CEMIG: A High-Risk, High-Return Opportunity

| About: Companhia Energtica (CIG)

Is CEMIG (NYSE:CIG) the bargain of the year or the value trap of the decade? At this point, I've chased the stock down and down and down, tossing dollars against each new bottom. Following this strategy with Bank of America I bought all the way down to $5.56 and then threw in a few more dollars on the way back up-and BAC continued way back up. If I stay in CEMIG I'd like to see a little more "up" to offset its remarkable facility with "down." The stock is down -15% over the past 12 months with a 52-week high of $11.73 and a low of $7.81. The last earnings call on August 14th brought an immediate -2.45% drop and CEMIG is still stumbling after missing analyst EPS expectations by a wide margin.

Thomson Reuters rates CEMIG a "strong buy" and Zacks rates CEMIG a "sell." So there is at least a 50/50 chance it will either go up or down. My DCF analysis puts CEMIG's fair value at $42 assuming just 5% annual growth for the next 10 years versus the 24% growth CEMIG delivered annually from 2005 to 2012. Spoiler alert: study 2013 carefully before you hit the "buy" button. I prefer to buy at least 50% below fair value for unpredictable stocks; but CEMIG is another 50% below that number or 75% below fair value. With a 75% margin of error or safety on valuation and a 10%+ dividend payout (excluding the discretionary special dividends that can be paid every two years) CEMIG seems extremely attractive; unless the potential risks exceed the potential returns, of course.

We'll compare CEMIG to two energy companies in Brazil CPFL Energia (NYSE:CPL), and Centrais Eletricas Brasileiras Sa-Eletrobras (NYSE:EBR) as well as Energias De Portugal SA (OTCPK:EDPFY), Korea Electric Power (NYSE:KEP), and Enersis (ENI), which operates in Chile, Brazil, Colombia, Peru and Argentina. We'll poke at some of the key numbers a little to see if we can understand their relative value equations in greater depth.

Company ROE ROA Debt to Capital Dividend Yield Interest Coverage Dividend Payout
CIG 35.5% 10.5% 0.3 18.5% 6 45%
CPL 17.8% 3.9% 0.6 7.1% 1.5 130%
EBR -10.3% -4.0% 0.3 41% -2.8 NA
EDPFY 12.4% 2.4% 0.6 7.7% 2.2 62.85%
KEP -6.3% -2.2% NA 0% 0.1 NA
ENI 2.8% 9.7% 0.3 3.2% 2.2 25.9%

*2012 performance data from S&P report through Fidelity.

CIG's dividend yield is sky high because the stock price has dropped so significantly. EBR's yield is even higher, but again this is the price dropping not dividends rising. You will see CIG's dividend published as anything from 10% to 25% because the special dividends (paid every two years at the company's discretion) are calculated differently by everyone. I'm calling it 10%+ because no one knows, not even the company, until after net income is computed. Even with a very high payout the dividend is covered with a 45% payout ratio. With ROE at 35% and ROA at 10% CIG exhibits solid economics with good to great returns for this industry.

Company Gross Margin Profit Margin Sales/Employee Income/Employee
CIG 25.8% 23.1% $1.1 M $249.3 K
CPL 18.2% 5.7% $1.2 M $70.6 K
EBR 10.1% -20.2% $.59 M -$120.2 K
EDPFY 19.7% 6.2% $1.8 M $108.8 K
KEP 11.8% -6.4% $1.2 M -$77.2 K
ENI 29.5% 5.7% $1.2 M $71.1 K

*2012 performance data from S&P through Fidelity. K = 1,000s, M = 1,000,000's.

Margins are also solid with CIG at 25% gross and 23% net. These are not Intel or Sanofi margins, but utility companies are much more resource intensive and margins are compressed accordingly. It is remarkable to me that revenues per employee are clustered so closely across these companies, but income per employee separates the cost efficient from the ones that are struggling to maintain or regain profitability.

Looking at changes in some of the key metrics from 2005 - 2012 we gain some additional insight. We'll talk about 2013 further down in this article as there are some disturbing drops in performance over the last few quarters. CIG, EDPFY, and ENI have solid performance over the seven years from 2005 to 2012. Any of these three would be attractive investments, at the right price, with growth numbers this strong.

Company Sales Growth Net Income Growth EPS Growth Shareholder Equity Growth Net Cash Flow Growth
CIG 10% 15% 24% 6% 10%
CPL 12.25% 4.64% 4.16% 7.36% 6.40%
EBR 7.09% -232.01% -228.52% .87% 7.37%
EDPFY 10.15% 0.19% 0.68% 9.53% NA
KEP 9.05% -203.23% -203.65% 1.67% -9.72%
ENI 11.85% 28.96% 29.17% 7.01% 9.36%

*Annualized return 2005 - 2012 historical data from S&P through Fidelity.

And, finally, we'll look at some valuation numbers relative to current prices.

Company Price to Earnings (NYSE:TTM) Price to Sales (TTM) Price to Book Value (TTM) Price to Cash Flow (TTM) PEG (5-Year Projected)
CEMIG 2.19 0.6 0.79 3.53 0.76
CPL 21.20 0.89 2.68 9.36 3.65
EBR NA 0.28 0.12 -1.28 NA
EDPFY 8.83 0.56 1.13 3.64 2.32
KEP NA 0.36 0.38 3.57 NA
ENI 10.05 0.82 1.09 5.51 NA

*2012 valuation numbers from Fidelity. NA = Not available due to negative numbers or missing data.

On a relative valuation basis CEMIG seems to be screaming buy me, with EDPFY and ENI tied for second, but let's redo our 7 year performance chart and fill in the numbers for the last 7 quarters. Without understanding the growth numbers and return ratios shown earlier, one might be tempted to consider EBR, but this company only looks cheap and was probably bid way down for solid economic reasons. That didn't stop me from buying it two years ago, but live and learn.

In the next chart we focus on the last 7 quarters and get a big flashing caution sign posted on CIG whereas EDPFY and ENI begin to look more attractive. EDPFY and ENI largely avoided the negative impacts of Brazil's efforts to rein in power rates.

Company Sales Growth Net Income Growth EPS Growth Shareholder Equity Growth Net Cash Flow Growth
CEMIG 0% -0.40% 1.48% -3.28% -9.46%
CPL 1.81% -192.42% -192.44% -2.54% -6.60%
EBR -5.39% -168.91% -166.17% -5.41% -12.55%
EDPFY 2.87% 6.84% 7.01% 0.34% -2.16%
KEP 2.9% -220.96% -221.01% -1.07% -1.33%
ENI 2.82% 13.41% 13.65% 6.80% -5.95%

*9/30/11 - 6/30/13 quarterly historical data from S&P.

This is, of course, a very different picture of CIG whereas EDPFY and ENI still look very strong. Of course you're paying a higher price for this strength as their PE ratios are much higher than CIG. It's what makes investing more of an art and less of a science - at least for me - because I find this utterly confusing. CEMIG exhibits the capacity for fantastic growth yet currently enjoys the trajectory of a spit ball nose diving for the punchbowl. The prudent course of action would be to hold steady, wait for evidence of some corrective action, then buy in once some obstacles have been swept from the path. But, I think I'll buy some more. This is an area where I believe the home player can "beat" the professionals. The professionals, I presume, bailed once the situation in Brazil became dicey. They'll come back in once earnings are projected to rise. Some money will be left on the table by jumping in and out, whereas we can stay in, buy more on the way down and reap our rewards once the situation stabilizes. I'm conjecturing, and the conjecture needs to be modeled and monitored over the next few years, but this is my ingoing hypothesis. In addition, Brazil will grow, Brazilian energy needs will expand 5%+ per year over the next decade and CEMIG may well benefit greatly by scooping up weaker players.

I'd like to put more money into CEMIG before their next earnings announcement, but there are at least four strategic risks to CEMIG I currently see: political intervention, generating capacity shortfalls, their parabolic 2013 performance, and capital allocation.

The risk from political intervention is not just headline risk. There is a real risk Brazil's political leadership will continue its efforts to drive down electricity prices short term at the expense of a rational long-term energy policy able to sustain GDP growth. If CEMIG loses generating licenses as a result of the political fallout the impact on revenue will be extreme. CEMIG dropped from over $17 to under $10 just prior to, during and after Brazil announced their drive to drop electricity rates to boost economic growth. At this point some or all of that risk is priced in, but this needs to be modeled to determine the worst case scenario.

Generating capacity shortfalls caused much of CIG's recent poor performance. Large amounts of power needed to be purchased because water tables and rainfall were too low to allow full utilization of the hydroelectric generating stations. If weather patterns are changing in ways that permanently impair hydroelectric capacity this will severely impact financials throughout Brazil.

The biggest issue with 2013's parabolic performance is we are seeing a strong downside trajectory. Although the seven year growth numbers shown in the charts above are terrific, the graph of the last 7 quarters is pointed down, down, down. I suspect there are reasons for the poor performance which can be ameliorated, but down is down and it requires we discount our discount rate to account for CIG's weakness. We de-rated the DCF analysis to reflect growth rates much lower than historical rates for precisely this reason. Even with the de-rating CEMIG is still a staggering value unless market pricing knows more about the likely short term performance curve than the historical numbers would suggest.

Capital needs to be available in large quantities for CEMIG to execute its aggregator strategy. Given the market's poor perception of CEMIG's future value one has to question how readily the market will support its expansion goals.

There is at least one major strategic opportunity associated with CEMIG. Despite the regional government being a majority shareholder CEMIG seems to have an enlightened and aggressive management with a clear long term strategy. CEMIG wants to be an aggregator of other power generation resources across Brazil and appears to be committed to long-term growth through acquisitions. This is probably a rational bet on the continued growth of Brazil's GDP and the increased consumption of energy accompanying such growth. I would appreciate hearing from anyone else who follows CEMIG more closely about any additional risks that may offset this strategic positive.

A footnote to the larger strategic issues at CEMIG is their communication around dividends. CEMIG's dividend policy is communicated poorly, like Gazprom and many other international stocks. The announced dividend is not clear or stable. CEMIG's intent is to pay out 50% of earnings at a minimum as dividends and they may pay special dividends every two years. Since the dividend is subject to both earnings fluctuations and special dividends it moves up and down seemingly at random. Investors do not like random. CEMIG would be better off to pay an easily calculated smaller dividend and raise the dividend at a more predictable rate. Changing dividend levels unpredictably sets off alarm bells and eventually investors discount the stock based on a perception the company is not in control.

There is some good news in 2013. CIG's debt leverage decreased from 52.4% in 2011 to 28.7% in 2Q13. Cash on hand at 1H13 was R$4.46 billion and the company is operating efficiently. Although the Brazilian economy slowed when the global economy crashed, unemployment is at a low 5.7% (March, 2013) and real income recently grew 3.5% (1Q12 to 1Q13 YOY). As noted in CEMIG's 1Q13 earnings report, electricity consumption in 1Q13, led by residential and commercial, grew 6.6% and 6.0% respectively even though we are using only 5% in our projections. Industrial consumption was down primarily as a result of lower metal production for world markets, but this may recover as the global economy comes back on line.

The political risk is clearly the single largest and most critical issue. I remain cautiously optimistic about CIG's growth potential and hope the market has too large a discount on the risks. There is no way, that I'm aware, to handicap these risks any further without simply waiting for events to unfold. CIG is a high potential investment, but carries with it high risks.

Disclosure: I am long CIG, OTCPK:EDPFY, EBR. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.