Research

This company is the only winner from PG&E’s rolling blackouts

The Camp Fires in northern California in November 2018 were one of the worst wild fires ever recorded in California. The impact was massive.

85 people were killed, and 14,000 residences were destroyed. Over 1,000 firefighters fought the fire over 17 days to finally contain the blaze, which eventually burned an area the size of greater Chicago across Butte County.

The financial impact was staggering, with nearly $7 billion in damages. And those massive losses turned people’s attention to the cause of the fire.

Of course for any disaster of this magnitude to occur, many things have to go wrong. But one issue in particular was pointed to as the catalyst. The utility for northern California, PG&E, had consistently been negligent. They had ignored requests to fix issues with sparking along transmission lines, had repeatedly avoided shutting down powerlines when high winds in the area could increase the risk of a fire, and in general shown a pattern of carelessness.

The massive liability related to this and a prior Napa & Sonoma county fire in 2017 led to PG&E declaring bankruptcy in January of 2019. PG&E only had $2 billion in insurance, not nearly enough to handle the claims against them.

As PG&E has attempted to shore up their balance sheet in the wake of the fires, the company has shown a renewed, or some might say new, commitment to safety in the face of wildfire risks. Unfortunately, this commitment has shown itself in a way that makes many Californians even less pleased with the utility.

The utility hasn’t had time to make massive investments in their infrastructure to reduce the risks of wildfires. Even if they did have time, they don’t have the capital available to do so. So instead, they’ve done the only thing they claim they can do to reduce the risk of triggering a new blaze.

They’ve shut off power to wide swathes of the state when winds pick up.

On Wednesday October 9th, the first of a wave of power grid shutdowns occurred in Northern California, in the face of 50mph wind gusts in PG&E’s areas of service. The utility has forced large areas of the 5th largest economy in the world, which California would be if it was an independent country, into blackout. An unheard of issue in the developed world.

Unfortunately, it doesn’t appear the blackouts have had their desired effect. Already in late October, two wildfires broke out north of San Francisco that the utility says may have been caused by their own equipment.

But whatever the efficacy of the shutdowns, they have caused Californians to react. An immediate solution for some has been to buy household generators to provide them with backup power.

Household standby generators work to serve as a “safety valve” for homeowners. If the main power gets cut, diesel, natural gas, or liquid propane generators get turned on. This can occur automatically, if the system is designed to do so, or the home owner can turn it on themselves. For a period, or continually if it’s connected to a natural gas feed, the generator can keep a house running.

One of the largest generator companies is Generac. The company has said they’ve already seen 300%-400% increases in demand out of California since the rolling blackouts started taking effect.

The market already had started to recognize the potential for Generac shares and generator demand overall, the company has been steadily rising since April. Thus far in 2019, the stock is up 85%. Since before the fires occurred last year, Generac shares are up over 60%.

But even after the recent rally in the stock, the markets still appear to not be pricing in Generac’s potential. The market is still pricing in returns to fade going forward. On the other hand, the company has strong fundamentals, and not only are the fundamentals strong, management is showing confidence about fundamental drivers that may enable them to continue to exceed market expectations.

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Markets are pricing in expectations for Uniform ROA to contract, but management is confident about their sales drivers and international business

GNRC currently trades below corporate averages relative to UAFRS-based (Uniform) Earnings, with a 19.1x Uniform P/E. At these valuations, the market is pricing in expectations for Uniform ROA to fall from 34% in 2018 to 23% by 2023, accompanied by 8% Uniform Asset growth going forward.

Meanwhile, analysts have similar expectations, projecting Uniform ROA to fall to 31% by 2020, accompanied by 7% Uniform Asset growth.

GNRC has historically seen declining profitability, with Uniform ROA falling from 88% levels in 2007 to 27% in 2017, before improving to 34% in 2018. Meanwhile, Uniform Asset growth has been robust, ranging from 4%-38% since 2008, partly driven by the firm’s acquisition of a number of smaller generator players.

Performance Drivers – Sales, Margins, and Turns

Declines in Uniform ROA have been driven by compounding trends in Uniform Earnings Margin and Uniform Asset Turns. Uniform Margins steadily fell from 28% in 2007 to 13% in 2017, before rebounding to 16% in 2018. Meanwhile, Uniform Asset Turns declined from 3.1x in 2007 to a low of 1.9x in 2015, before improving back to 2.1x in 2018. At current valuations, markets are pricing in expectations for declining Uniform Margins, coupled with stability in Uniform Turns.

Earnings Call Forensics

Valens’ qualitative analysis of the firm’s Q2 2019 earnings call highlights that management is confident power outages have steadily increased over the past 25 years and that California power shutoffs will be a long-term sales driver. Furthermore, they are confident they are realizing benefits from their international expansion strategy, and they are confident they have worked hard to promote the benefits of natural gas-powered generators.

However, management is confident that international growth has remained flat, and they may be concerned about the value of their fleet platform for their partners. Moreover, they may lack confidence in their ability to realize synergy from their acquisitions and sustain higher sales volumes.

UAFRS VS As-Reported

Uniform Accounting metrics also highlight a significantly different fundamental picture for GNRC than as-reported metrics reflect. As-reported metrics can lead investors to view a company to be dramatically stronger or weaker than real operating fundamentals highlight. Understanding where these distortions occur can help explain why market expectations for the company may be divergent.

As-reported metrics significantly understate GNRC’s profitability. For example, as-reported ROA for GNRC was near 10% levels in 2018, materially lower than Uniform ROA of 34%, making GNRC appear to be a much weaker business than real economic metrics highlight. Moreover, as-reported ROA has improved from 3% in 2008 to 10% in 2018, while Uniform ROA has fallen from 66% to 34% during this time, directionally distorting the markets perception of the firm’s profitability of the past 10 years.

Today’s Tearsheet

Today’s tearsheet is for Royal Dutch Shell. Shell trades at a slight discount to market valuations. At current valuations, the market is pricing in Uniform EPS to shrink slightly the next few years, but the company’s recent growth and forecast Uniform EPS growth is expected to be very robust. The company’s earnings growth is average relative to peers, while the company is trading at the higher end of peer levels. Importantly, the company does have some risk to their dividends if they cannot improve their capital structure and obligations.

Regards,

Joel Litman
Chief Investment Strategist