Description

Idea

PG&E is a Californian electric utility which will be subject to litigation revolving around the potential liability incurred by the Company’s role in the recent Californian wildfires. 

A massive turnover in the shareholder base and a 40% drawdown in PG&E’s equity proceeded a prudent dividend halt by PG&E management to bolster the b/s while they were being scrutinized for potential liability relating to the wildfires. 

I think the equity is cheap on its own right as the share price today prices in full responsibility for all outstanding insurance claims related to the wildfires (~$9 bn), plus a 40% gross up for uninsured claims, plus legal fees (for defending and to compensate plaintiffs) - but what truly excites me are the 2019 LEAP calls. 

Situation Overview

PG&E cut their dividend in December to bolster their balance sheet as their operations were soon to be investigated for potential involvement in the sparking of the recent northern California wildfires. 

The precedent in California suggests that utilities are to be held liable for damages caused by wildfires if their equipment is found to the cause of such fire (even if they are otherwise following regulations perfectly and all of their equipment passed inspection to the highest grade). 

Given this precedent and a natural shareholder base focused solely on yield, a significant dislocation in PCG’s trading price took effect post the announcement of the dividend cut. 

The reality, however, suggests that while a large investigation will likely find PG&E partially liable for some of the damages, it is unlikely PG&E will be found fully liable and unable to  reduce / recover such damages (both insurance claims and legal fees) through appeals / CPUC. 

Magnitude of liability 

PCG has about $800mm of insurance for this event. 

Every $1bn charge would be 26mm shares issued at current equity prices. 

Insurance claims outstanding are around $9bn. 

Gross up for potential uninsured claims of 40% suggests a potential further ~$3.6bn of potential claims. 

PCG’s own and potential compensation for Plaintiff legal fees may range in the $1-3bn range for a total $13.6 - $15.6bn of potential liabilities. 

Let’s call it $15.6 for good measure. That’s $14.8bn after insurance of pre-tax charges or 385mm shares issued. 

This would dilute 2018 eps to $2.18 from current estimates of $3.82. At a 17x utility multiple, the bear case would be a $37 stock. If they aren’t materially found liable for damages, it’s a $65 stock (17x $3.82). There’s a large range of outcomes in  between but my feeling is that the result will be a bit more binary than scaling, and the current valuation assumes the worst case scenario. 

LEAPs and Valuation

A common misstep of the black scholes option pricing model is the inability to properly price IV for fundamental binary events embedded in the underlying equities. 

Here we have a Utility that will likely be held liable for a minuscule amount of damages with a tail risk of being held liable for the full ~$15-16bn of potential claims whose one year implied volatility is only in the low 30% range. 

This optionality is clearly underpriced, the $50 strike 2019 LEAP calls trade for $1.95 (ask); if damages turn out to be miniscule this is a $65 stock and the return will be $15 - 1.95 / 1.95 = 670% (assuming dividends are NOT reinstated in the interim). 

If the liability turns out to be for 100% of the outstanding insurance claims, with 40% gross-up for uninsured claims, the legal fees chip in a few billion, AND if PCG is unable to successfully reduce this liability through appeals or through recoveries through the CPUC then you will lose $1.95 per share through the options (-5%). This analysis ignores value from the Loss carryforwards generated from claims. 

Precedents: 

In the past the 2015 “Butte” fire had a total of $750mm insurance claims; PCG had $900mm of insurance. In 2007, SRE had insurance claims of $2.4bn related to a fire (but only $380mm net of insurance).

Catalyst

Size of claims

future litigation results