PCG and EIX Remain Compelling Investments Given the Legal and Financial Implications of the Cal Fire Reports

gcopley
Print Friendly, PDF & Email

______________________________________________________________________________

Eric Selmon Hugh Wynne

Office: +1-646-843-7200 Office: +1-917-999-8556

Email: eselmon@ssrllc.com Email: hwynne@ssrllc.com

SEE LAST PAGE OF THIS REPORT FOR IMPORTANT DISCLOSURES

______________________________________________________________________________

June 12, 2018

PCG and EIX Remain Compelling Investments

Given the Legal and Financial Implications of the Cal Fire Reports

In this report we analyze the legal and financial implications of the Cal Fire reports released to date on the northern California wildfires and update our valuation of PCG in light of our analysis. We continue to see in PCG, and in EIX, compelling investment opportunities. Further updating our portfolio, we also remove D from our concerns list.

Portfolio Manager’s Summary

In Five Fires, PCG May Be Able to Recover Any Damages Paid or May Not Even Be Liable

  • The California Department of Forestry and Fire Protection (Cal Fire) has now released investigation reports on the causes of 16 northern California wildfires. Taken together, these 16 fires account for 34% of the structures destroyed by the northern California wildfires, and for 41% of the lives lost. Two large fires for which Cal Fire has yet to issue investigation reports, the Tubbs and Cascade fires, account for the remaining 66% of structures destroyed and 59% of lives lost.
  • In all of these fires, Cal Fire identified PCG’s equipment as the cause. In 11 fires, Cal Fire found evidence that PCG had violated state laws for vegetation maintenance and fire prevention, suggesting that there is evidence of negligence or imprudent behavior by PCG (Exhibits 2 and 3).
  • Based on the number of structures destroyed, these 11 fires where PCG was cited for violations could account for ~27% of the ~$16.6 billion in total damages caused by the northern California wildfires, and thus may be the source of ~$4.4 billion of claims for damages against PCG.
  • In the remaining four fires, Cal Fire identified factors apparently beyond PCG’s control that caused the fire, primarily falling tree limbs from apparently healthy trees with proper clearance from PCG’s powerlines. In respect of these four fires, PCG has a greater chance of proving that its behavior was prudent, that it is only liable for property damages due to the principle of inverse condemnation and that it should be allowed to recover from ratepayers any damages paid.
    • As these fires account ~7% of structures destroyed, PCG may be in position to recover a proportionate share (~$1.2 billion) of the ~$16.6 billion in total damages caused by the wildfires.
  • PCG has disclosed that it will book reserves against potential liabilities arising from 14 of the 16 fires. If PCG is correct on the two it excluded (the Atlas and Highway 37 fires) and is deemed to have acted prudently in connection with three other fires where Cal Fire found no evidence of violations, PCG may be in a position to avoid or recover any damages on fires accounting for 16% of the structures destroyed.  A proportionate share of the total damages caused by the northern California wildfires would be ~$2.6 billion (16% of $16.6 billion in total damages).
  • It is important to note that the Cal Fire reports are not definitive legal documents, but the start of the process of allocating blame and damages.Rather, they point to evidence that each side can use to support their position in litigation. Due to the large number of reports that Cal Fire had to prepare, and the unusual complexity of the conditions, PCG is likely to challenge the quality of the evidence and the conclusions of those reports identifying PCG as culpable.

PCG and EIX Remain Compelling Investments

  • In light of the Cal Fire reports, we have updated our valuation analyses of PCG and EIX. We continue to see in both stocks, but particularly in EIX, compelling investment opportunities.
  • We believe EIX to be significantly undervalued even in a worst-case scenario (see Exhibit 4).
  • In a scenario where EIX is required to pay in 2019 damages equal to the full value of all the insurance claims filed in respect of the Thomas wildfire and Montecito mudslides, plus our estimate of CPUC penalties and legal costs, we estimate the fair value of the stock at $71 per EIX share – representing 20% upside to Monday’s close of $58.94.
  • If, rather than litigate these claims, EIX were able to settle them for an average of 65 cents on the dollar (as San Diego Gas & Electric did with respect to the claims arising from the 2007 Guejito, Rice and Witch Creek fires), our estimate of the fair value of EIX rises to $75 per share, representing 27% upside from Monday’s close.
  • Finally, we have considered scenarios where (i) Edison is found not to be liable for the Montecito mudslides, resulting in an estimated value of $76 per share or 29% upside from Monday’s close and (ii) Edison is found not be liable for the Thomas Fire or the mudslides in any way, resulting in an estimated fair value of $79 or 33% upside from Monday’s close.
  • Our analysis assumes that California, whether through legislative, regulatory or court action, successfully protects it electric utilities against future wildfire risk, allowing the state’s utilities to resume trading at a modest 5% discount to the regulated electric utilities as a group. We have also conducted a sensitivity analysis where we assume that wildfire risk is not mitigated by the state, and as a result EIX and PCG trade at a 15% discount to the average regulated utility multiple.
  • As can be seen in Exhibit 5, this is a manageable risk in the case of Edison International, resulting in potential upsides of 7% from Monday’s close in the scenario where all damage claims are paid in full and 13% if these claims are settled at 65 cents on the dollar.
  • PCG provides more limited downside protection in a worst-case scenario, but offers material upside potential across a range of less adverse but more probable outcomes (Exhibit 6).
  • Valuing PCG at a 5% discount to the regulated utilities as a group, we estimate its value in a worst-case scenario, where it must pay all the damages arising from the northern California wildfires at their full face value, to be $44 per share, or 12% above Monday’s closing price.
  • In a scenario where PCG settles all the northern California wildfires claims at 65 cents on the dollar, however, we estimate fair value for the stock at $52, or 30% above Monday’s close.
  • Moreover, for every 10% of the damage claims arising from the northern California wildfires for which PCG is not found to be liable or is able to recover from ratepayers, we estimate the fair value of the stock rises by ~$1.70 per share.
  • We have also conducted a sensitivity analysis where we assume that California utilities’ wildfire risk is not mitigated by the state, and PCG trades at a 15% discount to the average utility multiple (Exhibit 7).
  • In this case, we estimate the fair value of PCG in our worst-case scenario (where it must pay all damages arising from the northern California wildfires) at $37, or 6% below Monday’s close.
  • In a scenario where PCG settles all claims arising from the northern California wildfires at 65 cents on the dollar, our estimate of PCG’s fair value rises to $44, 12% above Monday’s close.
  • We therefore believe PCG to be attractive primarily to those investors confident that California will find the means to protect its electric utilities from future wildfire liabilities, allowing the state’s utilities to trade once again at a modest 5% discount to the regulated utilities as group. Absent such reform, we continue to see potential downside risk in a worst-case scenario, although we see such a scenario as unlikely.
  • Finally, we are removing Dominion (D) from our list of least favorite hybrid electric utilities. It has significantly underperformed the group over the last several months and now trades at a 6% discount to large cap utilities (excluding EIX, PCG and PPL) on 2020 earnings. We believe this is a reasonable discount given the state of its balance sheet, the condition of the MLP markets, the need to execute on multiple transactions to raise capital, the low probability of the SCG acquisition succeeding and the low earnings quality of the company.

Exhibit 1: Heat Map: Preferences Among Utilities, IPP and Clean Technology

Source: SSR analysis

Details

The Cal Fire Reports and PCG’s Recorded Reserves Point to a Group of Five Fires Where PCG May Be Able to Recover Any Damages Paid or May Not Be Liable

The California Department of Forestry and Fire Protection (Cal Fire) has now released investigation reports on the causes of 16 of the northern California wildfires. In all of these fires, Cal Fire identified PCG’s equipment as the cause. In 11 fires, Cal Fire found evidence that PCG had for violated state laws for vegetation maintenance and fire prevention, suggesting that there is evidence of negligence or imprudent behavior by PCG.

In four fires, Cal Fire identified factors apparently beyond PCG’s control that caused the fire, primarily falling tree limbs from apparently healthy trees with proper clearance from PCG’s powerlines. In respect of these four fires, PCG has a greater chance of proving that its behavior was prudent, that it is only liable for property damages due to the principle of inverse condemnation and that it should be allowed to recover from ratepayers any damages paid. (See Exhibits 2 and 3).

In one of these fires, the Highway 37 fire, Cal Fire did not point to any specific evidence of PCG as a cause of the fire, but rather relied on the absence of evidence of other causes, which we believe is a very weak argument in favor of liability and consider this to be inconclusive. Therefore, PCG could avoid liability for this fire, which destroyed 3 structures, altogether.

In the last of its 16 fire reports, on the Nuns fire, Cal Fire again found no evidence of violations. The Nuns fire combined with five other fires to form one of the largest of the northern California wildfires (the Central LNU Complex) that destroyed 1,355 structures and killed three people. In respect of the four of these five contributing fires, Cal Fire has issued reports citing PCG for violations. The vast majority of the damage caused by the Central LNU fire appears to have occurred after the fires combined. If PCG is found negligent with respect to these contributing fires, therefore, it will likely be held responsible for most of the damages caused by the Central LNU fire. We would expect PCG to avoid liability only for non-property damage caused by the Nuns fire before it combined with the others.

Taken together, the 16 fires for which Cal Fire has issued investigation reports account for only 34% of the structures destroyed by the northern California wildfires, and for 41% of the lives lost. Two large fires for which Cal Fire has yet to issue investigation reports, the Tubbs and Cascade fires, account for the remaining 66% of structures destroyed and 59% of lives lost, with the Tubbs fire accounting for more than 95% of those numbers.

Nonetheless, the 16 reports issued by Cal Fire to date provide important information on the extent of the third party liability risk faced by PCG. For example, based on the number of structures destroyed, the 12 fires where Cal Fire cited PCG for violations could account for ~27% of the ~$16.6 billion in total property damage caused by the northern California wildfires, and thus may be the source of ~$4.4 billion of claims for damages against PCG.

Given PCG’s highly depressed valuation, however, we view Cal Fire’s decision not cite PCG for violations in connection with the remaining four fires for which it has issued investigation reports (the Redwood, LaPorte, Cherokee and Highway 37 fires) as holding open the possibility of a more favorable outcome than perhaps the market anticipates. These four fires account for ~7% of structures destroyed and 20% of the lives lost. Given Cal Fire’s assessment that PCG was not culpable for these fires, PCG may only be liable for property damages due to inverse condemnation and could be in position to recover these damages from ratepayers. Assuming these four fires gave rise to property damages commensurate with their share of structures destroyed, this would imply the potential for PGG to recover ~$1.2 billion of property damage claims, or the equivalent of 7% of the $16.6 billion in total damages caused by the northern California wildfires.

Interestingly, PCG has disclosed that it will book reserves against potential liabilities arising from 14 of the 16 fires. The exceptions are the Highway 37 fire and the Atlas fire, where PCG “does not believe a loss is probable at this time.” The Atlas fire was responsible for ~9% of the structures destroyed and 14% of the lives lost in the northern California wildfires.

If PCG is correct on Atlas and Highway 37, and the courts agree with Cal Fire’s assessment that PCG did not violate state law in connection with three other fires, PCG may be in a position to avoid any damages on the first two fires and to recover any damages paid in respect of the other three fires. Together, these fires account for 16% of the structures destroyed and 34% of the lives lost in the northern California wildfires. Based on the percentage of structures destroyed, a proportionate share of the total damages caused by the northern California wildfires would be ~$2.6 billion (16% of $16.6 billion in total damages).

Finally, it is important to note that the Cal Fire reports are not definitive legal documents, but the start of the process of allocating blame and damages. Rather, they point to evidence and offer expert witnesses that each side can use to support their position in litigation. Due to the large number of reports that Cal Fire had to prepare, and the unusual complexity of the conditions, PCG is likely to challenge the quality of the evidence and the conclusions of those reports identifying PCG as culpable.

Exhibit 2: Results of Cal Fire Reports on the Northern California Wildfires

_______________________

1. The Nuns, Adobe, Norrbom, Pressley, Patrick and Pythian fire originated as separate fires but later merged. While Cal Fire cited PCG for violations in connection with the Adobe, Norrbom, Patrick and Pythian fires, it did not do so in respect of the Nuns fire. Cal Fire has yet to release an investigation report on the Pressley fire.

2. The Cal Fire report on the Highway 37 fire does not point to any specific evidence of PCG as a cause of the fire, but rather relies on the absence of evidence of other causes, which we believe is a very weak argument in favor of liability. We consider this report, therefore, to be inconclusive.

Source: Cal Fire, SSR analysis

Exhibit 3: Breakdown of Released Investigation Reports by Fault and Potential Damages

_______________________

Source: Cal Fire, SSR analysis

Updated EIX and PCG Valuations

We have updated our valuation analyses of EIX and PCG and continue to see in both stocks, but particularly in EIX, compelling investment opportunities.

We have estimated the value of both companies in a worst-case scenario, where we assume that they must pay at full face value all of the claims for property, personal injury and other damages arising in connection with the 2017 wildfires. Our method for estimating the value of these claims, as well as CPUC penalties and legal costs, is set out in the appendix to this note.

We have also assessed the impact of select upside scenarios. The most important of these assumes that the two utilities follow the example of San Diego Gas & Electric, which in 2010 settled at 65 cents on the dollar all the claims brought against it in connection with the Guejito, Rice and Witch Creek fires of 2007.

We have also examined scenarios where the companies are able avoid damages or to recover from ratepayers or other parties some portion of the damages paid to claimants. These scenarios correspond to situations where (i) the principle of inverse condemnation does not apply because utility assets were not the cause of the damage, (ii) utility assets caused the fire, but the utility is found to have maintained and operated these assets prudently, and so is allowed to recover from ratepayers any damages paid under inverse condemnation, (iii) utility assets caused the damage but the assets or activities of other parties were important contributing factors, and (iv) utility assets caused the damage but these assets are subject to regulation by FERC, which may be more supportive of recovery than the California Public Utilities Commission (CPUC).

To quantify the financial impact of wildfire damage claims on the value of EIX and PCG, we have modeled each of these scenarios. Specifically, we have assumed that:

  • in a worst-case scenario, both companies must pay at full face value all of the property, personal injury, and other claims arising in connection with the 2017 wildfires and mudslides, as well as CPUC fines and legal costs, and that no recovery or securitization of these costs is allowed (see the appendix to this note for a detailed description of our assumptions);
  • in an alternative scenario, the utilities settle all the property, personal injury and other claims arising from the fires and mudslides by agreeing to pay 65% of the face value of these claims, reflecting the average ratio at which San Diego Gas & Electric settled the claims against it arising from the 2007 Guejito, Rice and Witch Creek fires;
  • in various upside scenarios, the utilities are allowed recovery of a fraction of the claims brought against them, sustaining no permanent financial loss, and settle the remainder at 65 cents on the dollar.

The assumptions we have used to quantify the financial outcome of these various scenarios are the following:

  • in each case, the utilities’ payments for damages due are made in mid-2019 and are funded immediately with equity to restore the utilities’ equity ratios to CPUC mandated levels;
  • the number of shares sold, and hence the dilutive impact of these offerings, reflects the ratio of (a) the damages to be paid (net of insurance and tax savings) to (b) the market value of the utility following the payment of these damages;
  • the market value of the two utilities, after payment of damages, can be estimated by multiplying consensus 2020 net income by the average forward PE multiple of the regulated utilities as a group[1], discounted by 5% for California risk. In so valuing the companies, we assume implicitly that California, whether through legislative, regulatory or court action, successfully protects it public utilities against future wildfire risk. We have also conducted a sensitivity analysis where we assume that utilities’ wildfire risk is not mitigated by the state, and where EIX and PCG could trade at a 15% discount to the average regulated utility multiple as a result.

Results: Edison International

Our analysis suggests that Edison International is significantly undervalued even in a worst-case scenario. We estimate the sum total of damage claims, CPUC penalties and legal costs faced by Edison International in connection with the Thomas wildfire and Montecito mudslides at $4.3 billion. (See the appendix to this note for an explanation of the assumptions underlying this estimate.) Net of insurance proceeds and tax savings, the loss to EIX is limited to $2.5 billion. We have estimated Edison’s fair market value after the payment of the damages in 2019 at $25.8 billion, by multiplying (a) consensus 2020 net income of $1,590 million ($4.87 per share on current share count of 325.8 million) by (b) the average one year forward PE multiple of U.S. regulated utilities (excluding EIX, PCG, PPL and SCG) of 17.1, discounted by 5% for California risk. To raise $2. 5 billion, therefore, Edison must sell a 9.8% interest in the company through a public offering or private sale of stock. The equity sale will thus require Edison International to increase its share count from the current 325.8 million to 361.4 million (325.8/90.2%), implying a fair market value per share, after the offering and payment of damages, of $71 per EIX share. Our estimate of the fair value of EIX, following the issuance of equity and payment of damages, represents 21% upside to Monday’s close of $58.94 (see Exhibit 4).

However, were EIX to determine, based on Cal Fire reports or internal evidence, that there was a high probability that it would be found liable for the damages caused by the Thomas Fire and Montecito mudslides, a more effective legal strategy might be to settle rather than litigate plaintiffs’ claims for damages. This was the strategy adopted by San Diego Gas & Electric in respect to claims arising from the 2007 Guejito, Rice and Witch Creek fires; in 2010, the utility was able to settle these claims for an average of 65 cents on the dollar. A similar outcome in respect of the Thomas Fire and Montecito mudslides would reduce Edison’s net costs, after insurance proceeds and tax savings, from $2.5 to $1.5 billion, similarly reducing the required sale of equity and raising our estimate of the fair value of EIX to $75 per share, representing 27% upside from Monday’s close (see Exhibit 4).

Finally, we have considered scenarios where (i) Edison is found not to be liable for the Montecito mudslides, resulting in an estimated value of $76 per share or 29% upside from Monday’s close and (ii) Edison is found not be liable for the Thomas Fire or the mudslides, resulting in an estimated fair value of $79 or 33% upside from Monday’s close.

Exhibit 4: Estimated Fair Value of EIX Stock, and Upside from Monday’s close, in a Worst

Case and Various Upside Scenarios

___________________________________________________________

1. We have estimated the fair market value of Edison International after the payment of all the Thomas wildfire and Montecito mudslide damages by multiplying (a) consensus 2020 net income of $1,590 million ($4.87 per share on current share count of 325.8 million) by (b) the average one year forward PE multiple of U.S. regulated utilities (excluding EIX, PCG, PPL and SCG) of 17.1, discounted by 5% for California risk. We have estimated the increase in shares outstanding as a result of the equity offering based on the ratio of (x) net damages to be paid, after insurance recoveries and tax savings, to (y) our estimate of the fair market value of EIX in 2019 after payment of the damages. Our estimates of fair value per share take into account the dilutive impact of the offering.

Source: Company reports, California Department of Insurance, SSR estimates and analysis

Given this range of potential upsides (21%-33%), we continue to find in Edison International a compelling investment opportunity, particularly in light of our medium term forecast for rate base growth (8.9% p.a. over 2018-2021).

Recall, however, that our assessment of fair value for EIX is predicated on the assumption that California, whether through legislative, regulatory or court action, successfully protects it electric utilities against future wildfire risk. We have also conducted a sensitivity analysis where we assume that utilities’ wildfire risk is not mitigated by the state, and where EIX could trade at a 15% discount to the average regulated utility multiple as a result. As can be seen in Exhibit 5, our analysis suggests that this is a manageable risk in the case of EIX, resulting in potential upsides of 7% from Monday’s close in the scenario where all damage claims are paid in full and 13% if these claims are settled at 65 cents on the dollar.

Exhibit 5: Estimated Fair Value of EIX Stock, and Upside from Monday’s close, in a Worst

Case and Various Upside Scenarios, Assuming No Action to Protect California’s Utilities Against Future Wildfire Risk

___________________________________________________________

1. We have estimated the fair market value of Edison International after the payment of all the Thomas wildfire and Montecito mudslide damages by multiplying (a) consensus 2020 net income of $1,590 million ($4.87 per share on current share count of 325.8 million) by (b) the average one year forward PE multiple of U.S. regulated utilities (excluding EIX, PCG, PPL and SCG) of 17.1, discounted by 15% for California risk. We have estimated the increase in shares outstanding as a result of the equity offering based on the ratio of (x) net damages to be paid, after insurance recoveries and tax savings, to (y) our estimate of the fair market value of EIX in 2019 after payment of the damages. Our estimates of fair value per share take into account the dilutive impact of the offering.

Source: Company reports, California Department of Insurance, SSR estimates and analysis

Results: PCG Corp.

Our analysis of PCG suggests that the stock provides more limited downside protection in a worst-case scenario, but we believe the stock offers material upside potential across a range of less adverse but more probable outcomes (see Exhibit 6). This is particularly so if we assume that California is successful, through legislative, regulatory or court action, in protecting its electric utilities against future wildfire risk, and California utility stocks as a result trade at only a 5% discount to the regulated utilities as a group. In this case, a scenario where PCG settles all the claims arising from the northern California wildfires at 65 cents on the dollar results in an estimated fair value for the stock of $52, or 30% above Monday’s close. Our estimate of the potential upside in this scenario falls to 12%, however, if we assume California does not mitigate its utilities exposure to wildfire liabilities, and the market consequently values PCG at a 15% discount to the group (see Exhibit 7).

We have applied the same analysis to PCG as we did to EIX, beginning with a worst-case scenario where PCG is required to pay in 2019 damages equal to the full value of all the insurance claims filed in respect of the northern California wildfires, plus our estimate of non-property and uninsured claims, CPUC penalties and legal costs. We estimate the sum total of these claims, penalties and legal costs at $16.6 billion (see Exhibit 6, as well as the appendix to this note for an explanation of the assumptions underlying this estimate). Net of insurance proceeds and tax savings, we estimate the out-of-pocket cost to PCG at $12.5 billion. Assuming an equity offering of this size is completed in 2019, we assess the fair value of PCG upon completion of the offering and payment of the damages to be $44 per share, ~12% above Monday’s close. This suggests to us that the market’s valuation of PCG already capitalizes a worst-case outcome, and that an investment in the stock implies little downside risk.

By contrast, the stock appears to offer significant upside across a range of more positive outcomes, whose cumulative probability in our view far exceeds that of the worst-case scenario just described.

Most importantly, were PCG able to settle all the damage claims arising from the northern California wildfires at 65 cents on the dollar, as San Diego Gas & Electric did in respect of claims arising from the 2007 Guejito, Rice and Witch Creek fires, our estimate of PCG’s fair value rises to $52, some 30% above Monday’s close. We believe this outcome to have a fairly high probability. Twelve of the 16 investigation reports issued to date by Cal Fire have uncovered evidence of alleged violations of state law, and were referred by Cal Fire to the appropriate county District Attorney’s offices for review. Rather than litigate the claims arising from fires for which it is apparently culpable, PCG may choose to settle, and plaintiffs may accept a discount on their claims to expedite recovery, reduce legal costs and avoid the risk of a potentially adverse court decision.

Shareholders may enjoy further upside if PCG is found not to be culpable for some portion of the total damages caused by the northern California wildfires. It is important in this respect that four of the twelve Cal Fire reports issued to date have found no evidence that PCG violated state law. By our calculation, these four fires (the Redwood, La Porte, Cherokee and Highway 37 fires) were responsible for the destruction of at least 626 structures, or ~7% of all the structures destroyed in the northern California wildfires.

Also significant is the fact that PCG has disclosed that it will book reserves against potential liabilities for property damages under inverse condemnation arising from only 14 of the 16 fires where Cal Fire identified PCG as the cause. The exceptions are the Highway 37 and Atlas fires, where PCG “does not believe a loss is probable at this time.” While Highway 37 destroyed only three structures, the Atlas fire was responsible for ~9% of the structures destroyed in the wildfires and 20% of the lives lost. If PCG is correct on Atlas and Highway 37, and the courts agree with Cal Fire’s assessment that PCG did not violate state law in connection with three other fires, PCG may be in a position to avoid or recover any damages paid in respect of these five fires. Together, these fires account for 16% of the structures destroyed in the northern California wildfires. Based on the percentage of structures destroyed, a proportionate share of the total damages caused by the northern California wildfires would be ~$2.6 billion (16% of $16.6 billion in total damages).

Our sensitivity analysis suggests that for every 10% of the northern California fire damage for which PCG is not liable, the fair value of PCG stock rises by ~$1.70 per share. If PCG is not liable for 10% of the total property damage caused by the northern California wildfires, and settles the remaining 90% at 65 cents on the dollar, we estimate the fair value of PCG stock at $53, representing 34% upside relative to Monday’s close. In a scenario where PCG is not liable for 70% of the total northern California wildfire damage (for example, were PCG found not to be responsible for the Tubbs, Redwood, La Porte, Cherokee and Highway 37 fires, or to have acted prudently and therefore able to recover from ratepayers the damages arising from these fires), we estimate fair value for PCG stock at $64, or 61% above Monday’s close (see Exhibit 6).

Exhibit 6: Estimated Fair Value of PCG Stock, and Upside from Monday’s close, in a Worst

Case and Various Upside Scenarios

___________________________________________________________

1. We have estimated the fair market value of PCG Corp. after the payment of all the northern California wildfire damages by multiplying (a) consensus 2020 net income of $2,160 million ($4.19 per share on current share count of 516.4 million) by (b) the average one year forward PE multiple of U.S. regulated utilities (excluding EIX, PCG, PPL and SCG) of 17.1, discounted by 5% for California risk. We have estimated the increase in shares outstanding as a result of the equity offering based on the ratio of (x) net damages to be paid, after insurance recoveries and tax savings, to (y) our estimate of the fair market value of PCG in 2019 after payment of the damages. Our estimates of fair value per share take into account the dilutive impact of the offering.

Source: Company reports, California Department of Insurance, SSR estimates and analysis

As in the case of EIX, our assessment of the fair value of PCG is predicated on the assumption that California, whether through legislative, regulatory or court action, successfully protects it public utilities against future wildfire risk. We have also conducted a sensitivity analysis where we assume that utilities’ wildfire risk is not mitigated by the state, and as a result PCG trades at a 15% discount to the average regulated utility multiple. We present the results of this analysis in Exhibit 7.

Exhibit 7: Estimated Fair Value of PCG Stock, and Upside from Monday’s close, in a Worst

Case and Various Upside Scenarios, Assuming No Action to Protect California’s Utilities Against Future Wildfire Risk

___________________________________________________________

1. We have estimated the fair market value of PCG Corp. after the payment of all the northern California wildfire damages by multiplying (a) consensus 2020 net income of $2,160 million ($4.19 per share on current share count of 516.4 million) by (b) the average one year forward PE multiple of U.S. regulated utilities (excluding EIX, PCG, PPL and SCG) of 17.1, discounted by 15% for California risk. We have estimated the increase in shares outstanding as a result of the equity offering based on the ratio of (x) net damages to be paid, after insurance recoveries and tax savings, to (y) our estimate of the fair market value of PCG in 2019 after payment of the damages. Our estimates of fair value per share take into account the dilutive impact of the offering.

Source: Company reports, California Department of Insurance, SSR estimates and analysis

Valued at a 15% discount to the regulated utilities as a group, we estimate the fair value of PCG in our worst-case scenario (where PCG must pay all damages arising from the northern California wildfires at a net cost to the company of $12.5 billion, and offsets this cost with an equity offering of equal size in 2019) at $37, or 6% below Monday’s close. In a scenario where PCG settles all claims arising from the northern California wildfires at 65 cents on the dollar, our estimate of PCG’s fair value rises to $44, or 12% above Monday’s close. In upside scenarios where PCG is found not to be liable for a portion of the wildfire damages, and settles the remainder at 65% on the dollar, our estimates of the company’s fair value range from $46 or 16% upside in a scenario where PCG is not responsible for 10% of the wildfire damages to $57 or 43% upside in a scenario where PCG is not responsible for 70% of the wildfire damages.

Finally, we have considered the possibility that, were PCG to litigate fully the damage claims brought against it, the process of trying and appealing the cases arising from the numerous northern California wildfires could take years. In this case, PCG might capitalize on its rapid rate base growth over the intervening period to raise the equity required to fund the payment of damages at a materially more attractive share price that would be feasible in 2019. To assess the financial implications of such an outcome, we modeled a scenario where PCG pays all the damages arising from the northern California wildfires in 2023 and is required to pay interest on these claims at 5.0% p.a. for the five years since the fires occurred. Given PCG’s 10.4% allowed ROE, and management’s decision to suspend the dividend, we have assumed that the utility is capable of growing its rate base at 7.5% p.a. with internally generated funds and still retain an annual surplus of $300 million of excess cash. Reflecting these assumptions, we forecast PCG’s earnings per share to rise 7.5% annually the from the consensus estimate of $4.19 in 2020 to $5.60 in 2024. We further estimate that by that year PCG will have accumulated $1.5 billion of excess cash that it can apply to the payment of damages. Applying the regulated utility industry’s current forward PE multiple of 17.1 to our estimate of 2024 earnings, and allowing for the dilutive impact of the equity offering required to fund the payment of damages, we estimate the fair value of PCG stock in 2023 at $47, if we apply a 5% discount for California risk, and at $40 if we apply a 15% discount, reflecting the state’s presumed failure to protect utilities from future wildfire liabilities. In the 5% discount case, our estimate of fair value corresponds to 18% upside from Monday’s close; in the 15% discount case, our estimate of PCG’s fair value is in line with its current share price. We see neither prospect as particularly compelling for an investor planning to hold a stock with no dividend yield for the next four years.

In summary, we believe PCG to be attractive primarily to those investors confident that California will find the means to protect its electric utilities from future wildfire liabilities, allowing the state’s utilities to begin trading once again at a modest 5% discount to the regulated utilities as group. Absent such reform, the stock presents significant downside risk in a worst-case scenario, although we believe such a scenario to be unlikely.

Appendix 1: Methodology for the Estimation of Wildfire Liabilities

  • The losses that EIX and PCG may incur as a result of the Thomas Fire and northern California wildfires, respectively, can be categorized as follows:
    • penalties, including fines and unrecoverable capital expenditures, imposed by the California Public Utility Commission (CPUC);
    • third party liability claims for deaths, injuries, property damage and consequential damage (e.g., loss of wages or profit);[2]
    • punitive damages, either awarded by the courts or implicit in settlements negotiated by EIX with victims of the fires;[3] and
    • legal costs for the litigation and CPUC proceedings.

We explain below how we estimate the range of potential losses in each of these categories.

  • CPUC Penalties. Historically, the CPUC has levied relatively modest penalties on the state’s electric utilities for regulatory violations contributing to brush fires.
    • In September, 2015, the Butte Fire in Amador County burned 71,000 acres, destroyed 549 homes and killed two people. The CPUC found that PCG’s negligence in pruning trees nears its lines had contributed to the fire and fined the utility $8.3 million.
    • In 2013, Southern California Edison (SCE) agreed with the CPUC to a $37 million settlement in connection with the 2007 Malibu Canyon fire, paying a $20 million fine to the State of California and absorbing $17 million in costs to assess the safety of utility poles. SCE admitted having overloaded its power poles in violation of CPUC rules and having withheld pertinent information from the CPUC.
    • In 2010, San Diego Gas & Electric (SDG&E) agreed to pay $21 million to settle allegations that its mismanagement led to the 2007 Guejito, Rice and Witch Creek fires and that SDG&E hampered investigators. SDG&E paid $14.35 million in fines to the State of California and absorbed $6.75 million in costs incurred as a result of the 2007 fires.
    • In 1994, PCG was found guilty of 739 counts of negligence in connection with a fire in the Sierra foothills that destroyed twelve homes.  PCG was fined $30 million by state regulators, or the equivalent of ~$50 million in 2018 dollars.
    • To be conservative, we have used the largest of these historical penalties, that levied in the Sierra foothills fire, as the basis for our estimate of CPUC penalties in respect of the Thomas Fire and northern California wildfires.
  • Third Party Liability. EIX and PCG face the risk of liability for property damages under the principle of inverse condemnation, and the risk of liability for property damages plus personal injury, pain and suffering and incidental damages under the principle of tort liability.
    • Inverse condemnation. Inverse condemnation is based upon the fifth amendment of the U.S. constitution, which stipulates that private property may not be taken for public use without just compensation. Under California state law, inverse condemnation, a principle that requires compensation for damage to property caused by government property, has been extended to cover investor owned utilities operating under state regulation. The principle stipulates that a utility must compensate property owners for damage to their property caused by a utility’s assets, whether or not the utility was negligent in the operation or maintenance of those assets. If the utility was not negligent in causing the damage, the CPUC should allow recovery of the damages from ratepayers. The principle of inverse condemnation does not extend to third party liability claims for death, injury, and consequential damages (e.g., loss of wages or profits); these must be pursued under the principle of tort liability.[4]
    • Tort liability. Third party liability claims for property damage could also be brought against EIX and PCG under the principle of tort liability in suits filed in state courts. Under the principle of tort liability. Plaintiffs may also seek compensation for death, injury, and consequential damages (e.g., loss of wages or profits). Under the principle of tort liability, however, the utility would be liable for property and other damages if the plaintiff could prove that the damages suffered were caused by the utility’s negligence. Plaintiffs can, and have, filed claims for both inverse condemnation and negligence at the same time, collecting the greater of the two liabilities they can prove in court.
      • Negligence. Whether a utility has been negligent in the operation or maintenance of its assets is of far greater consequence than whether a claim is pursued under the principle of inverse condemnation or tort liability. A finding of negligence is what determines if the utility suffers an economic loss or not. If a utility is not found to have been negligent, then, under the principle of inverse condemnation, it is to be allowed to recover from ratepayers any damages paid, implying minimal economic loss; under the principle of tort liability, it would not be liable for damages in the first place and thus, similarly, would suffer no loss. Conversely, if a utility is found to have been negligent, under CPUC rules, no recovery is allowed from ratepayers (regardless of whether the damage was awarded under the principle of inverse condemnation or of tort liability), implying that shareholders must absorb the cost of any damages paid.
    • Consequences. If a utility’s assets are found to be the cause of a fire, and it is determined that the negligence of the utility in maintaining or operating its equipment caused the fire, then the utility will be liable for all damage resulting from the fire, including property, death, injury, pain and suffering and consequential damages such as the loss of wages or profits.
  • Punitive Damages. We view the odds of an award of punitive damages to be very low and have excluded it from our analysis of potential impacts. In punitive damages cases, the burden of proof is on the plaintiff, who must demonstrate that the defendant engaged in “willful misconduct,” a higher legal standard of negligence which has generally been defined as a conscious disregard of probable harm. Given the absence to date of any physical evidence suggesting such egregious misconduct by EIX, and the significantly increased focus on vegetation management and fire prevention as California’s drought worsened over the last several years, proving conscious disregard of probable harm will be a challenge for plaintiffs.
  • Estimating the Scale of Potential Losses. It is too early to know the full scale of damage caused by the Thomas Fire and northern California wildfires. It is possible to estimate the scale of damage, however, by reference the damage caused by past fires, such as the 2007 Witch/Rice fires, the 2015 Butte fire and the fires in Northern California in October.
    • Property & Other Damages. Based on the insurance claims brought in connection with past fires, and the number of structures destroyed by these fires, it is possible to arrive at an estimated ratio of insured damage per structure, which we use as a proxy for property damage.[5] Adjusting for inflation, we found that the highest value of insurance claims per structure destroyed was registered in connection with the recent northern California fires. Dividing the $9.4 billion in property damage claims arising from these fires across the ~8,600 structures destroyed results in a ratio of ~$1.2 million per structure destroyed.
      • Applying this figure $1.2 million per structure to the ~1,060 structures destroyed by the Thomas fire, we estimate the property damage caused by the fire at $1.25 billion.
      • We also applied the $1.2 million per structure ratio to the ~130 structures destroyed by the Montecito mudslides. Unlike wildfires, however, mudslides tend to damage many more structures than they destroy; in the case of the Montecito mudslides, some 300 structures were damaged. To estimate the claims likely to arise from these damaged structures, we assumed a 50% lower ratio, or $0.6 million of costs per structure. This methodology results in an estimate of total property damage caused by the Montecito mudslides of ~$340 million.
      • Summing these estimates of the property damage caused by the Thomas fire and Montecito mudslides, we can estimate EIX’s total potential liability for property damage at ~$1.6 billion. However, the areas affected by the Thomas fire and Montecito mudslides include many wealthy neighborhoods with large homes. The calculations presented in this report, therefore, assume a 50% increase in the estimated damages, or ~$1.9 billion of property damage for the Thomas fire and ~$500 million for the Montecito mudslides, for a total potential liability of ~$2.4 billion.
    • Other Third Party Liabilities. EIX and PCG will likely also face other third party liabilities, including claims for damages arising from death and personal injury, consequential damages, such a loss of wages or profit, damage to governmental property, and firefighting costs. In the Witch/Rice fire, San Diego Gas & Electric (SDG&E) recorded total costs of $1.3 billion for all third party claims excluding insured claims. Calculated per structure destroyed, and adjusted for inflation since 2007, the losses from the Witch/Rice fire work out to ~$850,000 per structure. This ratio suggests that such additional third-party claims could total ~$6.8 billion in respect of the northern California widlfires, ~$900 million for the Thomas fire and ~$250 million for the Montecito mudslides. Given the high value of the real estate in the area of the Thomas Fire, however, in this report we have increased this estimate by 50% to ~$1.35 billion for the Thomas fire and ~$375 million for the Montecito mudslides.
    • CPUC Penalties. Reflecting the penalty imposed on PCG by the CPUC for the Sierra foothills fire of 1994 — the largest penalty imposed by the Commission over the last 25 years in respect of a brush fire – we assume that EIX and PCG will each face $50 million in CPUC fines and penalties.
    • Legal Fees. Based on the legal costs incurred by PCG in connection with the San Bruno gas pipeline explosion, we estimate that PCG will incur $300 million in legal costs in connection with the claims arising from the northern California wildfires. We estimate EIX’s legal costs in respect of the Thomas fire and Montecito mudslides at half this level, or $150 million, reflecting the smaller number of events and a much smaller number of properties affected (~1,060 as against ~8,600 in connection with the northern California wildfires).
  • The Offsets: Insurance and Taxes. EIX had $1.1 billion of third party liability insurance available to it to cover losses from the Thomas fire, while PCG had $0.8 billion of third party liability insurance to cover losses from the northern California wildfires. In addition, payments of third party liability claims and legal costs are tax deductible, although CPUC penalties are not. We have assumed, therefore, that both EIX and PCG can deduct their legal costs and payments of third party liability claims, net of insurance proceeds, from their taxable income in the calculation of their federal income taxes.

©2018, SSR LLC, 225 High Ridge Road, Stamford, CT 06905. All rights reserved. The information contained in this report has been obtained from sources believed to be reliable, and its accuracy and completeness is not guaranteed. No representation or warranty, express or implied, is made as to the fairness, accuracy, completeness or correctness of the information and opinions contained herein.  The views and other information provided are subject to change without notice.  This report is issued without regard to the specific investment objectives, financial situation or particular needs of any specific recipient and is not construed as a solicitation or an offer to buy or sell any securities or related financial instruments. Past performance is not necessarily a guide to future results.

  1. Excluding EIX and PCG, as well two stocks, PPL and SCG, which trade at a material discount to the sector for reasons that have no bearing on EIX or PCG, i.e., PPL’s large international portfolio and the SCG’s decision to abandon construction of the V.C. Summer nuclear power plant. 
  2. Third party liability claims for property damage could be brought against EIX under (i) California’s principle of inverse condemnation, which stipulates that a utility must compensate property owners for damage to their property caused by a utility’s assets, whether or not the utility was negligent in the operation or maintenance of those assets, or (ii) under the principle of tort liability in suits filed in state courts, in which case the utility would be liable for damages only if the plaintiff could prove that the damages suffered were caused by the utility’s negligence. The principle of inverse condemnation does not extend to third party liability claims for death, injury, and consequential damages (e.g., loss of wages or profits); these must be pursued under the principle of tort liability, requiring the plaintiff to prove negligence. 
  3. The principle of inverse condemnation does not extend to punitive damages; these must be pursued under the principle of tort liability. In punitive damages cases, the burden of proof is on the plaintiff, who must demonstrate that the defendant engaged in “willful misconduct,” a higher legal standard of negligence which has generally been defined as a conscious disregard of probable harm. 
  4. For a much more thorough discussion of inverse condemnation and the risk it poses for utilities, please see our note from December 5, CPUC Ruling Denying SRE Recovery of Forest Fire Costs Does Not Increase the Risks for California Utilities
  5. We used the insurance claims as an estimate of total property damage. While there are uninsured property damages, the vast majority of structures destroyed in the past fires were insured. Furthermore, the insurance claims include non-property damages, such as business interruption and the cost of replacement housing. We assuming the non-property portion of the insured damages is similar in size to the value of the uninsured property. 
Print Friendly, PDF & Email