PG&E Suspends Its Dividend, Sending Stock Down 9% After Hours; Reiterate Outperform

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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

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December 21, 2017

PG&E Suspends Its Dividend, Sending Stock Down 9% After Hours;

Reiterate Outperform

  • PG&E Corp. (PCG) announced yesterday the decision of its board of directors to suspend dividend payments on the company’s common shares as well as the preferred stock of its utility subsidiary, Pacific Gas & Electric Company.
    • PG&E’s press release quoted Chairman of the Board Richard Kelly a saying “After extensive consideration and in light of the uncertainty associated with the causes and potential liabilities associated with these wildfires as well as state policy uncertainties, the PG&E boards determined that suspending the common and preferred stock dividends is prudent with respect to cash conservation and is in the best long-term interests of the companies, our customers and our shareholders.”
    • As background to the board’s decision, the press release noted that, under California’s legal principle of inverse condemnation, “if a utility’s equipment is found to have been a substantial cause of the damage in an event such as a wildfire – even if the utility has followed established inspection and safety rules – the utility may still be liable for property damages and attorneys’ fees associated with that event.”
  • PG&E’s investor relations department suggested that the board’s decision reflected:
    • First, the need to maximize the financial flexibility of the company in the face of the risk that PG&E could be found liable under inverse condemnation for property damages arising from the October wildfires in Sonoma, Napa and surrounding counties.
      • Per filings with the California Department of Insurance, insurance claims for property losses caused by these fires had reached some $9.4 billion by the end of November.
      • Eliminating PG&E’s annual dividend would conserve $1.0 billion in cash, helping to defray this potential cost. PG&E also has $800 million of third party liability insurance available to it to cover losses from the fires and, as of September 30th, $2.9 billion in committed and undrawn revolving credit lines.
    • Second, concern that PG&E’s potential liability for $9.4 billion in property damages could put at risk the company’s ability to meet its financial obligations as these come due. Paying a dividend under these circumstances would violate California’s Corporations Code, which stipulates:
      • “Neither a corporation nor any of its subsidiaries shall make any distribution to the corporation’s shareholders if the corporation or the subsidiary making the distribution is, or as a result thereof would be, likely to be unable to meet its liabilities (except those whose payment is otherwise adequately provided for) as they mature.”
    • Third, a desire to signal to California’s state legislature and governor the gravity of the financial risk imposed on the state’s utilities by inverse condemnation and the need therefore to reform it.
      • PG&E’s press release states that, “PG&E is committed to working with state policymakers to address the negative investment environment that strict liability under inverse condemnation is creating for California’s utilities. This ultimately hurts our customers and the state.”
      • Whereas previously PG&E’s argument that inverse condemnation was raising its cost of capital was a theoretical one, the suspension of the dividend due to the threat posed by inverse condemnation to PG&E’s solvency, and the reaction of the share price, renders the costs of inverse condemnation starkly evident and empirically quantifiable.
      • The signal to lawmakers is certainly dramatic; PG&E last suspended its dividend in January 2001, three months before it filed for bankruptcy protection due to its inability under California law to recover from ratepayers the soaring cost of procuring electricity during the California energy crisis.
  • We continue to believe that, at its current price, PG&E stock capitalizes a worst case scenario with respect to PG&E’s liability for property damages, and presumed inability to recover these costs from ratepayers. Less adverse outcomes therefore offer material upside.
    • PG&E stock closed at $51.12 on Wednesday, before the suspension of the dividend was announced, and, as of this writing, had lost a further~13%% of its value in the after-market, trading down to $44.50.
    • We view PG&E’s share price of $69.15 on October 11, the day before the fires, as reflecting the market’s estimate of PG&E’s value in the absence of fire-related liabilities. PG&E’s share price decline since that date implies a market expectation that the cost of these liabilities, net of insurance proceeds and associated tax deductions, will be ~$12.6 billion. Given PG&E’s $0.8 billion of third party liability insurance, and federal tax rate of 21% under the tax reform bill, this is equivalent to ~$16.7 billion in pre-tax, pre-insurance losses.
    • By contrast, the insurance claims for private property damage caused by the fires now total $9.4 billion.[1] Based on a analysis of public entity damage claims in previous fires, and adjusted for the scale of these fires, we estimate public entity damage to be ~$1.0 billion, for an estimated total of $10.4 billion in property damage for which PG&E may be liable under inverse condemnation.
    • The implication is that the market expects no recovery of these property damages by PG&E from ratepayers, and for PG&E to incur a further $6.3 billion of pre-tax costs due to legal costs, fines imposed by the California Public Utility Commission, personal injury claims, consequential damages or punitive damages.
  • As explained in our note of October 17th, Upgrading PCG to Our List of Most Preferred Regulated Utility Stocks: The Stock Now Fully Discounts the Sonoma County Fires[2]we believe liabilities on this scale to be unlikely.
  • First, with respect to the $10.4 billion of property damages, for which PG&E could be liable, California’s principle of inverse condemnation allows utilities to recover from ratepayers damages paid in cases where the utility caused the damages, but was not at fault.
    • There is circumstantial evidence that PG&E has not been negligent in its vegetation management and equipment maintenance. In 2016, PCG reports having inspected all its overhead power lines, as well as 170,000 utility poles, and pruning 236,000 trees near its power lines – at a total cost $198 million.
    • In case where a utility believes that it was not negligent, it can protect itself by fully litigating the cases in court to reach a determination of fault.
    • In court, the burden of proof is on the plaintiff to prove negligence.
    • If a determination is made in court that the utility was not negligent and that damages were only rewarded due to inverse condemnation, we believe it would be difficult for the CPUC to deny recovery of the costs from ratepayers.
    • Regarding causation, PCG equipment is under investigation by CalFire for causing fewer than 20 of the 31 total fires and may not be found to be the cause of some of those fires, including the most destructive of them, the Tubbs fire.
  • Second, even if PG&E were found to be the cause of and at fault for all of the fires, and therefore was unable to recover from ratepayers the assumed $10.4 billion in public and private property damages paid, PG&E’s current share price appears to capitalize at least an additional $6.3 billion of pre-tax costs due to legal defense costs, firefighting costs, CPUC fines, personal injury claims, consequential damages and punitive damages.
    • Based on PG&E’s legal cost to defend itself in the various legal and regulatory proceedings in the five years following the San Bruno gas pipeline explosion, we estimate PG&E’s legal costs related to the wildfires at less than $300 million.
    • The CalFire website has been unavailable, but news reports suggest the firefighting costs could be as high as $300-400 million.
    • With respect to CPUC fines, we note that the largest CPUC fine levied on a utility for its role in causing wildfires was only $30 million (equivalent to ~$50 million in 2017 dollars). This fine was imposed on PG&E in 1994, after the utility was found guilty of 739 counts of negligence in connection with a fire in the Sierra foothills that destroyed twelve homes.
    • With respect to personal injury, 42 people have died as a result of the October wildfires in Northern California and ~200 were injured, although less than 20 appear to be serious injuries. If we assume $10 million per life, $5 million per serious injury and $1 million for all other injuries, these could add ~$750 million to PG&E’s pre-tax liabilities.
    • These categories of expenses thus total $1.5 billion.
  • To explain the drop to date in PG&E’s stock price, therefore, we must assume more than $4.8 billion in consequential damages, punitive damages or some alternative, unquantified source of damages.
    • Regarding the potential for consequential damages, such as lost business revenues or wages, we see no evidence at this time to suggest that the scale of these potential damages could be as large as $4.8 billion: this figure is equivalent to approximately half of the estimated value of property damage claims ($10.4 billion), implying a very high ratio of revenue and other incidental losses to the value of property damaged. Moreover, in tort liability suits to collect consequential damages, the burden of proof is again on the plaintiff, who must prove negligence by the utility, in addition to proving that the utility was the actual and proximate cause of the damages.
    • We view the odds of an award of punitive damages to be very low. 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 PG&E, the effort that the utility has put into improving its safety culture, and in particular the company’s increased focus on vegetation management as California’s drought has worsened, proving conscious disregard of probable harm will be a challenge for plaintiffs.
  • Less adverse outcomes than those apparently capitalized in PG&E’s share price could trigger significant upside in the stock. For example,
    • If PG&E feared liability for negligence and wished to limit its exposure, it could settle the claims against it. Based on the ratio of (i) the settlement costs and other expenses incurred by San Diego Gas & Electric in connection with the Witch fire in 2007 to (ii) the insurance claims for property damaged by the fire and the number of structures destroyed, we estimate that PG&E could see total expenses from the October 2017 fires of $11.0 billion before insurance, taxes and any contribution by third parties. This is the equivalent of $8.1 billion after taxes and insurance, vs. our estimate of $12.6 billion in after-tax, after-insurance losses capitalized in the stock today. The difference of $4.5 billion would imply upside of $8.70 per share, or 20% relative to PG&E’s after-market price of $44.50.
    • A finding by CalFire that PG&E was not a cause of the Tubbs fire would reduce our estimate of PG&E’s potential damage liability of $11.0 billion by 60-70%. Assuming only $4.0 billion in pre-tax costs, equivalent to $2.5 billion after insurance and taxes, the upside relative to the $12.6 billion in losses capitalized in the stock today is equivalent to ~$19.50 per share, or over 40% relative to PG&E’s after-market price of $44.50.
    • Plaintiffs’ failure to prove that the October wildfires were attributable to PG&E’s negligence would free PG&E from liability for personal injury, consequential or punitive damages, and would likely require the CPUC to allow PG&E to recover from ratepayers any property damages paid under the principle of inverse condemnation. The $12.6 billion in losses capitalized in PG&E’s stock today would no longer be justified, suggesting upside of ~$24.50 per share, or almost 55% of PG&E’s after-market price of $44.50.
  • While we still remain positive on PCG for long-term investors based on fundamental valuation, we caution that, absent a finding by CalFire in the next 12 months that PG&E was not a cause of the major fires, this investment thesis should take 2-3 years to unfold and could involve significant volatility in the interim.

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

Source: FERC Form 1, company reports, SNL, SSR analysis

©2017, 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. See the December 1, 2017press release of the California Department of Insurance, available at http://www.insurance.ca.gov/0400-news/0100-press-releases/2017/upload/nr135Statewideclaims.pdf. The $9.4 billion total, however, likely includes some consequential damage, such as business interruption and living expenses, that would not be recoverable under inverse condemnation, as well as some exaggeration of damage that may not be provable. 
  2. http://www.ssrllc.com/publication/upgrading-pcg-to-our-list-of-most-preferred-regulated-utility-stocks-the-stock-now-fully-discounts-the-sonoma-county-fires/ 
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