HE - Hawaiian Electric Industries: Why This Distressed Utility Is Primed To Outperform

2023-12-06 07:56:42 ET

Summary

• Hawaiian Electric Industries has dropped substantially and is down about 70 % in the past year.
• Based on both quantitative and qualitative factors, Hawaiian Electric Industries appears to be heading for outperformance going forward as the stock appears to have been "punished" too much.
• I'm issuing a Buy rating, but caution that Hawaiian Electric Industries should preferably be bought for a portfolio consisting of this and similar opportunities to mitigate risk.

Investment thesis

Utilities are mostly thought of as "safe" investments because of their monopoly attributes and steady cash flows. In the case of Hawaiian Electric Industries (HE), you would have thought much of the same would apply since HE supplies electricity to 95 % of Hawaii's population. You hardly get a more dominant position than that. But shares of this utility are down almost 70 % in the past year.

In this analysis, I examine the reasons for HE's poor price performance, and I take a look at some quantitative factors suggesting future outperformance. I also assess some qualitative factors - mostly management actions - that could support this thesis.

Based on my findings outlined below, I'm issuing a Buy rating for HE.

What caused the drop

At the beginning of August 2023, wildfires broke out on the island of Maui, Hawaii. Several residents of the island died from the fires, and substantial property was destroyed. The town of Lahaina was almost entirely destroyed. Thousands were temporarily left without power.

By the end of August, Maui County had filed a lawsuit against HE alleging, i.e. , that HE had caused the wildfires by failing to de-energize its power lines, thereby igniting dry vegetation.

At this point, it is not yet determined which side will prevail in the lawsuit. The outcome of an investigation into the cause of the wildfires is still pending .

Further, rating agency Standard & Poor's (SPGI) downgraded HE's long-term issuer credit rating to BB- from BBB, and downgraded its short-term issuer credit rating and commercial paper ratings to B from A-2. It revised the outlook to "Watch negative" from "Stable".

An excellent analysis on Seeking Alpha compares the situation to that of Californian utility PG&E (PCG) and their hardship from Californian wildfires. In that analysis, it is suggested that the lawsuit could end in a settlement, perhaps with some extent of shareholder dilution to follow. I agree that this is one possible outcome.

One learning from the situation I guess is misfortune never comes alone.

These quantitative signals suggest upcoming outperformance

HE's enterprise value to revenue ratio (EV/R) is ~1.3, quite a low ratio compared to its peers: Pinnacle West (EV/R ~4) (PNW), Alliant Energy (EV/R ~5.4) (LNT), MGE Energy (EV/R ~4.8) (MGEE). This ratio expresses the price you'd have to pay for total control of the company's assets through ownership of all shares bought at market and all bonds bought at market. Hence, it expresses the ratio a potential buyer for control would pay in relation to the turnover of the company. This very depressed EV/R ratio to me signals on a quantitative level an interesting opportunity for mean reversion.

I also appreciate the simple descriptive fact that HE is a (distressed) utility. Peter Lynch , the famed investor, has described how he would typically avoid utilities because of their slow, "plodding along" growth. But he'd make an exception for distressed utilities where he found several opportunities.

What qualitative actions have management taken

Aside from defending the company in the pending lawsuit, management has taken steps to address the issue of future potential wildfires.

Under its " Wildfire Safety Strategy ", the company expects to, i.a. :

• Deploy spotters to strategic locations in risk areas to watch for ignition when the National Weather Service issues red flag warnings indicating the combination of warm temperatures, low humidity, and strong, sustained winds.
• Automatically shut off power lines if a fault or disturbance is detected on a circuit in risk areas - until crews can visually confirm that it is safe to restore power.
• Expand visual inspections of poles and lines, including via helicopters and drones.
• Install cameras and weather sensors in critical areas.
• Expanding use of covered power lines, fast-acting fuses and fire-resistant poles and equipment.

Whether these initiatives are sufficient to mitigate risks of future potential wildfires - and not least enough to protect against allegations of wrongdoing in future incidents - remains to be seen. But it's clear management has taken steps in the right direction.

Risks

The most immediate risk of buying shares of HE is that of bankruptcy. There's an actual chance that this otherwise solid company with operations dating back to 1891 could go out of business if they are found to have neglected their duties and caused the wildfires, including those in Lahaina. An equity shareholder has a claim on corporate assets secondary to that of a bondholder. Because of the equity shareholder's position in the capitalization tranches, chances are that equity shareholders will suffer greatly from a bankruptcy - especially, of course, if the bankruptcy proceedings end in an actual termination of the business. If the company emerges from bankruptcy, investor value could eventually recover. Either way, there's substantial risk in buying a corporate issue where these outcomes are more than unlikely.

The question then is how this risk is managed. In the words of Howard Marks , risk should be managed rather than avoided.

I suggest diversification. When you buy into issues that show great potential for advance - which HE implicitly does because its share price has dropped so much and there is the reverse chance that HE is found not to have neglected their duties - you assume the risk of great loss in each particular issue (bankruptcy etc.) whilst also assuming the chance of great profit. If you own a portfolio of such issues, some of them will work out, others won't. But because returns on the upside could be several hundred of percent, whereas a stock on the downside can only drop 100 %, there's a statistical argument to be made that a portfolio of well-selected issues of this kind could turn out very well.

Key takeaways

HE is an electric utility serving most of Hawaii's population. It's an old company that recently faced severe headwinds because of wildfires that at least one public entity alleges were caused by neglect on the part of HE. These events caused extreme market valuation drops.

This in turn is what could see HE appreciating substantially if things work out. Credit ratings are down, and the company faces a lawsuit over its very survival, but the stock price has been hammered to a point where it trades at a level close to its lows of the financial crisis of 2007-2008. Other than the drop during the financial crisis, you'd have to go back to the mid-1990s to find a similar entry point. Some quantitative factors, including the EV/S ratio, suggest now could be a good time to buy and hold.

Management has taken steps in response to the occurrence of wildfires. These include advancing a wildfire safety strategy and expanding grid resilience work.

In terms of risks involved with buying HE, potential bankruptcy is "the elephant in the room". I think this risk can be managed through diversification, so my Buy rating is not so much out of rating HE a Buy on an individual issue basis, but out of suggesting it could be an interesting addition to a portfolio of issues showing the same properties as HE.

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