California Utilities Are Worth Another Look

Utilities investors have done well to avoid California for much of the past decade, but the landscape is shifting.

Political, regulatory, and legal changes during the past two years have reshaped the risk profile and long-term outlook for the state's three investor-owned utilities, Sempra Energy SRE, Edison International EIX, and PG&E PCG. Healthy, growing utilities will be essential if California wants to eliminate carbon emissions by 2045.

But the market doesn't appreciate this potential for rising earnings, dividends, and valuations. Edison International is one of the cheapest U.S. utilities we cover based on our fair value estimates as of early December 2021. PG&E and Sempra trade at a discount to peers when adjusting for their growth potential, both among the highest in the sector. With many other U.S. utilities trading at or above our fair value estimates, California utilities offer a margin of safety that we think is attractive.

Edison International

Morningstar Rating: ★★★ Morningstar Economic Moat Rating: Narrow Fair Value Estimate (as of Dec. 7, 2021): $71.00

Edison offers a triple play of value, growth, and income. It has stakeholder support to harden the grid against natural disasters, integrate renewable energy, and support electric vehicle adoption. Edison's electric-only business, recent regulatory success, and $5 billion annual investment plan give us confidence that it can average 6% earnings growth during the next five years. Management has raised the dividend 4% the past two years, and we expect that pace to pick up.

We think Edison has the best combination of growth, value, and yield in the California utilities sector. Edison has more long-term upside and less long-term risk than the market appreciates.

PG&E

Morningstar Rating: ★★★ Morningstar Economic Moat Rating: None Fair Value Estimate (as of Dec. 7, 2021): $11.50

A late-summer rally leaves PG&E's stock trading slightly above our fair value estimate. Market fears of more bankruptcy-inducing wildfire liabilities have eased three years removed from the 2017-18 disasters. The market has started to appreciate PG&E's long runway of up to 10% annual earnings growth to meet California's environmental ambitions. However, we think the market is correct to give PG&E a discount to peers given its zero-tolerance status with regulators, customers, and the courts. We expect PG&E will reinstate a robust dividend in 2024.

We think the stock price fairly reflects PG&E's growth potential and long-term risk. Expect the stock to remain volatile, especially during fire seasons.

Sempra Energy

Morningstar Rating: ★★★ Morningstar Economic Moat Rating: Narrow Fair Value Estimate (as of Dec. 7, 2021): $134.00

Sempra Energy's investment opportunities at its regulated utilities in California and Texas will remain the primary growth driver, though we think management will continue to look for additional liquefied natural gas opportunities. Regulated investment opportunities should drive 8% earnings growth through 2025, with our expectations for dividend growth to be in line with earnings growth. The biggest concern is California's potential transition away from natural gas, which represents approximately one third of the company's rate base in California.

Valuation is key to watch. Sempra's strong fundamentals, growth potential, and relatively small exposure to California are positives, but the long-term outlook for its gas business is a risk.

What About Wildfires' Impact on California Utilities?

Wildfires are a very real risk for California utilities, but the level of risk varies by utility, primarily because of the geography of their service territories. Wildfires during the past decade have been concentrated in PG&E's service territory, which is much larger than the service territories for Edison International's Southern California Edison or Sempra's San Diego Gas & Electric.

That said, property damage and casualties--not acres burned--are the most important variables for investors to consider. Utilities' equipment has contributed to eight of the 20 most destructive wildfires in state history when measured by structures damaged.

This is where California utilities turn to the California Wildfire Fund, which "exists as a mechanism for utility companies to recover certain costs and expenses arising from covered wildfires, after it has been determined that the fire was caused by the participating utility."

Still, some investors are concerned that another devastating wildfire season could drain this fund. We consider this a legitimate albeit low-probability risk.

The Role of the Utilities Sector in a Low-Carbon Economy

As California takes steps to its goal of eliminating carbon emissions by 2045, we estimate that the utilities sector will play the leading role in this effort by investing in infrastructure that supports more renewable energy, transportation electrification, and home and business electrification.

Despite a huge push, the state still needs much more wind, solar, and other emissions-free power generation to achieve net-zero emissions. And as it integrates additional renewable energy, the grid will need energy storage solutions.

Additionally, we forecast that California will far surpass nationwide electric vehicle growth if it stays on track to meet the state's emissions-reduction goals, and Edison is the best option for investors seeking exposure to electric vehicle growth in California.

Finally, residential and commercial buildings are the third-largest carbon emissions source in California behind transportation and electric power. Converting the existing building stock to electric space and water heating will be a huge challenge. Unsurprisingly, Edison is a strong supporter of building electrification since it is the only one of the state's three investor-owned utilities without a large natural gas business.

PG&E and Sempra are making a big push to integrate renewable natural gas and green hydrogen instead of building electrification, which would allow them to keep their gas customers and could create growth investment opportunities to prepare the system for new gas sources.