I have been buying PCG today. The stock is down 7%, equal to a loss of +$1.3 billion of market cap, on news that one of their gas lines was involved in an explosion in the
San Francisco suburb of San Bruno. I think the reaction is being driven by the sensational nature of the incident rather than any set of rational calculations.
PG&E is an integrated electric and gas utility serving the Bay Area. They are one of the largest utilities in the nation with over 5 million electric customers, over 4 million gas customers,
and a regulated rate base of nearly $20 billion.
The company has several features to its business that make it one of the most attractive places to invest capital in corporate America today. Pretend you were running a company
with a huge moat, like Federal Express. Now imagine a genie said to you, okay, in addition to having that huge moat, you can now pass all your fuel costs through to your customers dollar for dollar.
Your revenues are also now decoupled from unit volumes, so if volumes go down because of a double dip recession your earnings won't take a hit. In addition, because I'm in a good mood, you
will be allowed to pass all your pension costs through to your customers, and to top it off I'm going to give you mid to high single digit top line growth visibility for the next 5 years.
If I were that person running Federal Express and had those attributes granted to me I would be delirious. PG&E has those features.
In addition, its 11.35% authorized return on equity is among the highest of any regulated utility in the country.
Financial Impact of the Gas Explosion
My understanding is that PG&E has $1 billion of liability insurance. For the $1.3 billion drop in market cap to be justified there would have to be $2.3 billion in total costs associated with the explosion.
Consider that 120 homes are damaged, of which some are destroyed. Pretend they're all destroyed. The median home value in that neighborhood is $667,400 as
reported by Bloomberg News this morning. Replacing the 120 homes would cost $80 million. I don't see how compensation to familes of the 4+ dead and additional
injured plus legal fees could cost well in excess of the remaining $920 million of liability coverage. For perspective on legal fees, the 3 Mile Island nuclear incident incurred
legal fees of around $75 million.
PG&E paid a premium of something like $17 million for their liability coverage. It will go up. How much should the market cap be penalized because of that?
Say the premium quadrupled to $68 million. The delta would be $51 million. After taxes of 35% that would be a net increase of $33 million per year. Assume
the impact lasts into perpetuity; with a WACC of 6% (in line PG&E's recent past, and peers in the Philadelphia Utility Index) the NPV penalty to their market
cap would be $550 million. However, they would be able to get cost recovery of much, if not all, of that increase in their next General Rate Cast 3 years after the current one.
In addition, there are many layers in their insurance coverage, and therefore many participants. There are too many insurers in this type of coverage to hold ranks and maintain pricing discipline
on this insured for very long. Any increase in rates is unlikely to be permanent.
I don't yet how to put a number to the property damage of their gas assets. For perspective, remember that their rate base, which is mostly electric, was nearly $20 billion at 12/31/09.
San Bruno is a small area of their service territory which is tens of thousands of square miles. There will be some negative impact to their property insurance rates as well,
but it will be smaller, probably, and also temporary. I would be shocked, shocked, if the damage to PG&E's property exceeded their coverage limits.
For the insurance coverage to be voided there would have to be criminal behavior involved. I've read rumors online that residents were complaining about a leak in the
area as far back as a week ago. That wouldn't surprise me. However, it's not a crime to be lazy or slow to respond.
Comments on the Regulatory Impact
I'm not necessarily in love with the management team. They've done some things recently that have upset people. 1) The state ballot initiative that failed.
2) Trying to get +$2 billion of capex authorized for infrastructure reliability improvement outside the General Rate Case,and only being authorized to invest $350 million.
3) The Smart Meter installation fiasco in Kern County. If PG&E is found at fault in the explosion it may be some sort of tipping point inthe regulatory dynamic, but there are
other large investor owned utilities in the state like SCE, SDG&E, SoCalGas to give them cover. Regulators may come down on PG&E in a way thathurts their authorized revenues and cost recovery,
but it would be hard for them to be punitive given the presence of other utilities that haven't done anything wrong. PG&E can benchmark howthe regulators treat them against the way the regulators
treat the peers. If things get too extreme with PG&E the contrast with peers will be cast in sharp relief.
Comments on Valuation
I think this is normally a core type of holding. It's rare that this type of stock has press release risk. It's not every day you get to buy a company of this quality at a 6% discount
to the price it was trading at the day before. Even a couple of their preferred stocks are trading down. I bought a modest position because even if I'm right,
sometimes in fluid disaster-type situations more information comes out that causes the stock price impact to deepen (Macondo?), and I want to be able to buy more.
However, the difference with Macondo is that the problem has been contained relatively quickly.
The common stock is now at 1.6x book value of $27.82 per share. Over the decades the stock has traded at about 1.5x, but the business did not always possess the array of favorable
attributes it has now, and interest rates are at historical lows. Its peers in the Philadelphia Utilities Index are also trading at about 1.5x book, but most of them don't have those features
or the same level of growth visibility.
It's at 12.1x 2011 pre-explosion EPS estimates vs. 13.2x for the S&P 500. I would argue this is a superior business to the average S&P 500 constituent in this economic climate.
The stock is yielding 4% at these levels, which is higher than the 30-year Treasury, and the dividend should grow over time in line with the mid to high single digit growth earnings
growth they have visibility towards.
The main risk here is that criminality was involved. I just don't see it, but if I'm wrong about that then the floor under the stock may be at book value of $27.82 per share.
Possible Evidence of Market Confusion
SCE is owned by Edison International (EIX), which is down 1.15% today, even though they don't have any gas utility operations. SDG&E and SoCalGas are owned
by Sempra (SRE), which is up 0.28% even though both its utilities have gas operations in California. Go figure.
Comments on the Humanity
It sucks that this happened. From what I've read it was terrifying. If that type of explosion happened in my neighborhood I would probably be disgusted if hours later
somebody was calculating how to profit off the situation. Should respect for human dignity compel us to wait a certain amount of time
before taking advantage of the situation? How long is long enough? If I don't buy the stock somebody else will beat me to it. Why should somebody else
get that opportunity and not me? I want to provide for my family. Ah, to be human and full of such conflict. I'd be curious to hear how other people think about
the morality of investing in these types of situations.
Clarity around insurance coverage/claims.