Value Investors Club / PG&E CORPORATION (PCG US)

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).

			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