Utility Portfolio Update: Adding ETR to Our List of Preferred Utilities; FE, EIX and PCG Remain Our Favorite Names in the Sector, While SO Remains a Concern

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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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April 3, 2018

Utility Portfolio Update:

Adding ETR to Our List of Preferred Utilities;

FE, EIX and PCG Remain Our Favorite Names in the Sector, While SO Remains a Concern

We summarize our investment thesis on ETR, FE, EIX, PCG and SO in the Portfolio Manager’s Summary

of this note, and set out the analysis underlying our views in the Details section.

Portfolio Manager’s Summary

Entergy (ETR):

  • We are adding ETR to our list of preferred utilities. We see the stock’s 19% 2020 PE discount relative to the regulated utilities gradually closing as ETR retires it merchant nuclear fleet and evolves to a fully regulated utility with the prospect of top tier rate base growth through 2021.
  • We see ETR disengaging from its merchant nuclear business with little if any residual risk to shareholders. Our view reflects:
  • Management’s decision to retire its merchant nuclear plants by 2022;
  • The fully funded status of the nuclear decommissioning trusts for these plants, which hold $4.0 billion of assets against $3.2 billion in estimated decommissioning liabilities;
  • If need be, ETR’s ability to defer full decommissioning for up to 60 years, allowing time for the radioactive material to decay and trust assets to grow; and, finally,
  • ETR’s plans to sell the retired nuclear units, eliminating decommissioning risk altogether.
  • Following its exit from merchant generation, ETR will comprise a group of vertically integrated, fully regulated utilities that benefit from strong growth in industrial demand, driven by the expansion of the petrochemical industry around the Gulf of Mexico, and rapid rate base growth.
    • Based on management’s announced capex plans, we estimate aggregate growth in electric plant rate base at ETR’s utility subsidiaries at 9.8% p.a. over 2018-21 – among the highest growth rates in the U.S. regulated utility industry.
    • We estimate this growth will allow ETR to achieve the upper half of its earnings guidance for its regulated operations through 2020 – even allowing for planned equity issuance to meet the cash needs arising from tax reform.
    • We expect ETR to maintain above average rate base growth of 6.5% through 2025.

FirstEnergy (FE):

  • The bankruptcy of FE’s competitive generation subsidiary (FES), announced over the weekend, and concerns about FE’s ability to protect itself against the claims of FES’ creditors, have caused FE to trade at a significant valuation discount versus the primarily regulated utilities.
  • By contrast, we believe the financial impact on FE of an FES bankruptcy can be quantified and will be limited to:
    • $650 million of FES borrowings that have been guaranteed by FE, and
    • FE’s $950 million obligation for FES’ pension and OPEB liabilities.
  • These obligations already comprise part of FE’s credit profile, are accounted for in the company’s capital plans and will not require any equity issuance to fund.
  • Taking these obligations into account, FE’s remaining, purely regulated utility operations are trading at a 20% discount to other regulated electric utilities – despite expected rate base growth of 7.9% p.a. over 2018-2021, well above the industry average of 7.2%.
  • Moreover, our age of plant analysis suggests that FE may have opportunities to accelerate its current pace of rate base growth, and to grow faster than the industry average well into the next decade.
  • Reflecting rapid growth in distribution rate base, we see 2021 EPS of $2.60-2.70, at the high end of FE’s 6-8% EPS growth target. Using the average regulated utility multiple on 2020 earnings of 16.8x, this implies a value of $44-45 in 12 months, some 30% above FE’s Monday’s close of $34.

Edison International (EIX):

  • We believe EIX stock capitalizes a worst case scenario with respect to its potential liability for the damage caused by the Thomas wildfire and Montecito mudslide; that the probability of this worst case outcome is low; and that the stock therefore is significantly undervalued.
    • Based upon historical precedents, we estimate that the after-tax cost to EIX of third party liability claims, regulatory penalties and litigation costs is unlikely to exceed $7.79 per share.
    • If we apply the industry average multiple of 2020 earnings (16.8x) to the consensus estimate for EIX’ 2020 EPS ($4.83), assume a 5% discount for California risk, and then subtract worst case losses of $7.79 after tax, the implied fair value of EIX stock in a worst case is ~$70, 11% above Monday’s close of $63 per share.
  • A range of other potential outcomes exists, the bulk of which are materially less adverse and would justify a much higher valuation for the stock.
    • In a range of more favorable scenarios, we estimate that upsides of 16% to 22% are possible (see Exhibit 2).
  • EIX is one of the most rapidly growing regulated electric utilities in the country, with estimated rate base growth of 8.9% p.a. over 2018-2021, versus an industry average of 7.2%. The market’s overly conservative estimate of EIX’ legal risk has created the opportunity to acquire at an 11-22% discount to fair value a utility that ranks in the first quintile on rate base growth.

PG&E Corp. (PCG):

  • We have applied the same historical precedents to PCG as we have to EIX to estimate the potential extent of PCG’s third party liability claims, regulatory penalties and litigation costs.
    • Based upon these precedents, we estimate that the after-tax cost to PCG of third party liability claims, regulatory penalties and litigation costs is unlikely to exceed $24.23 per share.
  • If we apply the industry average multiple of 2020 earnings (16.5x) to the consensus estimate for PCG’s 2020 EPS ($4.15), assume a 5% discount for California risk, and then subtract worst case losses of $24.23 after tax, the implied fair value of PCG stock in a worst case scenario is ~$42, 3% below Monday’s close of $43 per share.
    • As in the case of EIX, however, a range of other potential outcomes exists, the bulk of which are materially less adverse and would justify a much higher valuation for the stock.
    • In these more favorable scenarios, we estimate that upsides of 13% to 51% are possible (see Details section below and Exhibit 3).
    • Critically, the cumulative probability associated with these more favorable outcomes is high.
  • In the case of PCG, then, we see both greater downside risk and greater upside potential than in the case of EIX. We believe the distribution of potential outcomes justifies the inclusion of PCG among our list of most preferred regulated utilities. For those unwilling to take the downside risk to PCG stock in a worst case scenario, however, EIX may offer a more attractive alternative.

Southern (SO):

  • We continue to view SO as one of the least attractive regulated utility stocks, due to:
    • the elevated risk that SO will be unable to recover with an adequate return its investment in the two nuclear generating units under construction at Plant Vogtle in Georgia, and
    • the prospect of below average rate base growth across SO’s utility subsidiaries, reflecting a younger than average T&D network and correspondingly low normalized rates of capital expenditure.
  • Given this slow growth in SO’s electric plant rate base, and after allowing for the drag from non-plant rate base and the dilution from SO’s equity needs, we estimate that the contribution of the electric utilities to SO’s EPS growth should average less than 3% p.a.
  • To offset the drag on earnings from slow rate base growth, SO is seeking approval to increase its utilities’ allowed ratios of equity to rate base.Even with this boost, however, we do not believe that SO will achieve anything higher than the bottom end of management’s target EPS growth range of 4-6%.
  • Although SO trades at a discount, we expect the risks surrounding Vogtle Units 3 & 4, combined with slow rate base and earnings growth, will cause the stock to continue to underperform.

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

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Source: SSR analysis

Details

Entergy (ETR):

For more than a decade, ETR has been attempting to unlock value by separating its merchant nuclear generation business from its core regulated utility operations, first by spinning off the merchant fleet as a separate company, then by diluting it in a larger, faster growing regulated business by acquiring ITC and, finally, by taking the decision to retire and, when possible, sell the merchant nuclear plants. With this process now well underway, we believe that the remaining risks from the merchant nuclear business are small enough that ETR no longer merits a meaningful discount versus regulated electric utilities. As a result we are adding ETR to our list of preferred utilities.

ETR is comprised of (i) a group of southern U.S. electric utilities (which, when grouped with the parent and other non-nuclear operations, the company refers to as utilities, parent and other, or UPO) and (ii) a group of merchant nuclear power plants primarily in the northeast (known as Entergy Wholesale Commodities or EWC). The utilities are vertically integrated, and benefit from strong growth in industrial demand, driven by the expansion of the petrochemical industry around the Gulf of Mexico. EWC owns four operating nuclear generating units, the last of which is currently scheduled to retire in 2022, and one retired nuclear generating unit.

Based on management’s disclosed capex plans, ETR’s regulated utilities will enjoy rapid growth in rate base over the next several years, driven by increased investments in transmission, grid modernization and new and replacement generating capacity. We expect ETR’s utility rate base to expand by 9.8% p.a. over 2018-21, among the highest growth rates in the U.S. regulated utility industry. We estimate this growth will allow ETR to achieve the upper half of its earnings guidance for UPO through 2020, in spite of the issuance of equity to meet cash needs resulting from tax reform. Furthermore, we expect ETR will be able to maintain above average rate base growth of 6.5% through 2025.

While we expect EWC to have minimal earnings until its final nuclear generating unit is retired in 2022, we do not expect the segment to be a drag on cash flow. Based on our forecasts and the current funding of the nuclear decommission trusts, we expect that EWC should generate positive cash flows after capex over the next five years.

More importantly, we believe that the tail risk to ETR from decommissioning at EWC is very limited, even if it retains the decommissioning risks of all five of its nuclear generating units. At the end of 2017, the net present value of ETR’s nuclear decommissioning liabilities were $3.2 billion while the balances of the nuclear decommissioning trusts totaled $4 billion. Importantly, the liabilities do not take into account acceptable methods to defer and reduce the net present value of decommissioning costs, such as the SAFSTOR option, which can defer actual decommissioning by up to 60 years, reducing the ultimate cost of decommissioning by allowing time for the amount of radioactive material to decline from radioactive decay. At the same time, the assets in the nuclear decommissioning trusts have additional time to grow, further reducing the risk of a shortfall of funds for decommissioning. We note, moreover, that any liabilities associated with these units should be primarily the responsibility of EWC as the nuclear plant licensee, with only limited exposure from unforeseen incidents for ETR as the parent corporation, provided ETR maintains a proper separation of control between the ETR and EWC. Finally, ETR is attempting to sell its reactors, starting with the planned sale of Vermont Yankee, expected to close later this year, which would permanently eliminate the risk of decommissioning or other expenses as each unit is sold.

A final concern of investors with ETR is the high level of parent company leverage, most of which was incurred to support the merchant nuclear business it is now exiting. ETR has $3.5 billion of debt at the holding company, including short term debt, or 20% of ETR’s total debt, with the remainder held at the utilities. With Funds from Operations to Debt (FFO/Debt) hovering around 15%, the low end of the range desired by the credit agencies for ETR’s current ratings (BBB+/Baa2), the risk of a downgrade is real. However, in light of ETR’s planned issuance of equity over the next year, the continued reduction in exposure to EWC, and the improvement in cash flows over time as the utilities grow and the need to fund the pension (~$400 million in contributions annually since 2014) declines, we expect that ETR will be able to maintain an investment grade rating at the parent company.

As a result, we see in ETR a company that is evolving towards a fully regulated utility with the prospect of top tier rate base growth through 2021, but is trading at a 15% discount to the forward PE multiple of the regulated utilities as a group. We do not see that discount going away immediately, but it should decline over the course of the next 2-3 years as ETR’s cash flow metrics improve and it completes the retirement of its merchant nuclear generating plants. In addition, there is the potential for to discount to shrink more rapidly if additional nuclear unit sales or other options to further limit ETR’s nuclear decommissioning risk are announced.

FirstEnergy (FE):

FE’s earnings and valuation have been eroded by years of poor performance at its competitive generation business. The long expected bankruptcy of FE’s competitive generation subsidiary (FES), and concerns about FE’s ability to protect itself against the claims of FES’ creditors, have caused FE to trade at a significant valuation discount versus the primarily regulated utilities. By contrast, we believe the financial impact on FE from the FES bankruptcy can be quantified and will be limited. Once FE separates itself from FES, FE’s remaining, purely regulated utility operations are likely to attract investor interest for their discounted valuation and attractive growth potential. Taking the impact of the FES bankruptcy into account, FE’s regulated utility operations are trading at a 20% discount to other regulated electric utilities – despite expected rate base growth of 7.9% p.a. over 2018-2021, well above the industry average of 7.2%. Furthermore, our age of plant and long-term rate base growth analysis suggests that FE may have opportunities to accelerate its current pace of rate base growth, and to grow faster than the industry average well into the next decade.

Reflecting rapid expected growth in distribution rate base, we see 2021 EPS of $2.60-2.70, at the high end of management’s 6% to 8% EPS growth target. Using the current sector average multiple for regulated utilities on 2020 earnings of 16.5x, this implies a value of $44-45 in 12 months, some 30% above FE’s Monday’s close of $34.

Fears regarding the potential outcome of the bankruptcy of FES are the primary cause of FE’s discount to the sector, but we believe those fears to be unfounded. In particular, we note that:

  • While FES has ~$3.6 billion of outstanding long-term debt and lease obligations, FE has only guaranteed $650 million of those obligations.
    • FE’s $650 million liability under this guarantee is already accounted for in the company’s capital plans and will not require any equity issuance to fund.
  • FE is also responsible for $950 million of FES pension and OPEB obligations that will remain with FE, but these obligations already comprise part of FE’s credit profile.
    • Moreover, these obligations will require only $80 million of funding in 2021.
  • In our view, holders of FES’ ~$3.6 billion of long-term debt and lease obligations will otherwise be unable to pierce the corporate veil of its parent and collect from FE.
    • At a maximum, we see FE’s additional cash exposure to the FES bankruptcy limited to $70 million, the amount of a dividend paid by FES to FE in 2015.
    • Before that, the last capital transaction between FE and FES was a $2.5 billion equity injection over 2012-13.
    • Furthermore, FE is likely to retain most or all of the tax benefits from the write-off of its investments in FE, worth ~$750 million. We do not include this benefit in our estimates.
  • Given FE’s quantifiable and limited exposure to FES, we apply no discount to FE for the FES bankruptcy beyond FE’s $650 million guarantee of FES’ borrowing and its $950 million obligation for FES’ pension and OPEB liabilities.

While investors have been very much focused on FE’s potential financial liabilities arising from the FES bankruptcy, the market seems not to appreciate the opportunity for rapid rate base growth at FE’s core regulated utility business.

  • Based on FE’s updates to their capex plans on their 4th quarter earnings call, we expect rate base growth of 7.9% p.a. for 2018-21, well above the industry average of 7.2%.
  • We believe, moreover, that FE has the opportunity to grow rate base and earnings even more rapidly. Based on our analysis, FE has one of the oldest distribution grids in the country, yet FE management have not even begun to look at the opportunities to replace aging distribution infrastructure.
    • In 1967, some 50 years ago, FE’s customer base was already at 60% of its current level, versus an industry average of 46%. By contrast, just 16% of FE’s current customer base has been added since 1988, versus an industry average of 27%.
    • FE’s 5-year capex forecast is approximately equal to our estimate of the inflation adjusted gross book value of FE’s remaining pre-1988 plant in service; for the industry as a whole, the average ratio of 5-year capex to replacement cost of pre-1988 assets averages 200%, twice FE’s level.
      • Should FE choose to close this gap, and focus on replacing its pre-1988 plant in service over the next 10 years, FE could increase its annual capex by ~50%.
  • FE also has one of the lowest depreciation rates in the industry, so every dollar spent has a greater impact on rate base growth than for other utilities.
  • While additional capex at FE’s regulated utility subsidiaries would require additional equity issuance to fund it, these investments would still be accretive to earnings per share as the utility ROEs exceed FE’s cost of equity.  As FE’s stock price rises, the earnings accretion from funding rate base growth through equity issuance would only increase.

In summary, we continue to see FirstEnergy as a highly attractive medium-term investment with upside of 30% to $44-45 in the next 12 months. We expect that the resolution of the FES bankruptcy will be a key catalyst for FE, allowing for consensus estimates to converge on the utility-plus-parent earnings and encouraging FE to more aggressively pursue opportunities for rate base growth.

 

Edison International (EIX):

Our view is that EIX stock today capitalizes a worst case scenario with respect to its potential liability for the damage caused by the Thomas wildfire and Montecito mudslides; that the probability of this worst case outcome is low; and that the stock therefore is significantly undervalued. A range of other potential outcomes exists, the bulk of which are materially less adverse and would justify a much higher valuation for the stock. Critically, the cumulative probability associated with these more favorable outcomes is quite high.

More specifically, we believe that the share price of EIX today capitalizes a worst case outcome where Southern California Edison is found to have caused both the Thomas wildfire and Montecito mudslides; second, that the utility is found to have been negligent in doing so; and that the utility is required to compensate the plaintiffs for the full amount of the damages claimed. We believe the probability associated with this outcome to be low.

On the other hand, highly risk-averse utility investors continue to under-estimate the much higher cumulative probability of a range of more benign outcomes. For example:

  • the utility’s equipment may not have caused, or may not have been the sole cause, of the Thomas wildfire;
  • Southern California Edison may not be found liable for the Montecito mudslides, which occurred more than two weeks after the wildfire following torrential rains;
  • the utility’s equipment may have caused the fire and mudslides, but Southern California Edison might not have been negligent in the operation and maintenance of these assets and therefore may escape liability in court or, alternatively, may be allowed by the California Public Utilities Commission to recover any damages paid under the principle of inverse condemnation;
  • finally, if Southern California Edison did cause the wildfire and mudslides, and was negligent in doing so, that it could nonetheless negotiate settlements with the plaintiffs that limit the damages paid for their claims.

The losses that EIX may incur as a result of the Thomas fire and Montecito mudslides can be categorized as follows:

  • penalties, including fines and unrecoverable capital expenditures, imposed by the California Public Utilities Commission (CPUC);
  • third party liability claims for deaths, injuries, property damage and consequential damage (e.g., loss of wages or profit);[1]
  • punitive damages, either awarded by the courts or implicit in settlements negotiated by EIX with victims of the fires;[2] and
  • legal costs for the litigation and CPUC proceedings.

We have estimated each of these potential costs based upon historical precedents, including the northern California wildfires of 2017, the Witch/Rice fires of 2007 and the Sierra foothills fire of 1994. (For a discussion of our methodology, see the appendix to this note and our report of January 24, 2018, Wildfires and Mudslides and Lawsuits, Oh My! Adding EIX To Our List of Preferred Utilities.) Based on this analysis, we estimate that EIX’s maximum potential losses for property and other third-party liability claims arising from the Thomas fire and Montecito mudslides, as well as CPUC penalties and litigation costs, could range as high as ~$4.3 billion in a worst case. Critically, however, when adjusted for insurance recoveries and EIX’s ability to tax deduct the cost of third party liability claims, we estimate the net cost to EIX in this case at ~$2.5 billion, or the equivalent of $7.79 per share.

In Exhibit 2, we estimate the value of EIX across a range of outcomes for the wildfire and mudslide litigation. We have modeled four scenarios:

    • Worst Case: Full Claims Paid. In our worst case, we assume that EIX must pay the full value of all the damage claims arising from the Thomas fire and Montecito mudslides. Based on (i) the consensus estimate of 2020 EPS for EIX ($4.83), (ii) the regulated utility sector’s average 2020 P/E multiple of 16.5[3], (iii) an assumed 5% discount for California risk, and (iv) our worst case estimate of $7.79 per share in net costs to EIX from the Thomas fire and Montecito mudslides, our analysis suggests fair value for EIX at ~$70 — 11% upside from Monday’s close of $63 per share. In a range of more favorable scenarios, we estimate that upsides of 16% to 22% are possible (see below and Exhibit 2).
    • Adverse Case: Settlements. In our adverse case, we assume that EIX settles the third party liability claims against it at a discount to the face value of these claims similar to that achieved by San Diego Gas & Electric in its Witch Fire settlement. This assumption reduces our estimate of the after-tax, after-insurance cost to EIX from the Thomas fire and Montecito mudslides to only $4.48 per share. If we again apply the utility sector’s average 2020 P/E multiple to EIX’s consensus 2020 EPS estimate and subtract 5% for California risk, we would estimate fair value in our adverse case to be ~$73 per share – some 16% above Monday’s close.
    • Adverse Case, Settlements but No Liability for the Montecito Mudslides. Again assuming that EIX settles the claims against it arising from the Thomas Fire, but assuming that EIX is not found not to be liable for the Montecito mudslides, our estimate of the net after-tax, after-insurance cost to EIX in falls to only $3.06 per share. Applying the above valuation methodology, we would estimate fair value in this scenario at ~$75 per share, 18% above Monday’s close.
    • No negligence. If EIX is not found to have been negligent, and therefore is allowed to recover from ratepayers any damages paid in respect of the Thomas fire and Montecito mudslides, we estimate the net cost to EIX at only $0.52 per share, reflecting only litigation costs and potential CPUC penalties. Applying the above valuation methodology, we would estimate fair value in this scenario at ~$77 per share, 22% above Monday’s close.

Given the substantial potential upsides in EIX stock, even in a worst case scenario, we include EIX among our most favored regulated utilities.

Exhibit 2: Scenario Analysis of EIX’s Potential Losses from the Thomas Fire & Montecito Mudslides

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Source: Company and press reports, SSR estimates and analysis

PG&E Corp. (PCG):

We have applied the same historical precedents to PCG as we have to EIX to estimate the potential extent of PCG’s third party liability claims, regulatory penalties and litigation costs. We estimate that PCG’s maximum potential losses for property and other third-party liability claims arising from the Northern California wildfires, as well as CPUC penalties and litigation costs, could range as high as ~$16.6 billion in a worst case. When adjusted for insurance recoveries and PCG’s ability to tax deduct the cost of third party liability claims, we estimate the net cost to PCG in this case at ~$12.5 billion, or the equivalent of $24.23 per share (see Exhibit 3). Based on these estimates, and given PCG’s share price as of Monday’s close ($43), we see more potential downside in a worst case scenario than we do for EIX, but also materially greater potential upside.

In Exhibit 3, we estimate the value of PCG across a range of outcomes for the wildfire litigation. We have modeled three scenarios:

    • Worst caseFull Claims Paid. In our worst case, we assume that PCG must pay the full value of all the damage claims arising from all the Northern California wildfires of last October. Based on (i) the consensus estimate of 2020 EPS for PCG ($4.15), (ii) the regulated utility sector’s average 2020 P/E multiple of 16.5[4], (iii) an assumed 5% discount for California risk, and (iv) our worst case estimate of $24.23 per share in net costs to PCG from the northern California wildfires, our analysis suggests fair value for PCG at ~$42 — 3% downside from Monday’s close of $43 per share. In a range of more favorable scenarios, however, we estimate that upsides of 13% to 51% are possible (see below and Exhibit 3
    • Adverse Case: Settlements. n our adverse case, we assume that PCG settles the third party liability claims against it at a discount to the face value of these claims similar to that achieved by San Diego Gas & Electric in its Witch Fire settlement. This assumption reduces our estimate of the after-tax, after-insurance cost to PCG from the Northern California wildfires to$17.14 per share. If we again apply the utility sector’s average 2020 P/E multiple to PCG’s consensus 2020 EPS estimate and subtract 5% for California risk, we would estimate fair value in our adverse case to be ~$49 per share – some 13% above Monday’s close.
    • No negligence. If PCG is not found to have been negligent, and therefore is allowed to recover from ratepayers any damages paid in respect of the Northern California wildfires, we estimate the net cost to PCG at only $0.56 per share, reflecting only litigation costs and potential CPUC penalties. Applying the above valuation methodology, we would estimate fair value in this scenario at ~$66 per share, 51% above Monday’s close.

Exhibit 3: Scenario Analysis of PCG’s Potential Losses from the Northern California Wildfires

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Source: Company and press reports, SSR estimates and analysis

An important difference between PCG’s case and that of EIX is that EIX has been accused of starting one wildfire, the Thomas fire, while our worst case scenario assumes that PCG is responsible for all 12 of the Northern California wildfires. EIX therefore faces a binary outcome (its negligence is found to have caused the Thomas fire or not), while PCG faces a range of possible outcomes (its negligence is found to have caused none to all 12 of the Northern California wildfires). This in turn implies a range of financial outcomes for PCG between our worst case and no negligence case.

More specifically, a single wildfire, the Tubbs fire, was responsible for 64% of the structures destroyed, while the remaining 36% were destroyed by the other eleven fires. If damages are proportionate to the number of structures destroyed, then, if PCG were found to be liable only for damages caused by the Tubbs fire, we would estimate the cost to the company in a scenario where it must pay the Tubbs fire damages in full at $15.27 per share, suggesting fair value for the stock of ~$51, or 17% above Monday’s close. Were PCG able to settle the claims arising from the Tubbs fire at the same ratio of losses as San Diego Gas & Electric achieved in its settlement of the Witch fire claims, then the cost to the company can be estimated at $10.23 per share, suggesting fair value for the stock of ~$55, or 28% above Monday’s close.

In the case of PCG, then, we see both greater downside risk and greater upside potential than in the case of EIX. We believe the distribution of potential outcomes justifies the inclusion of PCG among our list of most preferred regulated utilities. For those unwilling to take the downside risk to PCG stock in a worst case scenario, however, EIX may offer a more attractive alternative.

Southern (SO):

We continue to view SO as one of the least attractive regulated utility stocks, due to (i) the elevated risk that SO will be unable to recover with an adequate return its investment in the two nuclear generating units under construction at Plant Vogtle in Georgia, and (ii) the prospect of below average rate base growth across SO’s utility subsidiaries, reflecting a younger than average T&D network and correspondingly low normalized rates of capital expenditure. To offset the drag on earnings from slow rate base growth, SO is seeking approval to increase its utilities’ allowed ratios of equity to rate base. Even with this boost, however, we do not believe that SO will achieve anything higher than the bottom end of management’s target EPS growth range of 4-6%. Although SO trades at a discount, we expect the risks surrounding Vogtle Units 3 & 4, combined with slow rate base and earnings growth, will cause the stock to continue to underperform.

Beginning with Vogtle, we note that nuclear plants are extremely complex projects and that the risk of continued cost overruns and completion delays is correspondingly high, as evidenced by the fact that the first AP1000 projects, in China, have still not come online. In this context, the settlement reached between SO and the Georgia Public Service Commission with respect to Vogtle Units 3 & 4 puts SO at significant risk of additional disallowances and earnings erosion. Specifically,

  • The allowed ROE on SO’s investment in Units 3 & 4 declines to 8.3% if commercial operation is achieved after 2020 and to 5.3% if it is achieved after 2021. If further completion delays push the online date of these units into 2022 or beyond, this cut in ROE will reduce earnings by $0.15-0.20 per share initially and more over time if the costs to complete the units continues to rise.
  • Furthermore, there is a risk of disallowance if the costs for Southern’s share of Units 3 and 4 exceeds its current guidance $7.3 billion.

With respect to the prospects for rate base growth, our analysis, which is based on SO’s announced capex plans, suggests that growth in the electric plant rate base of SO’s regulated utilities will average ~5.2% p.a. through 2021, well below the industry average of 7.2%. Over the long term, we expect SO to achieve rate base growth of only ~4.0% p.a., again lagging our forecast for the industry of 5.1%. We view Southern’s plan to increase the allowed equity ratios at its utilities as confirmation that these utilities have limited opportunities to accelerate rate base growth, as an increase in the equity ratio when rate base growth is rising only compounds the impact on customer rates.

Key headwinds to the growth of SO’s electric plant rate base include the following:

  • SO’s T&D network is younger than the U.S. utility industry average on all metrics, including vintage of customer additions and the estimated ratio of replacement value to book value, suggesting more limited opportunities for replacement capex.
  • We also see limits to SO’s ability to invest in new generation assets. In particular, we do not see a significant opportunity to retire and replace SO’s coal fired power plants, as the bulk of these units are less than 50 years old. Moreover, SO’s coal-fired fleet comprises a large part of rate base, which would still need to be recovered if the plants were retired, materially increasing the cost to ratepayers of retiring and replacing these plants.
  • Finally, while SO’s regulatory relationships have historically been strong, an increase in equity ratios may still be difficult to achieve, coming as it does on top of the cost overruns at Vogtle and the Kemper County IGCC plant.

Given our forecast of slow growth in SO’s electric plant rate base, we estimate that, after allowing for the drag from non-plant rate base and the dilution from SO’s equity needs, the contribution of the electric utilities to SO’s EPS growth should average less than 3% p.a. Even if SO executes on all other portions of its plan, including the increase in allowed equity ratios, we expect the company only to achieve 4% annual growth in EPS, at the lower end of the range of management’s long term EPS growth target of 4-6% p.a.

In summary, we believe the market is underestimating the risk of additional delays in the completion of Vogtle Units 3 & 4, which would materially erode the allowed return on SO’s investment in these units. We also believe the market may be missing the limits imposed on SO’s rate base growth by its relatively new utility plant, as well as the difficulty of implementing the plan to raise the allowed equity ratios of the electric utilities.  We therefore expect SO to continue to underperform the group.

Appendix 1: Methodology for the Estimation of the Edison International’s Wildfire Liabilities

  • The losses that EIX may incur as a result of the Thomas fire 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);[5]
    • punitive damages, either awarded by the courts or implicit in settlements negotiated by EIX with victims of the fires;[6] and
    • legal costs for the litigation and CPUC proceedings.

Below we estimate the range of EIX’s potential losses in each of these categories using multiple methods.

  • CPUC PenaltiesHistorically, the CPUC has levied relatively modest penalties on EIX and other California 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.
  • Third Party Liability. EIX faces 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.[7]
    • Tort liability. Third party liability claims for property damage could also be brought against EIX 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 for EIX. If EIX is found to be the cause of the Thomas fire and that its negligence in maintaining or operating its equipment caused the fire, EIX 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 EIX’s Potential Losses. It is too early to know the full scale of damage caused by the Thomas fire and the Montecito mudslides. 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.[8] 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, at ~$1.2 million per structure destroyed.
      • Using that figure and applying it to the ~1,060 structures destroyed by the Thomas fire, we estimate the property damage caused by the fire at $1.25 billion (see Exhibit 2).
      • 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 (see Exhibit 2).
      • Summing these estimates of the property damage caused by the Thomas fire and Montecito mudslides, we estimate EIX’s total potential liability for property damage at ~$1.6 billion (our adverse scenario).
      • However, the areas affected by the Thomas fire and Montecito mudslides include many wealthy neighborhoods with large homes. We have therefore calculated a worst case scenario based on a 50% increase in the estimated damages, or ~$1.9 billion of property damage for the Thomas fire and ~$500 million for the mudslides, for a total of ~$2.4 billion (our worst case; see Exhibit 2).
      • We note that the above estimates are broadly in line with published estimates for total damages from the Thomas fire of $1.0-2.5 billion.
    • Other Third Party Liabilities. EIX 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 implies the potential for ~$900 million of additional third party claims for the Thomas fire and ~$250 million for the mudslides, or a total of ~$1.15 billion in our adverse scenario. In our worst case scenario, we increase this by 50% to ~$1.35 billion for the Thomas fire and ~$375 million for the mudslides, or a total of ~$1.73 billion.
    • 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 will face $50 million in CPUC fines and penalties for the Thomas fire.
    • Legal Fees. We estimate that in all scenarios EIX will face significant legal costs defending itself over the next few years, but less than the $300 million we estimate for PCG in the northern California fires, which total 31 fires and destroyed 8 times as many structures. We estimate EIX’s legal costs in respect of the Thomas fire and Montecito mudslides at $150 million.
  • The Offsets: Insurance and Taxes. EIX has disclosed that it has $1.1 billion of third party liability insurance available to it to cover losses from the Thomas fire. This would reduce our estimate of EIX’s out-of-pocket losses to ~$1.8 billion in our adverse case and to ~$3.2 billion in our worst case. We note, moreover, that payments in respect of third party liability and legal costs are tax deductible, reducing the after-tax cost of these loses to ~$1.45 billion in our adverse scenario and $2.5 billion in the worst case. (See Exhibit 2).

©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. 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. 
  2. 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. 
  3. Excludes EIX, the heavily discounted stocks PCG and SCG, as well as PPL, due to its predominantly international utility portfolio. 
  4. Excludes EIX, the heavily discounted stocks PCG and SCG, as well as PPL, due to its predominantly international utility portfolio. 
  5. 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. 
  6. 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. 
  7. 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
  8. 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. 
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