Recently I’ve come across a positively asymmetric (low risk – high reward) opportunity via buying puts on a utility firm that’s recently entered bankruptcy.
I’m talking about Pacific Gas & Electric Co (NYSE:PCG) – which is the holding company that owns the California utility firm Pacific Gas & Electricity (PG&E).
But first – here’s some context. . .
Pacific Gas & Electric was created in the mid-1800’s and is still the largest power provider in California. (And one of the largest in the entire country).
They provide energy to over five million customers – and have many sources of generating power (such as wind, water, solar, nuclear, conventional).
Putting it simply – the firm’s a massive power provider in one of the largest and wealthiest states in the U.S.
But – fast forward to today – and PG&E’s now bankrupt (just filed Chapter 11 in January 2019).
(Keep in mind that this is the second time they’ve entered bankruptcy – last time was in 2001 and later resumed operations in 2004).
So – what led to this?
For starters: years of mis-using shareholder capital. Significant debt accumulation. And deferred maintenance of equipment put PG&E in a very fragile position.
And – like most fragile things – they break once a ‘tipping-point’ is reached.
Well – that ‘tipping-point’ came in 2018. . .
The ‘Camp Fire’ (which was the deadliest and most destructive forest fire in California history) was the event that broke PG&E.
To put things in perspective – this forest fire killed 85 people and destroyed nearly 19,000 homes, businesses, and commercial buildings.
And making matters worse – last month (May) – the California Department of Forestry and Fire Protection (aka Cal Fire) publicly announced that “after a very meticulous and thorough investigation” – it has determined that the ‘Camp Fire’ event was triggered by the “electrical transmission lines owned and operated by PG&E. . .”
(PG&E also stated back in February that their equipment was most likely the cause of the ‘Camp Fire’).
This put PG&E directly liable for significant damages caused by their own “negligence” (estimated at $30-plus billion in wildfire liabilities – which dwarves the firms $1.5 billion in fire insurance coverage).
Therefore – ballooning liabilities from last years ‘Camp Fire’ incident – and further potential criminal and civil liabilities – pushed the already very leveraged and fragile company into Chapter 11 bankruptcy.
(There’s already been new fires this month in California which have been linked to PG&E’s falling power lines. This indicates that their liabilities will soar even higher).
So – what now?
Well – currently – PG&E stock trades for $24.00 per share (a roughly $12 billion market cap).
That’s because shareholders still believe that after paying liabilities and creditors – they will still receive something.
For instance – back during the 2001 bankruptcy – shareholders came out looking very well. (For those that held from the 2001 bankruptcy until September 2017 made over 700%).
PG&E was able to re-pay the $10 billion they owed to creditors via a combination of existing cash and new debt.
But what really saved the firm was the de’facto bailout from the State of California. . .
In short – the state bought PG&E’s spare electrical power (what they didn’t sell to citizens) at artificially high market prices for about five-years.
So – will this scenario happen this time around?
I’m doubtful.
Actually – I believe PG&E shares have much more downside compared to any upside potential (aka negatively asymmetric i.e. huge downside – limited upside).
For starters – PG&E’s assets – in my opinion – aren’t nearly worth as much as the market’s expecting.
True – power companies have the ability to hike utility prices (cost of electricity). And most are forced to pay for it (unless the government steps in).
But still – PG&E has destroyed significant shareholder value and has burned through lots of cash over the last 15 years (since coming out of their previous bankruptcy).
For instance – just over the last decade – the firm’s generated nearly $9 billion in negative free-cash flow. . .
This means that the firm hasn’t grown organically. And has instead depended on both debt ($10.5 billion worth over last 10-years) and selling stock ($6 billion worth over last 10-years). . .
Thus – if PG&E hasn’t been able to generate any cash flow over the last 10 years (and instead binged on debt) – I don’t believe things will change in the future.
(Keep in mind that the firm has mounting liabilities compared to cash. According to the recent PG&E filing (Mar/2019) – the firm has only $3 billion in cash. But has $5 billion due in short-term liabilities. $14 billion in wildfire claims. And $69 billion in total liabilities – this isn’t even counting the additional wildfire claims they owe in excess of $30 billion).
Another hit to shareholders is the fact that there are creditors sitting on $8 billion worth of unsecured bonds (aka debt that’s not backed by any collateral) that want to take a chance at reorganizing the company.
This means that – if the plan’s accepted – it would raise $30 billion of cash. And $18 billion of that would come from selling new shares. (They also want to rename the company ‘Golden State Power Light & Gas Co.’).
This would significantly dilute current shareholders (meaning their piece of the ‘corporate pie’ would be much smaller).
So – in summary – the key takeaway here is that it will take many billions to get PG&E whole again.
Liabilities such as: mounting wildfire claims – repaying creditors – employee pensions – and re-investing in ‘outdated’ infrastructure must be paid.
(Note that all these must be paid first before shareholders can receive anything – i.e. what’s left over).
Don’t forget that it’s already been six months since PG&E filed Chapter 11. And they still haven’t submitted a plan to reorganize.
Now – with the 2019 fire season underway in California – there could be even more wildfire damage. (Which is already happening).
This means even more claims PG&E must pay . . .
So here’s the big question: will PG&E shareholders get anything after they restructure?
Who knows.
But I believe it will be considerably less than the current share price of $24 per share.
Or said another way – I believe PG&E shareholders own more liabilities than assets.
And because of this – I’m buying long-dated, way out of the money, put options on $PCG. Since I expect shareholders will be wiped out over the coming year(s).
As always – do your own diligence.