PCG - Hawaiian Electric: How To Profit From Current Uncertainty

2023-09-19 14:42:27 ET

Summary

• Hawaiian Electric's stock has suffered a significant decline due to potential liability for the Maui wildfires, similar to PG&E's situation in California.
• There are significant differences between HE and PCG including the two companies and their situations, including the states they reside in and the direct evidence linking them to the wildfires.
• The outcome for Hawaiian Electric remains uncertain, with possibilities ranging from being found not liable to facing fines in excess of $5 billion and potential bankruptcy.
• Going long shares and short via options should provide the opportunity to profit from the uncertainty.

As a contrarian Deep Value Investor, I like to find opportunities that go against the grain. Sometimes these opportunities seem excessively risky and sometimes they are extremely risky. I frequently try to buy out of favor opportunities to get better returns. I often find inspiration in these words of John Templeton, " I never in all my life bought a stock because I liked it. I bought it because it was a cheaper bargain than any similar stock I would buy anywhere in the rest of the world. " Today that contrarian mindset has brought Hawaiian Electric ( HE ) to my attention. Hawaiian Electric has recently suffered a huge loss of value due to the possible liability in regard to the horrific and deadly fires on Maui. Having recently lost $3 billion dollars in market cap, I believe a lot of bad news is already priced into HE. The current price presents an opportunity to buy shares, but it is not without risk. To defray the risk we have hedged our recent purchase of shares with out of the money 3/15/2024 puts to limit the downside risk.

There has been a lot of conjecture as to whether or not Hawaiian Electric will be found responsible for these fires. The primary reason for concern has been a comparison to the 2018 fires in California that energy company PG&E ( PCG ) was found liable for and forced to pay $30 billion in damages. This ultimately led to the bankruptcy of PCG.

I think recency bias is driving a lot of this concern because there are significant differences between the two companies and their situations. One of the main differences is the states they respectively reside in and the direct evidence linking the company to the wildfire.

• In California, a wildfire's monetary liability is determined by its cause. So, a person or organization can be held financially responsible for the costs incurred by victims of a wildfire if the fire resulted from the careless actions of that specific person or organization.

• In regards to the California wildfires and PCG, there was a " smoking gun " that directly linked PCG to causing the wildfires. According to ABC channel 10, " This broken cast iron C-hook dropped the company's power line and sent sparks falling on the ground below. The thin silver point shows how thin the remaining metal was when the hook fell apart. On November 14, 2018, PG&E workers collected evidence in a criminal investigation against the company for starting the 2018 Camp Fire. " You can see those photos here .

Hawaii's laws regarding responsibility are slightly different and the lawsuits reflect these differences.

• Power Line Maintenance and Warning Responsibilities: The legal actions taken against Maui County and utility companies revolve around accusations of insufficient maintenance of power lines and a lack of warnings to residents regarding wildfire hazards. Hawaii's legal framework may define specific maintenance protocols, inspection requirements, and notification procedures aimed at safeguarding against potential fire risks.

• Negligence and Obligation of Care: In accordance with Hawaii's legal principles, negligence is recognized, imposing an obligation on individuals and organizations to exercise a reasonable duty of care to prevent foreseeable harm to others. The defendants' adherence to this duty will undergo close scrutiny to ascertain whether their actions adequately prevented or mitigated the impact of the fires.

• Funding and Oversight of the Forestry Department: The claim that the state of Hawaii failed to adequately allocate funds and staffing to its forestry department raises concerns regarding government responsibility. Hawaii's laws may stipulate certain obligations for public entities, ensuring the safety and well-being of citizens, including the effective management of forestry projects.

• Coordination of Response Efforts: If the lawsuits contend that the defendants did not effectively coordinate fire prevention and response efforts, Hawaii's legal framework may underscore the significance of seamless collaboration among relevant entities during emergency situations. A failure to coordinate efforts could potentially breach the duty of care owed to the community.

At this juncture, it remains premature to predict the unfolding situation for Hawaiian Electric. In the PG&E instance, there existed unmistakable and highly specific proof of the company's negligence and its direct link to the wildfires. Such clear-cut " smoking gun " evidence of negligence against Hawaiian Electric is not currently available, at least not at this time. Should evidence of negligence come to light in the future, we may anticipate an outcome akin to the PG&E case. If not, we may see a settlement of less than a billion dollars and there is the chance that Hawaiian Electric will not be found guilty at all.

They claim that the local fire department claimed to have the fire under control prior to a second breakout that sadly led to the death of 97 people. These claims seem to mitigate HE's potential liability but this will take a long time to figure out. In regards to the Maui wildfires, the liability might be spread between the county and utility companies such as Hawaiian Electric.

News in August seemed to be overwhelmingly negative

• August 12, 2023: Reports surfaced, revealing that Hawaiian Electric had not put into effect a public power shutoff plan, a deliberate strategy to cut off electricity in areas vulnerable to fire spread during strong wind conditions. This news triggered a significant impact, leading to a nearly 34% decline in Hawaiian Electric stock prices. You can read about that here .

• August 17, 2023: It was disclosed that Hawaiian Electric was in negotiations with restructuring advisory firms, exploring strategies to navigate the complex tangle of financial and legal challenges arising in the wake of the Maui wildfires. You can read about that here .

• August 17, 2023: Another revelation emerged, suggesting that Hawaiian Electric had long been aware of the wildfire threat but had taken minimal action over the years. The report pointed out that between 2019 and 2022, Hawaiian Electric invested less than $245,000 in wildfire projects specific to Maui and only sought state approval to increase utility rates for comprehensive wildfire safety improvements in 2022. The consequences were substantial, causing Hawaiian Electric stock prices to plummet by over 17%, further impacting investors. You can read about that here .

These news articles are damning but they do not constitute a smoking gun. However, they are not the only bad news for Hawaiian Electric. Not only are they facing litigation by those hurt in the fire, but they are also facing litigation from shareholders.

• On August 25th, 2023, the wildfire litigation storm surrounding Hawaiian Electric took a more troubling turn as the company's own shareholders and investors initiated legal action against both the corporation and its top executives. This fresh class action lawsuit by shareholders was filed in a federal court located in California, and it centers on accusations of Hawaiian Electric breaching federal securities laws. It is not surprising that these lawsuits were filed in California, but it remains to be seen whether they will stand up in court.

• The investors' lawsuit claims that Hawaiian Electric, through its recent SEC filings, made significant false and deceptive statements. It alleges that the company neglected to caution investors about their insufficient fire prevention protocols. These shareholder lawsuits represent yet another front in the swiftly expanding wave of legal actions against Hawaiian Electric.

These combined legal actions will definitely be a cost that the company must deal with regardless of the results. It is not surprising that these shareholder lawsuits were filed in California, but it remains to be seen whether or not they will stand up in court.

Dividend Suspended

In August, the company also announced a suspension of all dividend payments so that it could focus on rebuilding the infrastructure on Maui. For shareholders relying on the dividend this was additional bad news. This move should help the company retain $2.64 billion dollars of needed capital and could allow them to absorb any payments needed if they are found liable.

Balance Sheet

HE has a strong balance sheet capable of withstanding some bad news and increases in cap ex spending which will definitely be needed regardless of the litigation outcomes. Accounts receivable will likely drop in the coming quarters until they rebuild their capacity, but I expect the rebuild to be fast.

Total common equity is currently around $800 million more than the current market cap.

Long-term debt of $2.57 billion dollars should be manageable in the first two scenarios listed below. The main issue for HE is making sure that the worst-case scenario doesn't happen, and unfortunately for them they have little control over how the courts will decide the liability regarding the fires on Maui.

I tend to think that this is not the same scenario as PCG because up to now there is no smoking gun. My estimates say it is improbable that HE will end up going up in bankruptcy even though many are assuming it will, but the truth is we don't have all the information needed to make that assessment. My belief is that over the next few months this situation will start to become clear and we will know which scenario has occurred which is why I have hedged my position.

Given the current uncertainty, there are a few scenarios that could happen.

Scenario 1: Hawaiian Electric is found to not be liable

In this scenario, the stock price will return to its fair value of around $24. This fair value is on the low side and predicated on a 5% growth rate and an 11% discount rate. These numbers were in line with current growth of the company before the fire. I applied a lower value because of costs due to rebuilding that will likely be incurred.

It is possible that in this scenario that shares return to the $36-$40 dollar range that HE was trading at prior to the fires in Maui. This will only occur if the dividend gets reinstated at the previous level of $1.44 annually. I believe this range of values provides a daily large margin of safety. Buying shares at the current level will return at minimum a double if this turns out to be the case.

Scenario 2: Hawaiian Electric is found partially liable and pays fines of near $1 billion dollars

The current revenues of HE are $3.885 billion dollars. These revenues will allow HE to pay down fines and liability expenses reasonably quickly. By suspending the dividend, HE has freed up $2.64 billion a year to cover expenses. This will make any liability costs under $5 billion easy to absorb.

In this scenario, the current price of $12.84 is probably close to fair value. I would expect the share price to drop with the news and then steadily recover as the payments are made and the company returns to profitability.

Scenario 3: Hawaiian Electric is found liable and charged fines in excess of $5 billion dollars

If liability costs are less than 10 billion dollars, HE should be able to use their earnings to absorb the cost. However, there is a limit to their ability to absorb these costs.

If lawsuits by fire victims, local jurisdictions, and even their own shareholders all go badly for them, the expenses could start to approach the $30 billion dollars that PCG was forced to pay. In this scenario, Hawaiian Electric will likely be forced into bankruptcy and have to issue many shares in order to recapitalize. If this happens, the buying opportunity will occur after the issuance of shares and current shareholders will lose significant value. I believe that this is the least likely scenario because I am not convinced that HE will be held liable, but the possibility of this scenario is the primary reason I am buying puts to hedge my position.

Given the range of possibilities, I think purchasing the shares outright would be dangerous, but purchasing shares and purchasing puts together should provide downside protection while allowing shareholders to benefit from the possible upside. You can even earn additional income by selling calls at the price you would want to sell HE at anyway. The income from the calls could even be used to purchase the puts but I don't want to overcomplicate it for people that are not used to using options.

Final Thoughts

Hawaiian Electric is at a crossroads and has little control over its future. In many ways we could honestly say that the future of Hawaiian Electric is in the hands of the Hawaiian gods.

Although Hawaii's burden of liability might differ significantly from California's burden of liability, I do not know if it will allow HE to be found not negligible.

No one knows whether the shareholder lawsuits prove successful. These uncertainties have caused HE's share price to plummet. I am unsure of how news could get much worse and so I am inclined to lean into my contrarian impulse and buy shares at the current price. However, I am not willing to do so without some downside protection. I think the best way to currently have exposure to the long side is through buying shares. I also think the best method of protecting the position's value if the worst happens is through options. In order to execute this trade, I have bought shares and puts. I am also considering selling way out of the money-covered puts and calls on my current position to offset costs and produce some income. As always, please do your own due diligence prior to establishing any positions. Thanks for reading and good luck investing.

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