"It's a utility, what's the worst that can happen?"
News about PG&E has been almost impossible to avoid recently. They are under investigation for their role in several wildfires throughout California, most notably the Camp Fire, which resulted in 86 deaths and was the costliest natural disaster of 2018. For all of the fires, PG&E could face liabilities that total a minimum of $30 billion.
PG&E currently has a market cap of less than $10 billion and an enterprise value of $28 billion, at time of writing. They have about $4 million in cash on hand. They are looking to potentially sell their gas assets to help pay for the potential damages, or utilize California legislation to forgive it all together. Their stock has tanked by 31% over the past four days. Reuters released a report stating that the company has considered filing for bankruptcy.
PG&E has a pretty robust background regarding natural disasters over the past twenty years. Groundwater contamination, criminal negligence for failing to trim trees, exploding pipelines with activity that registered on the earthquake scale, and potentially causing twelve fires are some of the most notable ones.
Source: Capital IQ
Walking the Edge of a Liquidity Crisis: The Downgrade to B
Among all the news, the S&P Global Ratings downgraded PG&E's credit to B from BBB-, which is officially junk status. S&P Ratings has threatened to lower the rating even more, especially if management proves to be unable to create a quality plan to protect credit status in the future.
PG&E will have to pay much more to borrow in the future, due to this new bond status. PG&E notes are now trading at a yield of 9.9%, which is much more than the 7.5% average for other high yield bonds. Moody's and Fitch are also in the process of reviewing the company, and if they decide to cut the bonds to high yield, that would be further increase pressure on PG&E.
If the other two rating agencies decide to downgrade PG&E, an $800 million cash collateral call would rip through the company. The company has already suspended its dividend and drew out all lines of credit. They are running out of liquidity options, increasing the potential to continue on with bankruptcy plans, if another downgrade occurs.
The utility filed for bankruptcy back in 2001 and reemerged in 2004 under a new reorganization plan. But the circumstances are different now. Now, both the utility and the holding company are under fire, from acts ranging from sheer negligence, to breaking safety rules, and to falsifying records.
Finally, PG&E's senior vice president of electric operations is retiring on January 28th after a five year tenure with the company, which the market did not respond well to. Patrick Hogan belongs to the actual PG&E arm of the company, rather than the corporation. It's normal for companies to shake up management when in the midst of something as potentially catastrophic as a bankruptcy. And PG&E has walked this line before.
Investing in PG&E: The Hedge Fund Play
The only issue is, PG&E isn't going down alone, if they go down at all. 31 institutions and 20 hedge funds have the company in their top ten holdings, with 609 institutions holding the stock and 87 hedge funds. Hedge funds have increased their exposure by 40.94%.
As of September 30th 2018, BlackRock owns almost $2 billion in market value of the company, totaling 48 million shares, totaling almost 10% of the PG&E. Vanguard is next, with $1.7 billion in market share.With regards to overall portfolio exposure, Springhouse Capital Management has 12.5% of their portfolio dedicated to PG&E.
Source: Capital IQ
Baupost has dramatically increased the number of shares they hold in PG&E, going from 4.5 million in June 2018 to 18.9 million as of January 7th, 2019. That is a 4.2x increase. They are currently the top buyer of the stock.
Baupost purchased the 14.4 million shares at the Q3 2018 share price of $45. With the stock now trading at $17, it could have been a painful few months for Baupost. Blue Mountain Capital increased their stake by 88%, believing that the markets reaction to the fires were overstated. Blue Mountain Capital has a target price of $59.10 for the stock, with an average analyst target price of $40.13, still more than double its current trading price.
Looking at the Data: Defaults & Historical Performance
The chart below depicts the market signal probability of default for PG&E, which is currently at 1.87%, as compared to an average of 0.93% for the past year. The probability of default has increased, but it still remains relatively low, especially compared to the beginning of the year.
Source: Capital IQ
PG&E is the worst-performing stock in the S&P 500 Utilities Group. The S&P 500 Utilities Index has massively outperformed PG&E even over the past five years, posting a ~38% return versus PG&E's ~53% decline. Optimistically, this means that there is a lot of room to the upside for the PG&E. On the flip side, the momentum appears to be to the downside, with several variables weighing on the direction that the company could go.
Source: Yahoo Finance
PG&E's Role in the Day to Day Lives of Millions
PG&E is not like other publicly traded companies. It has complete market control over the electricity for 5.4 million homes, and gas for 4.3 million. They are responsible for almost half the state of California. They are an investor owned utility, so they carry a responsibility to shareholders as well.
Utilities are highly regulated. The market does not set its rates, the California Public Utilities Commission does. PG&E was asking for a $1.1 billion revenue increase in early December, according to their General Rate Case, which doesn't include funding for claims against the wildfires.
The future of California's climate change goals rests in the existence of PG&E. There are billions and billions of dollars in contracts that will collapse if PG&E goes under, which would "send potentially a very negative signal in terms of future development in California" according to Jan Smutny-Jones, chief executive of Independent Energy Producers.
Source: LA Times
Regulators are trying to decide whether they should let the company issue bonds to pay for its liabilities, or break it up entirely. Even if PG&E gets bailed out by California, there is so much risk surrounding the stock with credit downgrades and the potential for more disasters in the future.
Xerox (XRX) was downgraded to junk back in December 2018. They cut jobs and the stock fell 13%. But Xerox doesn't provide electricity to millions of homes, nor does it provide heating in the middle of winter. Utility stocks are considered a defensive strategy within a portfolio, primarily because of the necessity of the product they provide. They have a monopoly on products and services, and those goods are relatively inelastic.
Conclusion: A Risky Stock But Potentially a Good Buy
There is a lot of pressure on PG&E currently. They completely eliminated their dividend. Bankruptcy talks are never a positive sign. There is a general appearance that they don't seem to learn from their previous mistakes. PG&E is owned primarily by institutions, with the general public holding approximately 14% of the company.
But they are an integral component of people's lives. The utility, not the corporation, filed for bankruptcy before, back in 2001 during the energy crisis. Back then, executives said: "The political regulatory process has been able to negotiate but not close the deal. A federal bankruptcy court is a better way to get a deal closed." Governor Gray Davis called the filing a "slap in the face to California."
Shareholders who held on to PG&E throughout that Chapter 11 process saw their investment triple. Rate payers paid off $7.2 billion of PG&E's $9 billion debt. But now, in 2019, things are different, as PG&E could be potentially responsible for the loss of lives and massive natural disasters. A utility bankruptcy would weigh on California's entire electricity business.
Gavin Newsom took the office as the new California governor on Monday, and he said, "My role for the state of California is to protect your interests and not PG&E's, interest but sometimes those interests align and that's where it gets complicated." PG&E spent $8.4 million in the first three quarters of the 2018 on lobbying, which is $7 million more than it spent throughout all of 2017.
The direction of PG&E is up in the air. They could file for bankruptcy, just as they did back in 2001, without much warning. Or they could take a bailout package from the state, potentially sweetened by lobbying money. Or their bond ratings could get slashed even more. Criminal charges could be brought against them. They could be converted into a publicly owned utility.
But right now, PG&E's goal is to optimize shareholder return on investment. Institutional investors seem to recognize that, as hedge funds increase their stake in the company. Cash flows are positive. The company trades at an elevated PE ratio, but their EV / EBITDA value is far below industry peers.
Source: Seeking Alpha
The company has room to the upside. But, they also have a series of extreme allegations against them. This seems to be an investment that could really pay off, or one that could collapse. Giving the company more time to sort itself out might be the best play here. However, if you think that the stock has bottomed out and the company will get bailed out, it would probably be a good buy.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.