PCG - Scandal Stocks: Too Soon To Buy Hawaiian Electric

2023-08-17 09:40:00 ET

Summary

• Hawaiian Electric faces lawsuits, investigations, and large potential liabilities from the Lahaina fire.
• Stocks with major negative events tend to decline for several months before hitting a bottom.
• This is not the time to "buy the dip."

For several years, I've been tracking stocks that have suffered serious material adverse events - "scandal stocks" for short.

The fall in Hawaiian Electric Industries, Inc. ( HE ) after last week's devastating wildfires on Maui certainly qualifies for the list.

As of this writing, the fires that rapidly spread from drought-stricken grassland to the resort town of Lahaina had killed 110 people and destroyed 2,200 structures.

Scandal stocks tend to have a cycle. First, an event triggers a rapid decline. Then, pressure on the stock builds as lawsuits are filed, media reveal further problems and governments start investigating.

At some point (a median of about four months), most of the bad news has come out, and the stock turns back up. This usually occurs before the final stage, when corrective action, such as a government fine, is taken.

As you can see on the chart, the median stock on my non-exhaustive list declined 41% and took 130 days to bottom.

Source: Author's research

The closest comparison is with PG&E Corp. ( PCG ). The stock closed at $48.80 on Nov. 7, 2018, the day before its equipment caused the Camp Fire in Butte County, killing at least 84 and destroying 18,800 structures.

A week later, the stock was down to $17.74. The company filed for bankruptcy in January 2019 and finally bottomed at $3.80 on Oct. 28, 2019, a 93% drop in 255 days. PG&E emerged from bankruptcy in 2020 with stock greatly diluted to help pay claims and has risen back to the $17 range since then.

It was fairly obvious, then, that investors who bought the 34% drop in HE on Monday were too early, and I bought a few puts that day. The thesis was borne out with a 31% decline Tuesday after Standard & Poor's reduced the utility's credit rating to junk status. An attempted rally Wednesday failed late in the session on a Wall Street Journal report the company had met with restructuring advisors. Falling bond prices are also a bad sign.

At the very least, Hawaiian Electric faces huge costs for restoration of service. FEMA provides assistance on a cost-share basis , not less than 75% of eligible costs. It does not replace private homeowner insurance, and insurance companies are likely to try to recoup payouts from anyone they can plausibly blame for the fire.

The company is already facing a class-action lawsuit that says its equipment started at least one of the fires and blames the company for not de-energizing power lines during high-wind events, as is done in California.

Hawaii, unlike California, does not have an inverse condemnation law that holds the party that caused damage liable even if it was not at fault. However, the plaintiffs are claiming inverse condemnation anyway, saying that under the Hawaii Constitution, "private property shall not be taken or damaged for public use without just compensation." The legal case may turn on one issue :

Stock analyst Shahriar Pourreza told The [New York] Times that "the issue becomes whether they did everything they could that was reasonable to prevent this incident."

"Was there gross negligence, was there imprudence?" he added.

Depending on what investigations find, the company might prefer to settle rather than have an angry Hawaii jury decide that question.

Hawaiian Electric's financials are not exactly comparable to other utilities because the company also owns a bank. Utility revenues of $794 million and net income of $45 million in the second quarter compared with $5.29 billion and $410 million for PG&E, making it roughly one-eighth the size of the Northern California utility, which ultimately paid about $24 billion to fire claimants including insurance companies.

Maui County released an estimate of preliminary capital exposure (rebuilding costs) at over $5.5 billion. The exposure of insurance companies has been estimated at $3.2 billion .

Will the worst-case scenario - a total wipeout of shareholders - come to fruition? Probably not. Like California, Hawaii has reason not to drive the stock price to zero, as repairs, lawsuit settlements, and safety improvements require attracting equity capital as well as debt. A PG&E-type outcome with claimants getting much-diluted equity along with cash would seem more likely.

Conclusion

There appears to be more bad news to come, and I don't think the bottom is in yet. My options strategy is to wait for a rebound and roll my September $17.50 puts into a lower strike price where there would be more bang for the buck.

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