throw off to shareholders or reinvest, and 3) no valuation upside.

Based on these factors, I rate PCG a hold.

Background Fundamentals

Founded in 1905, PCG has woven into the public infrastructure in Northern and Central California. It produces and distributes energy via electricity and natural gas, alongside nuclear, hydroelectric and photovoltaic means.

In 2015, revenues were $16.8 billion for the company on operating income of $1.4 billion. After a challenging period from 2016 to 2019, where revenues did not surpass $17.2 billion, the company put up $21 billion of revenue in 2022, lifting to $24.4 billion last year as mentioned. This was on operating income of $3.2 billion and $3.4 billion respectively.

The company has 28,000 employees and with revenues of $24.4 billion in 2023 revenue per employee was $871,400 for the year, quite productive in my opinion.

The electric utilities industry operates on reasonably high average gross margins of 40% and operating margins of around 20%. It produces an average 4.5% return on capital each rolling 12-month period, as seen below. PCG falls behind the industry on each one of these metrics. This isn’t a good sign.

For instance, it is 500 basis points behind and gross margin, and around 300 basis points behind and operating margin, suggesting that it has higher operating costs as a percentage of sales compared to the industry. It also operates lower than average return on capital and has a deeper free cash flow margin loss than the industry. As I will explain below, this situation is worsened by the extensive capital that must be committed to the enterprise to maintain its competitive position each year. Figure 1.

Electricity demand is rising, as I’ve mentioned just before, and so is the need for meeting that supply. The “electrification of things” is also a large component that is driving demand. However, there are challenges ahead, including bottlenecks to harnessing new supply, potential grid congestion due to ageing and insufficient assets, and the capital investments required to fulfil this.

A Deloitte report into The utilities sector suggests that upgrading and expansion of grid infrastructure remains the biggest challenge on corporate utility CEOs’ minds. Ultimately, billions of dollars of investment are required to upgrade these assets, some of which the utility is more than a century old.

The investment is required to build out capacity. For instance, Deloitte mentions that power companies are anticipating “a 12% yearly increase in data centre expansion” and that large tech firms should drive a “threefold increase in annual demand by later this decade, primarily due to the expected surgeon generative AI computing needs“.

With huge incremental capital requirements in need, only companies with the most exceptional economics will deliver attractive returns for shareholders in my opinion.

Figure 2.

Q1 FY 2024 Analysis

PCG’s Q1 2024 numbers from April came in largely in line with expectations. Total operating revenues were $5.8 billion, down from $6.2 billion the year prior. Both segments of electric and natural gas sales were down on the year, to $4 billion and $1.8 billion respectively. As such, variable costs were for both electricity and natural gas Woody 38% and 42% year over year respectively. Adjusting for interest in taxes, earnings of $781 million grew 24% year-on-year.

Management also confirmed on the call that it is still committed to a $62 billion “customer investment” over the next five years. Another 5 billion of this is set to be allocated for cost control purposes.

In view of the company’s Q1 numbers, there were no major standouts in my opinion, for a long-standing utility company.

Fundamental Economics

Recent surges in the price of natural gas and electricity have been positive for the company. Net operating profit after tax has increased from $3.4 billion in 2022 up to $4.3 billion in the 12 months to March 2024. Incremental capital commitments have been exceptionally large on this. For instance, in 2022, 2023, and in the last 12 months, management has invested $1.4 billion, $1.9 billion, and $600 million back into the business to maintain its current level of operations respectively.

However, two things are obvious from the reinvestments: 1) earnings have, in fact, grown, and 2) the company is throwing off $2 billion-$3 billion in free cash flow on a rolling 12-month basis.

But I am turned away by the profitability of these underlying assets. A print of $4.3 billion in net operating profit after tax is by any means an impressive result. Put against the capital of $104.6 billion required to produce that figure – a 4.1% return on it is a less pleasing result.

A quick look at the return drivers reveals why. Whilst post-tax margins have increased in the last three years, this is largely a result of pricing benefits rather than operational efficiencies. It is not enough to overcome the fact PCG produces a turnover on invested capital of around 0.2.x. That is, one dollar of investment in the company produces around $0.20 in revenue. This is tremendously inefficient and ultimately leads to slack business returns and equally slack returns for the investor.

Figure 3.

Regardless of what growth management has exhibited, this has not created economic value in my opinion. I define economically valuable earnings as those profits on invested capital greater than 12%. This figure represents the long-term market averages. A return above this 12% threshold margin is what we call an “economic profit“, different from the accounting profit you see on the financial statements.

In the figure below, I show what PCG has needed to produce in terms of post-tax earnings on invested capital on a rolling 12-month basis since 2021. As mentioned, any returns that are above the 12% threshold would create economic value, and vice versa. For instance, in Q1 2024, it needed to do $12.5 billion on $104.6 billion of capital employed. The company did $4.3 billion. The resulting economic loss was $8.2 billion. Said another way, if we were a hypothetical investor who could achieve 12%, we would have done a better job at compounding capital than PCG in the last three years.

Figure 4.

Factors impacting proper recovery of underlying assets

Given 1) the company’s large size, 2) its extensive history, and 3) that it is in a highly regulated, unchanging industry, the predictability of future cash flows is higher than say in the tech industry, for example.

Management’s capital allocation decisions on a rolling TTM basis since 2021 are shown below. As expected, sales growth has been negligible at around 180 basis points per quarter, in line with the long-term inflation rate.

However, it is the capital intensity with which PCG has to maintain its operations that strikes me as a challenge. For every dollar of sales growth over this time, management has had to invest $5.37, including all investments to regulated assets. Unsurprisingly, the majority of capital has flowed into fixed assets – $3.43 to produce a single dollar in sales. When I mentioned “good capital chasing bad capital” earlier, this is what I meant. We have a huge sum of investment required – more than five times the amount of revenue produced – yet these funds are being invested at abysmal returns.

Figure 5.

If the company is to continue along its trajectory of the past three years, my estimates say it could do $26.3 billion in net revenue by 2025, roughly in line with consensus estimates. My numbers have the company to do $4.1 billion in NOPAT on this and throw off $2.4 billion in free cash flow that year. At the current enterprise value of c.$97 billion, as I write, this is a forward free cash flow yield of just 2.5%. If you were looking for a free cash flow yield of 5% with my assumptions, this company would need to see its enterprise value reduce to around $50 billion, from the $97 billion it sells today. Figure 6.

Valuation

The stock sells at around 14x trailing earnings and 23.8x trailing EBIT. The latter is an 18% premium to the sector. You’ve also got the company priced at 1.5 times the net assets in the business, but I believe this is fair given the slack returns on equity capital, as $25.9 billion of equity holds up $127.6 billion of assets through $53.4 billion of long-term debt. This is an equity multiplier of 4.9 times.

The question is whether these multiples of earnings are fair or not. Projecting my assumptions in the forecast from above out 10 years, then discounting these at a 12% hurdle rate, I arrive at a valuation of $20.50 to $24.80 per share. This is roughly in line with where the company trades today and therefore supports a neutral view.

Figure 7.

Upside Risks to Thesis

Investors should recognise the following upside risks which could impact the neutral view:

1. If electricity prices continue to surge in an uncapped way, this would be beneficial to PCG’s income base and potentially increase capital efficiency. This could see its share price attract higher valuations.

2. With interest rates in the “higher for longer” regime, an early wind-down of policy rates will reduce the cost of capital for many intensive industries, including energy utilities. This could increase cash flows due to lower interest expense and debt servicing ratios. If so, this might nullify my neutral view of the company.

3. I would also guess that we have not yet fully grasped the full impact AI and the associated infrastructure will have on the energy industry. This is something that I cannot bake into my models and something that is unfolding before our eyes as it happens. Any upside surprises here could notify the neutral view.

I urge investors to consider the risks before making any investment decisions.

In Conclusion

Highly regulated, intensive businesses in the utilities energy sector are due for a transformation thanks to factors such as AI, infrastructure, and the electrification of the world. Finding the most selective opportunities is paramount.

Whilst this may be difficult, it isn’t difficult to cipher out the weeds. In my opinion, PCG has a difficult job creating shareholder value above what investors could reasonably achieve elsewhere. This is a capital-intensive business, that requires enormous sums of reinvestment to maintain competitiveness, but without the business returns to show for it. In that vein, my judgment is the company is fairly valued at around $20 per share in my base case. Rate hold.