Description

Edison International Equity Long

Shameless Hype. 

Value investing got you down? Wondering how an S&P 500 trading at 21x a post-implied-V-recovery-2021 EPS is meant to produce acceptable rates of risk-adjusted return over the next five years? Wondering if we are going to inflate our way out of this recession and cash is the worst investment or, conversely, a 2nd wave of Covid-19 is going to bring us back to market levels in March ’20 and you’ll wish you had plenty of dry powder? Are you simultaneously afraid of significant inflationary pressure and asset markdowns? Have I got a stock for you!! Trading at a value multiple of 11.8x P/E, growing earnings 7-8% per annum for the foreseeable decades (plural, not a typo), paying a 4.5% cash dividend, and a regulated monopoly.

Bearings. 

Edison International’s primary holding is Southern California Edison, a regulated utility serving 15 million customers in Southern California. Catalyzed by California’s utility regulator (the CUPC) denying SDG&E recovery of costs arising from the Witch Fire in 2009, investors no longer felt comfortable assuming that EIX would be able to pass costs to the ratepayers for liabilities arising from the 2017 Thomas and 2018 Woolsey wildfires. Coupled with the PG&E bankruptcy, real-money investors abandoned the California utility stocks wholesale in 2019.

The current fires in California are no doubt contributing to EIX weakness, but after unprecedented 2019 changes to the utility compact in California between the utilities, regulator, government, and ratepayers, unlike in years past, EIX has several additional protections including a) a large state-wide insurance fund, b) a higher innocent until proven guilty bar (vs the other way around previously) required to attribute damages to the utility, c) wildfire mitigation spending increase by several orders of magnitude, d) mandate to turn the power off more aggressively, and e) government recognition that California needs well-functioning electrical utilities that can access the capital markets at attractive costs of capital in order to keep the lights on…literally.

This write-up builds on a great EIX write-up from ElCid last year at this time. A year ago, EIX was trading at $66/share, trading at 14.5x fwd earnings (vs 18.5-20x for comps), paid a 3.7% cash dividend and had an intrinsic value = $85-90/share. Now EIX is trading at $56/share, 11.8x fwd earnings (vs 18.5-20x for comps), pays a 4.5% cash dividend (that is not at risk of getting cut), and worth at least $90-95/share, if not more, given its peer-leading earnings growth trajectory.

And in a world where value is difficult to find, EIX is a monopoly, pure-play, electric utility. With a regulated return to equity of 10-11% on every book equity dollar it spends. Further, EIX has excellent and easily identifiable equity spend tailwinds driven by a lawfully mandated rapid electrification of California as well as wildfire mitigation spend.

Why is it trading here? 

After PG&E bankruptcy and record wildfires in California, utility investors have abandoned EIX, for fear that inverse condemnation (primer below) will bankrupt EIX as well. Your typical utility investor does not own utilities for “excitement,” and the hedge fund investors are more focused on the carcass to phoenix potential at PG&E (pssst, that’s a losing bet because…geography…more below in (3) under variant perceptions).

In addition, we are in the middle of the worst part of fire season (typically ends by mid-November), and this is been a very visceral, graphic, tragic fire season, but notably, none of the major fires in 2020 that EIX may have been involved with will create liabilities greater than the $1B of commercial insurance they carry, let alone touch the Wildfire Insurance Fund.

Variant Perceptions:

(1) EIX trades at 6-7.0x price/earnings discount to the average level for US electric utilities on 2020 earnings, too wide now that the passage of AB-1054 protects EIX from permanent value destruction due to wildfire damage. In fact, where in this market can you find an equity trading at

2)  Once the dust settles and investors get comfortable that

A) the new earnings guarantee paradigm for California’s utilities is effective,

B) EIX is efficiently emulating SDG&E’s best practices against utility-caused wildfires:

Examples of wildfire mitigation investments include (per CEO on q2 ‘20 call)

“Since the beginning of the year, SCE has completed more than 330 miles of covered-conductor, installed nearly 400 additional weather stations, and completed over 135,000 ground-based inspections of our infrastructure and high fire risk areas. SCE is also making good progress in acquiring more high-definition imagery through a combination of helicopters and drones to facilitate additional assessments that are not possible from the ground.”

In additional Cal Fire has bolstered its resources (per CEO on q2 ‘ 20 call)

“For instance, CAL FIRE reported that it completed all of the planned 35 emergency fuels management projects in May, making 90,000 acres safer ahead of wildfire season and protecting 200 vulnerable communities. Some of these projects were located in or adjacent to SCE service territory. CAL FIRE has also made substantial investments to support its firefighting capabilities, including the addition of C-130 airplanes and new helicopters with better night firefighting capabilities.”

C) Then investors will re-focus on the earnings growth trajectory which is buoyed by decades-long visibility in annual above-market rate base growth.

3)  Geography. Two points: a) drought, b) population/property concentration.

a. Many generalist investors do not understand just how drastically different the drought is impacting Northern California versus Southern California. A little history is helpful. Historically EIX’s and SDG&E’s territory in Southern California has been drought prone and windy which is conducive to wildfires. Northern California has been historically much wetter and not prone to wildfires. That all changed during the last seven years as the many years long drought (likely structural in nature) has killed over 100 million trees in Northern California, creating an abundance of fuel in a utility territory unused to wildfire risk. Additionally, much of northern California is mountainous and much more difficult to monitor, protect, and maintain equipment. Additionally, fighting fires in the foothills and mountains of northern California is a much greater physical challenge.

b. If you look at the maps below, you can see that the majority of EIX territory is desert which supports very little population and does not produce significant wildfire fuel. Conversely, all of Northern California is forestland or (tall, dry) grassland and the population is spread widely across many highly populated towns in the foothills (the most dangerous place to live…e.g. the wildland-urban interface area).

Valuation:

Key Risks:

Southern California Emigration. Without wasting time on Cormack McCarthy style dystopian end-of-world scenarios, it’s possible that families and businesses decide California’s drought and wildfires are too much to handle and begin to move out of the area. This would be like revenue-water-torture in that it would slowly erode the number of paying customers that can split the electrical bill, raising electricity prices on those remaining, and likely eroding the terminal value of the utility, imperceptibly at first, and then rapidly, as history has shown cities decline.

Primer on California’s Changes to Regulatory Compact with State Utilities

Overview of Strict Liability and Inverse Condemnation.

In the simplest sense, strict liability for inverse condemnation applies when a government harms private property intentionally or accidentally. In this scenario, the government must pay just compensation to the harmed property holder. This concept has been upheld in court many times. It’s meant to spread out the cost of government actions (which are presumed to benefit the entire populace) by using the government’s taxing ability on the entire populace to pay for the costs. In California, unlike any other state in the US, strict liability for inverse condemnation applies to its utilities as well.

Using a more tangible example, in California, if a windstorm causes a utility wire to arc and start a fire, all damages from the fire (whether the utility was at fault or not), are paid for up-front by the utility. Then the utility applies to the regulator (the CPUC) for cost recovery, to be charged by raising rates incrementally to its entire ratebase (ratebase = all electrical customers in a utility’s territory). Or at least that’s how everyone assumed it would work, until November 2017 when the CPUC shocked the California utilities and their investors by not granting cost recovery to SDG&E for their involvement in the 2007 Witch Fire, “based on a determination that SDG&E did not meet the CPUC’s prudency standard.” You might have missed it if you were focused on Powell’s appointment to the Fed or the Mueller investigation, but California utility shareholders were suddenly jolted into the realization that they may be on the hook for the enormous fires raging across the state in 2017 (and again in 2018). Cue Wile E Coyote falls off a cliff sound.

SB-901

Legislators first attempted to support the state utilities without “letting them off the hook” after the major wildfires of 2017 (Tubbs and Thomas) was the passage of Senate Bill 901 in September 2018. This bill stipulated that the CPUC could consider whether climate change played a role in the cause of the fire, put in place a “stress test” to determine a utility’s ability to pay (and not exceed it), allowed wildfire liability securitization funds (but bizarrely omitted fires in 2018), mandated each utility submit a wildfire mitigation plan (WMP), and established a Blue Ribbon Commission to evaluate general reform of the burden-sharing framework, including inverse condemnation and potential state wildfire insurance.

PG&E’s Bankrupt in January 2019

California’s 2018 wildfire season ended with the most damaging fire in state history known as the Camp Fire in November 2018. With a vague set of rules that had never been tested in SB-901, PG&E opted to file for bankruptcy in January 2019. The company believed bankruptcy “in the best interests of all stakeholders, including wildfire claimants and PG&E’s other creditors and shareholders.” 

Rating Agencies Downgrade EIX Debt in March 2019

In March 2019, Moody’s downgraded the debt at SCE and warned that without a  near-term legislative fix before the 2019 fire season they would downgrade the debt to junk.

Governor Newsom’s Strike Force

In early 2019, Governor Newsom organized a Strike Force of experienced utility experts to outline the options for a legislative solution that kicked off a sprint to pass a bill by July 12, 2019, the last day of the legislative session before the start of fire season.

AB-1054 – Urgency Bill Passed July 12, 2019

AB-1054 made the following key changes to the utility regulatory pact in California:

·        Prudency Standard – “innocent until proven guilty” standard, whereas previously the utility was presumed guilty until they proved they were innocent

·        Created a $21B statewide wildfire insurance fund. $10.5 billion is funded by ratepayers and $10.5 billion by the utilities. EIX is responsible for 31.5% PG&E for 64.2% and SDG&E for 4.3%. In addition, insurers agree to cap subrogation claims at 40% of total insured claims.

·        Liability Cap – in the event that wildfire damages arise due to utility negligence, each major utility’s absolute liability is capped at 20% of its T&D rate base equity (which includes its FERC regulated rate base equity) and covers a rolling three-calendar year period. In practice, this means that approximately $2.6B of EIX’s earnings could be at risk, or roughly half its projected earnings over the next three years. Any amount in excess of the cap would be deemed an eligible claim against the Wildfire Fund.

·        PSPS: Public Safety Power Shut-off - utilities are permitted to shut-off electricity much more aggressively when weather conditions are high risk for wildfires.

Catalyst

End of fire season Nov 15-30

Patience (for investors to realize the stock is safe again)