Understanding PG&E’s Dividend Cut

Today, Pacific Gas and Electric (PCG) is down in after-hours trading to $46 per share on the news that the Board of Directors has elected to suspend the $0.53 quarterly dividend. A PG&E press release blamed the California wildfires for the dividend cut, as California law does not shield utility companies for they damage they cause during natural disasters even if they are in compliance with the applicable health and safety laws.

Initial estimates suggest that PG&E’s liability could be in the $1.0 billion to $1.5 billion range. Presently, Pacific Gas maintains an insurance policy covering natural disaster damage up to a maximum amount of $800 million. Assuming that Pacific Gas triggers this cap, the California wildfires stand to cause $200 million to $700 in losses to shareholders. Considering that there are 515 million shares, this could be a maximum hit of $1.35 per share (with the lower end ranges causing about $0.38 per share in damages).

From an earnings power perspective, PG&E normally makes about $3.65 per share in profits, with the previous dividend speaking for $2.12 of those earnings. In a realistic bad case scenario, the hit from the wildfires would consume all of their retained earnings over the next twelve months. By suspending the dividend, Pacific Gas is carrying on with its usual amount of retaining earnings and is replacing “dividends” with “California wildfire liability” for a short period of time.

This is intriguing because Pacific Gas & Electric is the dominant utility in Northern and Central  California. It has extremely steady earnings and dividends. Prior to this suspension, PG&E had enjoyed a fairly typical dividend history–grow earnings by 4-7% each year, and repeat perpetually. It enjoys a near monopoly over its customer base, subject to the restriction that price increases can only occur at a rate permitted by regulators.

The short of the analysis is that Pacific Gas is a $2 billion annual profit engine that is presently enduring a potential $700 million cloud. This strikes me as a real-life example of what Peter Lynch called “sold enterprises with solvable problems” that will eventually reap value when the problem subsides. The earnings power is under siege due to a specific event; the business will remain intact and restore the dividend in the years.

What will that look like? Assuming modest 3-5% growth, Pacific Gas will be earning $4.25 to $4.75 per share five years from now. Assuming it pays out a little over half its earnings as dividends, I estimate that the annual dividend payout will be around $2.50 per share in the 2022-2023 time period.

Based on the current price of $46 per share, this suggests a future dividend yield of 5.5%. Why is that worth waiting for? Because a lot of capital appreciation will occur simultaneously with the expiration of the California wildfire payments and the dividend’s subsequent restoration.

At $46 per share, Pacific Gas is trading at around 12x current earnings and is trading at 9x five-year earnings. That is intriguing because, due to the stability of Pacific Gas’ operations that normally exists, this business typically trades in the 17-20x earnings range because the earnings are so predictable.

People like Jack Bogle have been sounding the alarm that the S&P 500 should only generate 2-5% returns over the next decade. Throw in a recession, eventual tax increases to pay for this tax cut, higher interest rates, and a readjust of P/E ratios, and the stock market will return to historical norms.

You don’t have to go along with the crowd and buy overpriced assets. You can still find relative bargains that have a realistic possibility of generating 8-12% annual long-term returns. But if you want to find discounts, you will have to search through the businesses that are experiencing current problems. Right now, there is so much prosperity in corporate America that the thought is “if your business is struggling during good times like now, when do you honestly expect to find success?”

My preference is to search for businesses with reliable cash flows that are dealing with some defect. Due to recency bias and the desire to make a quick buck, these types of businesses are too quickly discarded. PG&E is a monster that generates $2 billion per year in profits when it is not facing financial calamity. It will use the maximum $800 million in insurance coverage, and after, will pay out a figure in the hundreds of millions to meet its liability.

The long-term prospects remain rosy. The 10% sell-off is the result of the fact that this stock is owned by people who need income now. As the shareholder base shifts from current income investors to future income/value investors, therein lies the opportunity. Someone that buys Pacific Gas at these after-hours prices or lower, and holds for ten years, will reap dividends and capital gains that far exceed the S&P 500 over the next ten years. Buying utility stocks at 10x earnings rarely fails.