"Liquidating Before Your Eyes" - PG&E's Clock Is Ticking

Grant's Almost Daily, submitted by Grant's Interest Rate Observer

On Tuesday, California governor Gavin Newsom signed Assembly Bill 1054, establishing a $21.5 billion wildfire relief fund and setting a June 30, 2020 deadline for fallen utility PG&E Corp. (PCG on the NYSE) to emerge from bankruptcy in order to participate. PG&E, which was found liable for a series of 2017 and 2018 blazes including the Camp Fire (which killed 85 people and destroyed the town of Paradise), entered Chapter 11 on Jan. 29. Investors have kept their hopes up for a swift return to business as usual, as the company still commands a $9.8 billion market cap.

There is reason for that optimism. The new legislation will allow utilities to choose between accessing designated liquidity and insurance funds which allow for fire cost coverage. While PG&E cannot participate in the scheme until it emerges from bankruptcy, analysts at Bloomberg Intelligence note today that PG&E shareholders “would face significantly less downside” if the company can achieve various safety certifications and make the necessary payments to buy in to the insurance fund post-bankruptcy.

As noted by The Mercury News yesterday, “as much as some legislators may have wanted to roundly punish bad actors among California’s electricity providers, they were mindful that even a slap on the wrist to utilities could have the unintended impact of a punch in the nose to consumers.”

But will PG&E investors avoid the proverbial knuckle sandwich? In its most recent 10-Q filing on March 31, the company disclosed $14.2 billion in existing wildfire-related liabilities. In testimony concurrent with the filing, CFO Jason Wells estimated that figure could end up topping $30 billion.

The clock is ticking for future liabilities, as claims from any new wildfire damages would take precedence over existing liabilities.  A study released Sunday by the journal Earth’s Future finds that: “During 1972–2018, California experienced a five-fold increase in annual burned area, mainly due to more than an eight-fold increase in summer forest-fire extent.”

Media scrutiny continues apace. Last Wednesday, The Wall Street Journal reported that company executives were aware of problems with transmission lines that were eventually responsible for the Camp Fire, yet “repeatedly failed to perform the necessary upgrades.”  In addition, PCG estimated in 2017 that its transmission towers were 68 years old on average (already above the mean life expectancy of 65 years), with some as old as 108.

The company is no stranger to bad press surrounding environmental disaster and big payouts. In 1996, PG&E was forced to pay $333 million to settle claims it dumped more than 350 gallons of chemically-poisoned water into ponds near Hinkley, Calif., an episode memorialized in the 2000 film Erin Brockovich.

It might be harder to shake the wildfire legacy costs than the bulls reckon. In a bearish analysis of PG&E in the Feb. 22 edition of Grant’s, Angelo Thalassinos, the deputy managing editor at Reorg Research, Inc., noted that the Camp Fire may act as a millstone around PCG for years to come.

The thing that jumps out at me, and the distinction here from other mega cases, is the damages and liabilities from the wildfires. It most harkens back to old Chapter 11 cases that had asbestos liabilities. . . . There is potential for continuing damages from that respect throughout the bankruptcy case and even post-emergence.

In the five months since our report, PCG shares have treaded water, lagging the 8.3% total return from the S&P 500 Utilities Index over that period.  But the company’s debt has fared well, with the senior unsecured 6.05% notes of 2034 rallying to 111 cents on the dollar (from 93 in February), for a 283 basis point pickup over Treasurys.

That performance disparity seemingly reflects the unfolding political situation. On Friday, The Journal reported that creditors led by Elliott Management Corp. petitioned California lawmakers for bondholder-friendly tweaks to the bill, including allowing PG&E to issue debt to pay future wildfire claims but not existing liabilities, such as from the Camp Fire. As noted by the WSJ: “Legislators ultimately sided with bondholders on the issue.”

Victory in court for that Elliott-led bondholder group would likewise spell trouble for shareholders. Creditors have proposed injecting up to $18 billion into PCG, in return for control of the company.  A court hearing at which Elliott et al. will present their arguments is scheduled for July 23.

With PCG continuing to sport a substantial market cap, investors may be underestimating the risks. That Feb. 22 Grant’s analysis broke down the pertinent numbers, concluding:

To the equity holders, it’s a daunting figure. Wildfire claims of just $10 billion (around a third of the CFO’s estimate) would impair the equity— assuming that PG&E’s asset base is not overstated through overly long depreciation schedules.

Even prior to the recent disaster, PCG’s shareholder economics looked less than compelling. From 2013 to 2018, the company generated $25.5 billion in operating cash flow, well shy of the $31.9 billion in capital expenditures over that period. In his Jan. 31 affidavit, CFO Wells forecast that cash from operations will lag capex by an additional $1.6 billion per year in 2019 and 2020. Even after suspending its dividend in December 2017, post-2013 disbursements to shareholders foot to $4.4 billion, a sum which PCG borrowed to pay.

The utility increased operating earnings to $3 billion in 2017 from $2.3 billion in 2008, while capital employed jumped to $62 billion in 2018 from $30 billion in 2008. James S. Chanos, founder and managing partner of Kynikos Associates L.P. and a PG&E bear, noted to Grant’s in February:

It’s a 2% return on incremental capital. That is below their cost of capital. They are liquidating. The utility is in effect liquidating before your eyes before any wildfire liability.