Heat Wave Investing

Man was it hot today.  According to weather.com the high for today out here in Granite Bay was 113!  And I sure felt it.  I have to say that this kind of heat really puts me in a bad mood.  You can’t go outside and do anything. 

But, believe it or not, there are some people who are loving the hot weather: the electricity companies, such as PG&E, and their shareholders.  Regulatory constraints limit their ability to profit from extremely high demand days like today but they still do well. 

Consider PG&E (NYSE: PCG), the electricity company for those of us out here in Roseville and Granite Bay.  PG&E is the dominant electricity provider for northern and central California servicing 5 million locations (this map shows who services which areas in California).  That’s some pretty prime real estate I am sure you would agree.  About 4.35 million of those locations are residential like your house and mine.  Another 500,000 are businesses.  PG&E derived about 39.7% of it’s electricity operating revenues from residences and 42.3% from businesses in 2005. 

So how is PG&E as a business? 

The stock closed Friday near a 52 week high at $40.62.  With 349 million diluted shares outstanding at the end of the 1st Quarter of 2006 that gives PG&E a market cap of about $14 billion dollars.  They have net debt of about $7.5 billion for an enterprise value (market cap plus net debt) of about $21.5 billion.  (You always want to consider the debt a company has because as a shareholder you essentially assume that debt which has to get paid out of earnings.  If you were to overlook this in analzying PG&E it would look alot cheaper than it really is!). 

In 2005 PG&E had revenues of $11.7 billion, operating cash flow of $2.4 billion and free cash flow of $600 million.  (Operating and Free Cash Flow are superior measures of earnings compared to the commonly used net income because they are not subject to non-cash accounting entries such as depreciation and amortization).  Their enterprise value to operating cash flow ratio is an attractive 9.0 – that means that you are essentially paying 9 times what the company took home in 2005, excluding capital expenditures. 

The free cash flow ratio, which takes into account capital expenditures, is less attractive at 36.  But my sense from reading the CEO’s Shareholder Letter from the 2005 Annual Report is that PG&E is investing heavily in growing and improving it’s assets.  What we really need to know is how much of that capital expenditure should be considered “maintenance” and thus an ongoing operating expense and how much “investment” which could increase earnings in the future.  Unfortunately company financial statements and reports never tell you this.  You have to kind of feel it out for yourself. 

In the first quarter of 2006 PG&E had revenues of $3.148 billion, a 17.9% increase over the $2.669 billion it generated in last year’s first quarter.  Based on that revenue it was able to generate $1.129 billion in operating cash flow, an 18.6% increase over the $952 million it generated in last year’s first quarter.  Free cash flow was $553 million, an 8.3% decrease from last year’s $603 million, due to a more than $200 million increase in capital expenditures. 

Based on these numbers, PG&E seems to represent a pretty good value. 

Not only that but with the stock market currently rewarding defensive names, utilities are an excellent place to have your money.  (Utilities are “defensive” because in a slowing economy people cut back on “luxuries” like new cars, fancy dinners, new clothes and not on “necessities” like food and air conditioning!).  Like I said, PG&E is trading near a 52 week high. 

PG&E’s stock has also rewarded investors quadrupling over the last 4 years from a low of just above $10 towards the end of 2002 to it’s present price around $40 and pays a quarterly 33 cent dividend representing a 3.25% current annual yield. 

Goldman Sachs, the premier investment bank, seems to like PG&E too.  According to MSN Money, they own almost 20 million shares amounting to about 5.7% of the company. 

Be careful, however, about buying it tomorrow (Monday July 24).  After the heat wave here in California this weekend and forecasts for it to continue the stock could jump.

Be smart this summer: hole up inside, blast your AC, and buy some PG&E.