The energy sector in Argentina is in shambles. The populist policies adopted by the current government are not sustainable and dragging almost every company operating within the power sector into financial crisis. Edenor SA (EDN), a power distribution company and a subsidiary of Pampa Energia SA (PAM), is not a lien to the difficulties faced by the power sector. The reluctance of the Argentine government to increase electricity tariffs and the increasing costs of providing and maintaining quality service to its customers has resulted in EDN reporting net losses over the past few years. The losses accumulated by the company over the years resulted in the company reporting a negative equity in the first quarter of 2013. Although this situation was temporarily rectified as a consequence of the partial recognition of higher costs for the period May 2007 to February 2013 the long term prospects of the company's performance remains bleak so long as the government shows reluctance to adjust tariff rates.
The announcement of its second quarter results and the aforementioned reversal of its negative equity balance spurred a revival in the company's ADR shooting to its highest valuation in over two years. This upsurge in price was initially halted by a storm that hit the Argentine capital resulting in a massive power outage in the region and further when the government threatened to nationalize power utility companies as they struggle to keep pace with the rise in the demand for power in the capital and surrounding suburbs.
Subsequent to these events EDN shed more than 42 percent of its value and fell to $5.08 per ADR within a month after reaching its highest valuation in two years. Bearing in mind the track record of the current regime the threat of nationalization was seen as a legitimate and imminent threat to the shareholders' interests, and rightly so. The threat of a takeover from the government seemed even more probable for EDN as the National Social Security Administration "ANSES", an Argentine government agency, currently has 26.8 percent ownership of the company.
The plummet of the company's share price has stabilized at around $5 per ADR. The company currently trades at a PE of 2.03xand is expected to grow its earnings at an annual rate of 2.5% over the next 5 years. Investors have punished EDN on the basis of the poor environment of the power sector and the recent threat of nationalization. Further in this article I will try to scrutinize both of these factors in order to determine whether or not this fall in price is justified or just a result of an overzealous market and thus providing an investment opportunity.
Understanding Argentina's Nationalization Mindset
Ever since the start of the Kirchner regime the country's policy has shifted from one of privatization to that of nationalization. Ever since the start of the regime, after the country defaulted on its loans, the government nationalized multiple enterprises including the flagship airline, a water company and the national postal services. The most recent manifestation of this changed policy came as the government passed a bill to nationalize the largest oil company in early 2013.
Isolated from foreign lenders the country has limited sources of financing the large bills that are created from its existing subsidy programs. With stagnating exports, currency devaluation, rising import billsand a declining growth rate the country saw its budget surplus of 3.7% of GDP in 2005 slowly turning into a deficit of 3.2% of GDP in 2013. The recent steps taken by the government had no impact in terms of easing the situation and in such difficult circumstances the government decided to renationalize multiple enterprises in an attempt to inject much needed cash into its national exchequer.
However, in my opinion,the nationalization of YPF was a multifaceted move played by the current regime. One aspect, as explained above, was to bring in a much needed stream of revenues and the other was to play on the public sentiments during a time of declining popularity for the standing president. The government accused Repsol of under investing and expatriation of profits in the form of dividends and moved to nationalize the company in order to own key strategic assets of the country. Although it may seem that the government's claims might be legitimate given the extraordinary payout of the company to its investors and declining production and reserves Repsol's representatives deny these claims and holds the Eskenazi family responsible for the high payout ratio. They suggest that the company was in negotiation with foreign investors to develop new assets. Whosoever is at fault one thing that is certain and that is the move to nationalizing YPF has received a voice of approval by a majority of the country's population and this will surely go a long way in re-establishing Kirchner's overwhelming popularity.
Another Change in Policy
The news of the renationalization of YPF resulted in a flood of opinions chastising the regimes' actions as it was largely seen as precursor to the further isolation of its economy. Contrary to that, the year has progressed as a somewhat pleasant period for the country as is evident by its appeasing relations with international lenders and the start of negotiations for settlements with Repsol, the former major stakeholder in YPF. These concerted efforts should be seen as a sign of the government's realization that it has bit off more than it can chew. With the government now running the largest oil producer in the country any failure to enhance its production would be seen as a failure of the government and this is something that the ruling party would not want to carry into the next election.
With a large amount needed to tap into the large amounts of unconventional shale reserves in the country the company would most certainly need foreign investments to help finance the development costs as the country has already exhausted its existing resources. This realization has brought a change in the government's mood and it is now showing more compliant behavior towards paying off its existing foreign debt in order to make the country eligible for further borrowings. The start of negotiations with Repsol also sends a signal that the government is taking concrete steps to improve its relationship with other nations.
However in any case, I believe that no amount will be lent or invested in the country without some serious changes in its business policies. The lenders will most certainly require a reduction in the amount of subsidies provided by the government and investors would want less interference from the government in the market dynamics. Each of the two conditions will result in rising fuel prices in the country. Although these are steps that the government might not want to take, it is a necessity in order to make its investment in YPF a success.
What of the Threat
I strongly believe that the threat given to the power sector by the government was only that, a threat. The reason for this is that the government's renationalization has historically been aimed at cash rich and profitable enterprises that would enable the government to keep funding the ridiculous amounts of subsidies. With a majority of the power distributors, and specifically EDN, operating at losses and surviving only through government payments the nationalization of these companies will only put added pressure on the frail finances of the government.
The signs coming from the government are neutral at best and if the country is able to settle with its debtors and Repsol it will be once again eligible to approach international lenders which it desperately needs to make its investment in YPF successful. Once this happens the structural changes that are expected to occur will bring about positive changes for the power sector. Furthermore the power tariffs in the Buenos Aires region have been constant over the last 5 years and a revision of these rates is more than due. With the rising cost of operations, continued pressure by power companies, and depleting reserves of the government, I believe that this revision will occur sooner than later.
EDN currently trades at a significant discount to its closest available peer company and the average multiples of Argentine electricity utility companies (including generation, transmission and distribution companies), as depicted in the table below. The substantial discount at which the company trades shows the significance of the negative investor sentiments that has harmed its valuation even though there has been no significant changes in its operations to justify such sharp price decline. Thus, as mentioned above, it is the perception of increased political risk rather than company performance that has led to the fall in price. Once this negative perception subsides the company's share price will start moving towards the pre-threat level which will provide with a significant return to investors over a relatively short time period.
The key trigger events that will lead to a reversal in the recent price fall are listed below:
- No more ominous threat from the Argentine government to power distributors will result in the rise in share price to the pre-threat level
- Revision of tariff rates in the Buenos Aires region will significantly improve the company's results leading to a rapid increase in share price
- Settlement of debt with international lenders and/or the settlement with Repsol will be seen as a change in the Argentine government policy thus reducing the currently perceived high political risk which will result in a rise in share price
With the threat of a hostile takeover and an expectation of tariff revision, I believe the recent fears of the market have created a highly lucrative opportunity for investors. Thus I will strongly recommend buying EDN as a reversal in trend is expected in the next few months.