Some utility companies are not so safe

I’ve been following the PG&E (NYSE: PCG) story rather closely.

I don’t know anybody that would actually want to operate a utility in California with the state’s liability regime (you are completely liable for damages as a result of wildfires) and this is a pretty clear example of avoiding an investment that will have a good blow-up disaster potential.

Most publicly traded utility companies trade as if they are stable and boring, but in reality, there are quite a few that have embedded hidden risks – beyond their insurance regimes.

The more interesting part of this story is that even after the initial wildfires to cause the slide in the stock, an investor still had plenty of time to bail out before PCG was finished.

But now they’re into Chapter 11, primarily to shed liabilities associated with the California wildfires.

Financially, PCG has US$20 billion in equity on the balance sheet, which works out to about $38/share. They accrued $2.8 billion in wildfire-related claims in liabilities, but estimates are that there will be about $22 billion coming in, which would nearly wipe out the equity in the company.

The unsecured debt is trading at around 80 cents on the dollar presently, but one could make quite a bit of money on the equity if your loss projections on claims were less than what the market is projecting at the moment.

I’m not the type of person to be playing such types of financial games as there are typically far more smarter people than I am (to determine the residual value of PG&E after claims), but I still find it interesting to see how it will resolve nonetheless.

One thing is for certain – people still need to be supplied electricity, and electricity is a very inelastic commodity. When you have so much state regulation in place, especially when hearing about multi-billion dollar capital and maintenance expenditure proposals to prevent future wildfires across huge amounts of power lines, it all serves to have one effect – raising the cost of electricity for captive customers. California residents (e.g. Los Angeles) already pay very high rates for power – and after this debacle on PG&E, they’ll be paying more after these claims are settled. The money has to come from somewhere.

Think a moment about your investments in well-known utility companies such as Emera (TSX: EMA) or Fortis (TSX: FTS) or Hydro One (TSX: H) for a moment. Is there more risk than you originally anticipated?

IFRS 16 – large change in lease accounting

I talk much more about finance than accounting on this website, although I am a professional accountant. A good analogy is math and physics – people in both fields tend to understand the other, more so than the difference between chemistry and biology.

Effective this year, companies will have to adopt IFRS 16, which governs accounting for leases.

Other than enriching accounting consultants that will have to dig into the structures of leases of various firms, this will have a material impact of the reported assets and liabilities on a company’s balance sheet. New students of accounting will also have one more layer of complexity to memorize at exam time, while textbook manufacturers will undoubtedly be happy.

Specifically, the distinction between an operating lease vs. a capital/finance lease is removed and instead all leases will have an asset and liability component. The asset of the lease (the item which you are buying the rights to use) will be depreciated over time, coupled with an interest expense component for the financing cost of the lease, with a depreciation charge to reduce the asset value.

From an investment perspective this changes the character of “EBITDA”, where companies that heavily use operating leases would previously have expensed such costs (typically in operating expenses), while after IFRS 16 is implemented, they will suddenly find their EBITDAs increase because the lease cost will have strictly an interest and depreciation component. They are still expenses, but the characterization of the expense is now changed. This will be an accounting windfall for companies that traditionally are valued on EBITDA metrics.

So if you find it annoying how companies use EBITDA as a proxy of profitability (which it could be given the right assumptions – but most companies abuse the EBITDA number to inflate the perception of their profitability), after IFRS 16, good luck! Just remember, you can only live on after-tax cash flows and not EBITDA!

The other strange implication of the rule is that once a lease is initiated, it will initially be more expensive at the beginning of the lease, and less expensive later in the lease as the embedded interest expense of the lease declines. So let’s say you lease a million dollar jet for 10 years, your expense profile, depending on your cost of capital component, on year 1 would be $125,000 while on year 10 would be $75,000 even if you fork out $100,000/year to use it. Investors have to add one more layer of effort to separate what is happening on the income statement with what is happening on the cash side of things. (Even this example is not quite correct – the lease asset may be $1 million, but the liability is going to be bigger since nobody will want to lease a $1 million jet for a $1 million stream of cash).

You have to love these accounting standards that make life even more complicated for the layman in the name of increasing accuracy. Currently, an investor could look at the notes on the financial statements to understand what a company’s future lease commitments were. One-shoe-fits-all accounting sounds great in principle but it has the consequence of making financial statements more difficult to read and understand between companies even though the goal is to make them directly comparable.

Markets chasing yield again

Life looks rosy again in the financial markets!

So going from the “the world is about to end” mantra in December, we’re back once again to sunny skies.

In particular, interest rate futures are projecting a rate cut later this year, which is a complete turnaround to events just three months ago.

So as a result, almost anything with a yield has been bidded up since the beginning of the calendar year.

It’s as if everything that has been thrown away in the previous rising rate environment is now back in vogue again. It’s like the proverbial crowd rushing out of the exits in December, only to rush back in January?

Very fascinating.

S&P/TSX 2019 year-end projections and predictions

Article on the Financial Post of various analysts predicting where the TSX will end up in 2019. Right now it closed at 14,222. I’ve put percentages next to the predictions:

Predictions for TSX at the end of 2019:
Laurentian Bank of Canada — 18,500 points (+30.0%)
BMO Capital Markets — 18,000 points (+26.6%)
National Bank of Canada — 16,600 points (+16.7%)
Russell Investments — 16,000 points (+11.1%)
CIBC — 15,600 points (+9.7%)
Sunlife Global Investments — 15,000 points (+5.5%)

I wish this list was more comprehensive. Sadly after doing a couple minutes of scouring the internet, I could not find a decent list of December 2018 predictions made in December 2017 other than Russell Investments predicted in late 2017 that the TSX would close 2018 at 16,900. I’m sure my readers can find a more appropriate list.

All I can say is the following – the numbers above also are based on a price index. The total return of the TSX includes dividends, and this would increase the stated percentages by approximately 3%. So the worst prediction of the six above would show a total return on the TSX of roughly 8.5%.

The TSX’s total return (dividends reinvested), as measured over the past decade, is approximately a shade over +5% compounded annually. Recall that 10 years ago was in the depths of the financial crisis and was one of the best investing opportunities in a generation.

If I was a broad market investor, I’d be concerned at this degree of bullishness.