In April, Warren Buffett quashed a rumor that Berkshire Hathaway (NYSE:BRK-A) (NYSE:BRK-B) was in talks to acquire embattled utility PG&E (NYSE:PCG). But that denial isn't an unconditional rejection: Price is a significant variable when a canny value investor considers an investment opportunity. That was then, with PG&E's stock at $21.53, and this is now, with the stock at $6.48 (last Friday's close). With the rumor resurfacing -- before being summarily dismissed -- this Buffett watcher thinks it's highly plausible; in fact, a deal to acquire PG&E has the hallmarks of a classic Buffett "coup."
As fires continued to burn in California, The New York Times reported (subscription required) at the end of last month that Buffett's vehicle, Berkshire Hathaway, is (again) rumored to be a potential buyer for the struggling company. Faced with mounting liabilities linked to California wildfires, PG&E filed for Chapter 11 bankruptcy in January; the shares have lost close to 90% of their value over the past 12 months.
Berkshire and PG&E: Sell the rumor?
But the Times reporters aren't buying the rumor, so to speak, pointing out that analysts are skeptical: "In general, there is not a strong appetite to buy turnaround stories at Berkshire," said Meyer Shields, an analyst who covers Berkshire for KBW.
Furthermore, they note that "[t]here are other hurdles. Berkshire would need to get approval by the Federal Energy Regulatory Commission, which has stringent standards for market power."
Those arguments have a surface appeal, but they obscure the fact that Berkshire is uniquely positioned to acquire PG&E. Let's deal with the two objections mentioned above -- and a few others along the way.
We've seen this movie before
First, let's agree that the motivation and logic for such an acquisition are impeccable. In fact, Berkshire Hathaway Energy (BHE), one of Berkshire's Hathaway's "powerhouses" (Buffett's expression), has already demonstrated its appetite and credentials as an opportunistic acquirer of distressed utilities:
- In 2017, BHE acquired the bankrupt Energy Futures Holdings (EFH) for $9 billion; EFH is the vehicle for Texas electrical utility Oncor. EFH was profitable on an operating basis, but the company had been saddled with $31.5 billion in debt in what was then the largest leveraged buyout in history.
- On Sept. 18, 2008, MidAmerican Energy Holdings (BHE's predecessor) announced it was picking up Constellation Energy, then the largest seller of wholesale power in the U.S., for $4.7 billion. Over the two trading days that preceded the announcement, Constellation's share price had been cut in half due to concerns about the company's liquidity. (MidAmerican was ultimately unsuccessful.)
PG&E: Profits are present and (over-)accounted for
On the face of it, Buffett's distaste for turnarounds would appear to exclude PG&E from consideration: Berkshire Hathaway's second acquisition criterion states that the company is not interested in "'turnaround' situations." However, that rule reflects Buffett's requirement that a potential acquiree have "[d]emonstrated consistent earning power."
PG&E's quandary isn't due to a lack of consistent earning power, though it's true that the company's reported profits were overstated. Why? Because those profits were based on depreciation charges that understated the true cost of maintaining its transmission towers and power lines in order to mitigate the risk of fires (and due to under-investment, the company's free cash flow was also overstated).
Let's be clear: When they are properly managed, utilities are the very picture of consistent earning power, which makes sense, given that they are often regulated monopolies. As Buffett explained to his shareholders in his 2009 letter (emphasis added):
[Our railroad business and electric utilities] will require heavy investment that greatly exceeds depreciation allowances for decades to come. ... Both will earn and invest large sums in good times or bad, though the railroad will display the greater cyclicality. Overall, we expect this regulated sector to deliver significantly increased earnings over time, albeit at the cost of our investing many tens -- yes, tens -- of billions of dollars of incremental equity capital.
Those tens of billions of incremental investments that are required to maintain a utility's productive capacity are the reason that Berkshire Hathaway Energy is one of the few companies that can even contemplate this deal. Let me explain.
Berkshire Hathaway and BHE: A voracious appetite for capital
Owned at 91% by Berkshire Hathaway, BHE highlighted in a 2018 presentation that being a subsidiary of one of the world's largest and best-capitalized companies is the very core of the energy group's competitive advantage. In particular, BHE cited:
- "Access to capital from Berkshire Hathaway allows us to take advantage of market opportunities."
- "Berkshire Hathaway is a long-term owner of assets which promotes stability and helps make BHE the buyer of choice in many circumstances."
Finally, as Buffett highlighted during this year's annual meeting, "[Berkshire Hathaway has] never had a penny of dividends in close to 20 years of owning MidAmerican Energy. ... Other utility companies pay high dividends -- they just don't have the capital appetite, essentially, that we do."
Greg Abel: the rise of the frugal son
Here's a wholly legitimate objection to any deal for PG&E: The company's present circumstances raise the issue of finding competent management that can lead it through the next phase of its existence. The historic underinvestment in plant assets perpetrated by the existing team suggests they aren't up to the task. That lacuna runs up against Berkshire's fourth acquisition criteria: "Management in place (we can't supply it)."
In my estimation, if BHE chairman Greg Abel assured him that he and his top executives could "clean house" at PG&E and establish a "safety first" culture like BHE's, Buffett would give the acquisition his blessing.
Abel has established an extraordinary level of trust and credibility with Buffett -- he is one of his top two lieutenants (if we exclude vice-chairman Charlie Munger, 95, from the discussion) and is thought to be one of two executives who are most likely to succeed him.
Regulators: They should be so lucky!
As far as regulators' potential objections go, I think they would view Berkshire Hathaway's interest warmly, considering that Buffett's conglomerate is a more stable owner than the bidding groups dominated by hedge funds that have already supplied reorganization plans for PG&E.
Or as California Gov. Gavin Newsom told Bloomberg last month, "We would love to see [Berkshire Hathaway's potential] interest materialize. ... That would be encouraging to see."
Mind the cap
There is a final hurdle to an acquisition of PG&E and it's not insignificant: Naturally risk-averse, Warren Buffett is not in the habit of taking on open-ended liabilities. But that risk could be eliminated by a loss-sharing provision with the state of California that would cap Berkshire's exposure to claims against PG&E.
Or as a report commissioned by Gov. Newsom and released in April concluded (my emphasis), "[a]s long as electrical lines run through tinder-dry forests, California can mitigate but not eliminate utility-sparked fires. ... No single stakeholder created this crisis, and no single stakeholder should bear its full cost."
Looking for a win-win
If BHE does surprise the market with a bid for PG&E, expect it to be the first, best, and final offer, as Warren Buffett won't get drawn into a bidding contest. For California residents and the state government, Berkshire Hathaway's embrace would arguably be the best available option, and you can expect Buffett and his executives to look after Berkshire shareholders' interests, too -- without abusing their "preferred bidder" status.