Login

PG&E CORPORATION PCG US
July 27, 2018 - 6:35am EST by
value_31
2018 2019
Price: 44.70 EPS 3.80 4.03
Shares Out. (in M): 516 P/E 11.9 11.1
Market Cap (in $M): 23,115 P/FCF 4.9 4.2
Net Debt (in $M): 18,990 EBIT 2,827 3,430
TEV (in $M): 42 TEV/EBIT 10.9 12.2

Sign up for free guest access to view investment idea with a 45 days delay.

 
* Idea not eligible for membership requirements

Description

Summary Thesis: A dividend suspension has caused the market valuation of a regulated electricity utility to become disconnected from intrinsic value and create a very asymmetric payoff => limited fundamental downside (arguably none) at current valuation vs. ~50% upside to a conservative base case with a series of catalysts in the coming months
  • Asset value is predictable and stable => PCG Is a regulated utility. Cyclicality is not an issue, earnings and asset value are very stable and easy to predict (the likelihood the asset valuation here is materially wrong is low)
  • Limited Downside / worst case liability more than priced in => market value loss since the October 2017 wildfires commenced is ~$12.5 billion compared to a worst case liability of ~$7-8bn (net liability post-tax). Based on the market value destruction more than the worst case scenario is currently priced in. It’s far from certain the worst case comes to fruition (the worst case is not the base case)
  • Potential Upside => fair value in my base case is $68/share (+52% vs. current). Assuming the worst case for wildfire liabilities would imply fair value is $50/share (+12% vs. current). Assuming the best case outcome would imply fair value is $80/share (+80% vs. current). More details in the main body of the write-up 
  • Why does the opportunity exist? => PCG suspended its dividend in December 2017. This created significant share register churn (and a wave of indiscriminate selling) and makes the stock difficult/impossible to own for the ‘natural’ holder base of a regulated utility until the dividend is re-instated
  • Catalysts => broadly speaking there are two issues that need to be resolved for PCG’s valuation to move toward fair value ((i) & (ii) below) and a third issue that needs to be resolved for PCG to move to fair value: 
    • (i) Quantification of the 2017 wildfire liability: while this will ultimately take many years to finalise (and thus the NPV of the liability is lower than the headline numbers above) events in the coming weeks/months will narrow the range of outcomes considerably;
    • (ii) Reinstatement of the dividend: this will be done once the liability in (i) is quantified 
    • (iii) Resolution of the “Inverse Condemnation” liability standard for utilities in California. In short, utilities in California are strictly liable for civil damages caused by wildfires (even if the utility was not negligent) on the basis they can subsequently recover damages through customer rate increases. For reasons I describe below there are three pathways by-which more clarity will be provided on this issue: (i) judicial (likely timing 2019); or (ii) legislative (4 bills currently before the state legislature); or (iii) California Public Utilities Commission
(1) BACKGROUND
In October 2017 multiple wildfires began at different locations throughout Northern California which ultimately caused significant damage across at least a dozen counties (see here: https://en.wikipedia.org/wiki/2017_California_wildfires and here: https://en.wikipedia.org/wiki/October_2017_Northern_California_wildfires for background).
 
The estimated damages pre-tax for the Northern California wildfires in PCG’s service area are between $6-11 billion depending on the data source you look at. Here are five:
  • CA State Insurance Commissioner: ~$10.0bn (https://www.insurance.ca.gov/0400-news/0100-press-releases/2018/release013-18.cfm)
  • Aon Benfield: ~$11bn (http://www.artemis.bm/blog/2018/01/25/california-wildfire-industry-losses-put-at-13-2bn-by-aon-benfield/)
  • RMS: ~$6-$8bn (http://www.rms.com/blog/2017/10/27/wine-country-wildfires-reconnaissance-and-loss-estimate-update/)
  • PCS: ~ $10.4bn (http://insider-publishing.msgfocus.com/q/17Lc0hgjcNvLt01DVGOMv2/wv)
  • AIR Worldwide: $8-10.5bn (http://www.air-worldwide.com/Press-Releases/AIR-Updates-Insured-Loss-Estimates-for-California-Wildfires/)
 
 
 
 
 
 
 
 
 
 
 
The current application of California law is supposed to work as follows: (i) a private utility is liable for damages if its equipment was the cause of a fire (under the legal theory of inverse condemnation); but (ii) the utility is then able to recover these damages through an increase in (regulated) rates charged to customers. In theory there could be a timing mismatch but the utility is not ultimately out of pocket for the damages unless it behaved imprudently. If that’s how things end up working PCG is worth no less today than it was in October 2017 (i.e. ~$70/share or +~60% vs. current). However, like many things the realities are a little more complex.
 
(2) VALUATION RANGE
 
(A) Market value destruction since 2017 wildfires 
Approximately $12.5 billion of market value has been eviscerated since the wildfires commenced on 11 October 2017. This is idiosyncratic and related to the 2017 wildfires – the average/median performance of PCG’s comps is roughly flat over the same period. The market is implying the wildfires destroyed $12.5 billion of after-tax value at PCG.
 
 
 
 
Please note the comps have been taken from the Pay Comparator Group from the PCG 2017 Proxy but exclude the two utilities with Californian exposure (Edison and Sempra) as these two entities have also experienced liabilities from wildfires (Edison) and a de-rating in sympathy plus activist action from Elliot (Sempra) making them tainted comparables for the purposes of isolating the market value change above.
 
(B) Estimated Valuation Range
PCG is a regulated utility. As such, the predictability of its earnings stream is very high and the error bars around valuation are relatively narrow. Theoretically a regulated utility should be valued based on the difference between its allowable return on capital and its actual cost of capital on its exiting rate base plus any
excess value that can be achieved through growth (i.e. value created through the ability to deploy capital at returns that exceed cost of capital). If RIOC = actual WACC then the utility is worth 1.0x its regulated asset base (and the 1.0x increases if ROIC > actual WACC and decreases if ROIC < actual WACC).
 
Notwithstanding this, most regulated utilities in the US are valued by the market based on a P/E. Prior to the wildfires PCG was trading at approximately 18x P/E. Comparable companies currently trade at approximately 18x (median).
 
 
 
Using the P/E valuation framework the key valuation inputs for PCG will be:
  • (1) EPS estimate
  • (2) P/E Multiple
  • (3) Quantum of wildfire liability which PCG will ultimately end up paying for
 
Below is a summary valuation range. Unless one believes that PCG should trade at a material discount to comparable companies (and a material discount to its historical valuation) it’s difficult to argue there is fundamental downside, even assuming a draconian case for the 2017 wildfire liabilities. Regarding the valuation below EPS is an estimate (note: H1 2018 actual EPS is $2.07/share or $4.14 annualised) and the midpoint P/E multiple is broadly in line with history and comparable companies. The wildfire liability estimate will require more explanation, which I will outline in detail below. Suffice to say, I think the asymmetry is compelling.
 
Please note that PCG is growing its rate base at a high single-digit CAGR at an authorised ROE of 10.25%. As such, EPS will continue to grow going forward (and the base line valuation above will continue to grow).

 

 
 
 
 
Also, as a cross check from above the market value destruction since the fires is ~$12.5 billion, which equates to approximately $16.5 billion of damages pre-tax (assuming a 24% aggregate federal + state tax rate). The highest estimate of damages is $11 billion (per above). Add something to this to account for legal fees and additional (as yet unknown) damages and it’s still difficult to get to $16.5 billion. Also please bear in mind when thinking about PCG being liable for $16.5 billion: (i) this implies PCG is liable for 100% of damages (which is unlikely); (ii) there are no settlements for less than the full claimed amount (almost unprecedented) (iii) PCG gets zero recovery from 3rd parties (also unlikely); (iv) PCG gets zero recovery from FERC and the CPUC (unlikely); and (v) PCG cannot claim on its insurance (company has said it expects to receive $800 million of insurance proceeds). As long as one believes that the damage PCG will ultimately end up paying for (i.e. after recoveries) is less than $16.5 billion (i.e. less than 50% greater than the highest estimate of gross insured damages) then the current valuation is attractive (i.e. the market value decline is too severe). 
 
Estimated Damages (Feeds Into The Valuation Above)
Below is my estimate of damages. The insured claims estimate is in line with the data from the sources described above and the additional liabilities are estimates (which I believe are conservative). PCG’s equipment is often shared with 3rd parties (e.g. telecom companies that place equipment on PCG poles) and there is precedent for recovery by utilities from 3rd parties where 3rd party equipment or acts/omissions were a contributor or cause of the fire. FERC also allows recovery (through rate increases) for assets it regulates and there are precedents supporting this. PCG is also entitled to seek recovery of damages through increased rates
on customers (see discussion on inverse condemnation below for more details).
 
 
 
 
 
Note that a key variable is whether specific fires were actually caused by PCG equipment (PCG cannot be responsible for damage if its equipment did not cause the fire). In aggregate there were 19 fires. The California Department of Forestry and Fire Protection (Cal Fire) investigates each fire to determine the cause. Cal Fire has determined the cause of 16 fires with determinations on three fires remaining. One of these three remaining fires, the Tubbs fire, is estimated to account for approximately 60-70% of total damage (i.e. $6-7 billion of damage). The determination of cause for this fire will be important – if PCG is determined not to be the cause of the Tubbs fire that alone will reduce the maximum total liability by ~$11-13 per PCG share (or 25-30% upside to the current share price). While the outcome of the Tubbs fire investigation is impossible to predict there are some data points that are important to consider: 
  • An incident report was issued for a private residence at Bennett Lane, which is believed to be the ignition point for the Tubbs fire. The contents of the report indicate that Cal Fire took possession of secondary service lines that had detached from the home and certain customer-owned equipment. The report also indicated that no damage to PCG equipment was readily apparent. While not dispositive, the equipment that appears to be damaged is not PCG equipment (see report here: http://cpuc.ca.gov/uploadedFiles/CPUC_Public_Website/Content/Safety/USRB_FW_%20Electric%20Safety%20Incident%20Reported-%20PGE%20Incident%20No_%20%20171026-8601.pdf ) 
  • On 25 July 2018 a Cal Fire representative appeared at a legislative conference committee and indicated that determining the cause of the Tubbs fire could be difficult and that equipment from the ignition area had been sent to a 3rd party for review (which is unusual). This suggests an inconclusive outcome is possible (or at a minimum a clear determination of cause is difficult). For what it’s worth this was an exchange on this topic on PCG’s 2Q call
Christopher Turnure, Analyst:
Okay. And then one other question on the Cal Fire testimony from yesterday. I'm wondering
if in all your experience with Cal Fire investigations Butte or the fires, et cetera, how
frequently you've been aware of equipment being sent to third parties for review.
 
Geisha Williams, Chief Executive Officer and President: We don't have a lot of visibility to the
inner workings of Cal Fire's investigative process. So, we don't know if this is highly unusual
or something that they do more regularly it really there is no transparency on that.
 
Christopher Turnure, Analyst: Okay. Got it. But you haven't typically seen that in the past.
 
Geisha Williams, Chief Executive Officer and President: Not that, I'm aware.
 
 
A Case Study on Damages – the Witch Fire (San Diego Gas & Electric Liability)
The Witch fire was the 2nd largest wildfire of the 2007 California wildfire season. The total economic loss claimed on the fire was $4 billion. This total liability was reduced to $2.4 billion (or 60% of the loss claimed) after settlements. SDG&E started settling claims in June 2009, about 18-20 months after the fires. In addition
to insurance proceeds SDG&E was able to recover from a number of 3rd parties which reduced SDG&E’s ultimate liability to $379 million.
 
 
SDG&E attempted to recover this $379 million residual amount through a case at the California Public Utilities Commission (CPUC). This request was unsuccessful as the CPUC found SDG&E did not meet the prudent manager standard for recovery (see here: http://docs.cpuc.ca.gov/PublishedDocs/Published/G000/M199/K994/199994592.PDF ). However, the important takeaways are (i) the ultimate amount of pre-tax damages for SDG&E in this case was 39% of the original total liability claim (before insurance proceeds) and 11% after insurance proceeds; and (ii) this was despite SDG&E being deemed by the CPUC not to have acted prudently. If SDG&E was deemed to have been prudent it would have recovered 100% of the residual amount (i.e. SDG&E liability would have fallen from 11% of the original economic claim to zero).
 
Recovery of Damages from Customers
As a regulated utility PCG is entitled to seek recovery of damages through increased rates on electricity customers as long as these damages did not result from the wrongful conduct or negligence of PCG. The result of this is that PCG should not be out of pocket for wildfire damages (i.e. the liability outlined above ‘should’ be zero) as long as PCG has not acted negligently. I believe opacity created by a recent CPUC decision has caused some investor concern around the legal theory of Inverse Condemnation which is also contributing to PCG’s depressed valuation. There are both judicial and legislative pathways currently progressing to address/clarify the Inverse Condemnation situation. I believe resolution of the Inverse Condemnation “issue” is likely and also believe this will cause a re-rating in PCG’s valuation.
 
 
 
 
 
 
 
 
 
(3) BACKGROUND TO INVERSE CONDEMNATION
Typically in order to be liable for civil damages a plaintiff must show that said damages were proximately caused by the wrongful conduct of the defendant. This is not the case for regulated utilities in California. Under the current application of the law in California a regulated utility is liable for civil damages simply by
being the cause of said damage – i.e. civil damages accrue based on strict liability rather than wrongful conduct or any finding of negligence by the utility. In other words, a utility will be held liable even if there was nothing the utility reasonably could have done to prevent the damage.
 
The theory of Inverse Condemnation determines that the state is required to provide compensation to a private party when it takes or damages that party’s property for the public use through eminent domain. California courts have explained the policy objective underlying inverse condemnation is to distribute throughout the community the loss inflicted upon an individual by the making of public improvements: to socialise the burden. The underlying premise is that the cost of damage from a public good can be better absorbed with less hardship by taxpayers as a whole.
 
The doctrine originated by application to publicly owned utilities and perhaps is logical in that domain (i.e. the state, which is the owner of public utilities, has taxing power) but California courts have also extended the doctrine to privately owned utilities. The rationale for this was that there is no distinction between a public and private utility because private utilities are able to pass on (i.e. recover) damages to customers through increases in (regulated) rates charged. The California court of appeal made this explicit in the case of Pacific Bell Telephone Company v. Southern California Edison Company:
“Edison argues that this loss-spreading rationale does not apply because as a public utility it does not have taxing authority and may raise rates only with the approval of the California Public Utilities Commission. We note … that Edison has not pointed to any evidence to support its implication that the Commission would not allow Edison adjustments to pass on damages liability during its periodic reviews.”
 
This is a critical point. There is an explicit presumption that inverse condemnation is applicable to privately owned utilities because utilities can pass on damages to the community as a whole – i.e. the loss inflicted on the individual will be socialised to the community in the form of an increase in electricity rates (the equivalent of the taxing power of the states).
 
 
 
From a practical perspective, a private utility (unlike a public utility) needs to have rates approved by the California Public Utility Commission (CPUC). The implicit presumption from courts is that the CPUC would allow said rate rises and thereby enable the loss spreading that is a key limb of inverse condemnation to operate effectively from a policy perspective. In general, this was the way things operated until the CPUC’s decision in SDG&E in late 2017.
 
CPUC Decision in San Diego Gas & Electric (“SDG&E”)
In 2007 several wildfires spread throughout portions of Southern California. After the fires, Cal Fire and the CPUC’s Consumer Protection and Safety Division attributed the ignition of three of these fires to electrical facilities owned and operated by SDG&E. SDG&E established a Wildfire Expense Memorandum Account
(WEMA) to track costs associated with the fires. SDG&E applied to the CPUC to recover, through rates, certain costs in the WEMA account for unreimbursed costs that SDG&E paid due to inverse condemnation. After administrative review the CPUC denied SDG&E’s application for recovery of costs. The CPUC applied a
“prudent manager” standard under which it determines whether costs incurred are reasonable to deny recovery to SDG&E. In coming to its decision the CPUC explicitly stated that the loss-spreading principle of inverse condemnation is not a relevant consideration to cost recovery:
“Inverse Condemnation principles are not relevant to a Commission reasonableness review under the prudent manager standard … Even if SDG&E were strictly liable, we see nothing in the cited case law that would supersede this Commission’s exclusive jurisdiction over cost recovery/cost allocation issues involving Commission regulated utilities”
 
There are a number of implications of this development:
  • (1) A utility is strictly liable for damages (cause is all that matters not wrongful conduct) but is not assured of “socialisation” (recovery) of these damages;
    • The adoption of a “prudent manager” standard by the CPUC is what causes this disconnect
  • (2) The judiciary may need to revisit its application of Inverse Condemnation – a key assumption underpinning the legal reasoning (socialisation/recovery of damages) no longer holds
  • (3) Market concern that utilities will be liable for damages without means for recovery (note: this is only where a utility has not been prudent)
It’s important to highlight that the CPUC acknowledges the current situation needs addressing. Concurrent with the SDG&E decision referenced above the CPUC Commissioners held a hearing in which they affirmed the CPUC’s policy but recognised that courts should revisit the continued application of inverse condemnation to private utilities that, unlike public utilities, cannot automatically spread inverse condemnation costs. At that hearing Commissioner Rechtschaffen stated:
“It is worth nothing that the doctrine of inverse condemnation as it’s been deployed by the courts and applied to public utilities may be worth re-examining in a sense that the courts applying the cases to public utilities have done so without really grappling with the salient difference between public and private utilities, which is that there’s no guaranty that … private utilities can recover the cost from their rate payers. So this is an issue that the legislature and the courts may wish to examine and may be called on to examine in the future. But having said that, it doesn’t change our obligation to rule that the utility can’t recover unless they acted prudently.”
 
How Does This Get Resolved?
As this write-up is getting long I am happy to take this up in more detail in the comments if people have questions but in summary there are two avenues for the Inverse Condemnation Issue to be resolved: (1) Judicial; and (ii) Legislative. Either avenue has the ability to clarify/resolve the Inverse Condemnation issue and thereby provide certainty that wildfire damages incurred by a utility will be recovered.
 
(1) Judicial review: for the reasons outlined above there is a good legal argument that post the CPUC decision in the SDG&E case a core underpinning of the legal theory of Inverse Condemnation no longer holds, namely the explicit presumption that a private utility can recover damages from rate payers. Without this, courts should rule that Inverse Condemnation does not apply to privately owned utilities. PCG have appealed cases to the California Appeals Court and have sought leave for the California Supreme Court to hear this issue. The general view is that PCG’s arguments to overturn the current application of inverse condemnation are strong.
 
(2) Legislation: The Governor of California and senior legislative leaders have jointly sought to have the Inverse Condemnation issue addressed in the current California legislative session, which ends on 31 August 2018. See for example:
  • Governor Brown and Legislative Leaders Issue Statement on Formation of Wildfire Preparedness and Response Conference Committee: https://www.gov.ca.gov/2018/07/02/governor-brown-and-legislative-leaders-issue-statement-on-formation-of-wildfire-preparedness-and-response-conference-committee/ 
  • Gov. Jerry Brown proposes changes in utilities’ wildfire liability http://www.pressdemocrat.com/news/8564494-181/gov-jerry-brown-proposes-changes?sba=AAS 
There are currently four bills pending in the California State Assembly relating to wildfires/inverse condemnation. Of these SB 1088 and AB33 are the most important: 
  • (i) SB 1088: Requires IOUs to develop a safety, reliability, and resiliency plan and establish a memorandum account to track costs associated with the plan. The bill would require the CPUC to allow recovery of the memorandum account and future disaster events if a utility is in compliance with their plan
  • (ii) AB33: a bill to allow the securitization of prudently incurred costs arising from the 2017 Wildfires (i.e. the CPUC can authorise creation of a securitization vehicle whereby debt securities issued will be repaid from increases in customer rates levied over many years into the future)
  • (iii) SB 901: require any wildfire mitigation plan put forth by a utility to include protocols for when the utility should deenergize its electrical lines and deactivate its reclosers
  • (iv) SB 819: CPUC to take a more nuanced approach to their reasonableness standard
There is also extensive Committee conference and consultation progressing (see here for a recent example: http://focus.senate.ca.gov/sites/focus.senate.ca.gov/files/SB%20901%20Conference%20Committee%20Agenda_7.25%20Hearing.pdf)
 
The intention appears to be to pass legislation in the next month. The most likely outcome is that the bills above get combined and re-written to adopt some or all of the concepts contained therein. I expect there will be more press and other information forthcoming about legislative progress in the coming weeks.
 
Background reading on Inverse Condemnation:
 
(4) CONCLUSION
PCG appears to be pricing in a worst case outcome related to liabilities for the 2017 Wildfires. This seems like a low probability result as it’s not yet clear PCG was the cause of all fires, there are generally settlements (lowering liabilities), recoveries from 3rd parties (lowering net liabilities) and the ability to recover from FERC
(federal) and the CPUC (state). Legislative bill AB33 also proposes securitisation of the liability with repayment  of this liability from increases in customer rates. If any of these things happen the current valuation is almost impossible to justify. I believe the reason for this mispricing is the suspension of PCG’s dividend which has caused the shareholder base for PCG to move to transition to holders with a much higher cost of capital. PCG will be in a position to reinstate the dividend after there is more clarity on 2017 wildfire liabilities (and in particular causation for the Tubbs fire). I expect this clarity in the coming months. Finally, the 2017 wildfires
have brought the issue of inverse condemnation onto the legislative and judicial agenda and there are pathways where opacity around this issue can be clarified. While it’s not in the numbers and valuation I present above I believe that resolution of Inverse Condemnation (i.e. putting California on the same footing as
other states) could create a not unreasonable argument that California utilities should trade at a premium valuation to peers to account for superior growth and high regulated returns. PCG is forecasting high-single digit rate base growth at >10% regulated ROE. California’s clean energy agenda creates a growth runway for
regulated utilities for decades to come. For many reasons California (with resolved Inverse Condemnation) is one of the most attractive jurisdictions in the United States for regulated utilities.

 

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 

 

I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise hold a material investment in the issuer's securities.

Catalyst

  • Progress on Inverse Condemnation legislation – end August 2018
  • Progress on Inverse Condemnation judicial path – various events in 2018 & 2019
  • Report on cause of Tubbs fire – no confirmed date but should be in the coming months
  • Dividend reinstatement – once there is clarity on the quantum of damages from the 2017 wildfires
    show   sort by    
      Back to top