Texaco, WR Grace, & Pacific Gas & Electric
Texaco & The Getty Oil Company
I love the story of Texaco’s takeover of the Getty Oil Company.
Getty Oil had been founded by the legendary J. Paul Getty, who had famously once said that the three keys to success were to i) Rise early, ii) Work late, and iii) Strike oil. He would have been well advised to add a fourth to that list: avoid litigating against Joe Jamail.
On January 3, 1983, Pennzoil had entered into a binding agreement to acquire Getty Oil. Four days later, Texaco submitted a superior bid. Getty terminated its agreement with Pennzoil and sold itself to Texaco. Pennzoil, with Joe Jamail acting as its lead counsel, sued Texaco for damages in a courthouse in Texas and was ultimately awarded an enforceable judgment of $10.5 billion. There’s a great book on the jury trial and award, Texaco and the $10 Billion Jury by James Shannon, which is worth the read.
After the judgment, Texaco approached Pennzoil to settle, stating clearly that without a quick agreement it would be forced to enter into Chapter 11. Pennzoil incorrectly called the bluff and Texaco, led by its legendary CEO Jim Kinnear, filed for Chapter 11. The parties ultimately settled for $0.30 on the dollar, approximately $3 billion.
Soon thereafter, Texaco emerged healthy from Chapter 11 and generated significant returns for its shareholders in the following years, with its shares almost doubling in 24 months:
W.R. Grace
A similar case occurred in the early 2000s, when W.R. Grace faced a towering wave of lawsuits related to asbestos liabilities. While many of these weren’t proven claims, the expectation (and reality) was that Grace would become liable for these amounts. So Grace filed for Chapter 11.
Through the Chapter 11 process, Grace was able to set aside a trust for pending and future asbestos-related litigation, and, even though it took thirteen years, was able to emerge as a long-term viable going concern in 2014. During this period, Grace’s share price rose almost 60 times as the company thrived and ring-fenced its exposures to the asbestos-related claims.
This investment was one of the most lucrative made by Berkshire Hathaway investment manager Ted Weschler (who started his career at Grace) when he still ran his private fund, Peninsula Capital Advisors.
Pacific Gas & Electric
When I began to research the current situation at Pacific Gas & Electric, I immediately saw some similarities to both Texaco & W.R. Grace.
For Pacific Gas and Electric, two wildfires caused catastrophic damage to large areas in California and were attributed to faulty or problematic equipment operated by PCG. In January 2019, the company filed for Chapter 11 to protect itself from the claims.
However, the loss in market value of PCG since its high has been more than US$30 billion, compared to the reported net losses from 2018 to 2020 of ~US$15.8 billion. This divergence creates an opportunity, as PCG has emerged from Chapter 11 as a solidly profitable company, generating adjusted net income of over $1 billion in just the first six months of 2021.
This article, while negative, gives a good overview of the situation.
Recent Updates
Historically, I have not invested in any large cap utilities (other than indirectly through Berkshire Hathaway), but have had PCG on my radar since the Chapter 11. Seth Klarman’s purchase of insurance subrogation claims was simply genius. (It looks like Klarman still owns ~$300 million pf PCG shares, Baupost’s 11th largest holding).
It’s been an interesting file to watch. Yet the shares are approximately where they were when PCG exited Chapter 11 in the summer of 2020:
However, there have been a number of positive updates which don’t appear to be recognized in the valuation:
I. Wildfire Fund
In the summer of 2019, the Governor of California signed a $21 billion wildfire fund, which enables California’s utilities to access quick financing in case wildfires cause similar liabilities as PG&E experienced in the past. This allows PG&E to draw down liquidity that would be repayable with future customer surcharges to pay for wildfire claims (i.e. not dilutive to PCG). It appears as if this new legislation substantially reduces the probability of another bankruptcy event due to future wildfire claims. PG&E entered into this program as it exited Chapter 11.
II. S&P 500 Milestones
As of Q2 2021, PCG now has four consecutive quarters of positive earnings, has a market cap of ~$22 billion and meets the float requirement. An S&P 500 inclusion should be forthcoming?
III. Capital Expenditure Commitments
In July, PG&E made a commitment to bury tens of thousands of miles of electric lines in high-risk areas. This “permanently derisks” the longer-term wildfire risk for these areas, and the cost of this will “likely be shouldered by PG&E customers.” While the Wildfire fund legislation reduces the probability of another bankruptcy over the near-term, the undergounding of these lines reduces the probability of another bankruptcy over the long-term.
IV. Future Dividend
Some analysts are predicting a reinstatement of the PCG dividend as soon as 2023 (when it may meet its requirement of $6.2 billion in non-GAAP core earnings). When will this start to be discounted in the share price?
Idea: Name Change
At one point, Elliot Management, as part of its creditor-led bankruptcy reorganization plan, had proposed that PG&E should rebrand itself, given that it had become one of the most hated companies in America.
Much of the input / feedback that I’ve seen is that PG&E is making sincere efforts to engage with the local community and repair the goodwill that they lost over the years, and this is going a long way to restoring their credibility with their customers. A name change would help re-enforce these efforts and commitments.
Philip Morris changing its name to Altria and Anderson Consulting changing its name to Accenture were both smart moves.
Valuation
The long thesis is therefore as follows:
The near-term risk of Chapter 22 (a second Chapter 11) due to new wildfire claims is substantially reduced due to the newly established California wildfire safety net;
The longer-term risk of Chapter 22 is mitigated due to non-dilutive capex plans to bring electric lines underground
Dividends from PG&E, currently restricted, could be reinstated as soon as 2023 (analysts estimate)
An S&P 500 inclusion is once again possible, which would result in index fund purchasing
Lastly, PCG trades at a substantial discount to all of its peers:
My view is that it could trade to >$20 if/when the dividend is resumed and the S&P 500 inclusion occurs. The most material risks appear to have been mitigated with the new wildfire fund and management’s long-term commitments.
Therefore, we’ve initiated a small long-position (shares). Though of course I am confident - now that I have written this position publicly (and solely for that reason) - that it’s going to sell off further. I’ll plan on adding if it does.
Sherwood Ltd.
September 26, 2021
Disclosure
Sherwood Ltd. has prepared this report with the expectation that anyone reading this analysis isn’t foolish enough to think that it is anything other than an opinion that is held at the time of writing. This isn’t investment advice. Rather, Sherwood Ltd.’s investment advice is for you to read Burt Malkiel and invest monthly in a diversified low-cost index fund over a long period of time.
In no event shall Sherwood Ltd. or the author(s) of this report be liable for any claims, losses, costs or damages of any kind, direct or indirect, arising or in any way connected with this report. Any actions you take are at your own risk. Sherwood and the author(s) of this report have no intention on updating as to when and if they close out any positions or change their investment theses.
Hopefully there are no material errors in this analysis, but if there are, we would appreciate if you would contact us so that we may correct them. Even better if you can change our minds with your different perspective and facts which we may not have seen in the course of our research.