CEMIG (NYSE:CIG), like many developing market stocks, has been hit hard by investors running from emerging markets as U.S. rates rise, inflation flares as politicos attempt to purchase popular support and hot money flees cooling markets. The BOVESPA index for the Brazilian stock market was down 15.5% from the end of 2012 to the end of 2013. CEMIG's ADR price is down 22% over the past 52 weeks after adjusting for two splits. CEMIG also faces the potential loss of 12% of its earning capacity at some point during the next 3-6 months and another 12% over the next 2-3 years from power concessions, which may be canceled. Were it not for the 10-20% dividend opportunity it would be easy to dismiss CEMIG. Even with a strong dividend yield this may be a stock with too much uncertainty for risk adverse investors.
On the other hand, most of the headline risk may already be built into CEMIG's price, there is a non-zero possibility of a 30-40% pop in the price, and CEMIG stated they will recommend a sizable dividend to their Board in 2014 as a reward for waiting out the turmoil. There is still a large degree of headline risk. In fact Reuters' headline following release of the 2013 results on March 21st may be typical of market reaction: "Annual profit falls at Brazil power utility Cemig." This is, of course, literally true and perfectly incorrect. Profit did fall by 27% yoy, but the prior year included an extremely large non-recurring payment. Adjusted for non-recurring payments, CEMIG's net income rose 9.7%.
What is a fair value for CEMIG's stock? Let's use the simplest possible approach to fair value with the Gordon Growth Model and calculate the value based on dividend payments. The Gordon model calculates a price by dividing the annual dividend by a discount rate minus the growth rate expected for future dividend payments. The dividend for next year is not approved yet, but we'll assume half of the proposed reserve is approved and provides a $0.52 dividend per ADR. I always use 10% for the discount rate as I'd like to earn slightly more than the historical average of 6-9% for stocks, and we'll assume the dividend grows 3% yoy given CEMIG's volatility. Fair value with these assumptions is $7.43. The reserve (discussed below) CEMIG proposes setting aside for future dividends would pay from $0.52 to $1.00 per ADR. However one does the math there appears to be sufficient headroom to take a reasonable risk as long as one is prepared to wait out any extended price drops, which could be driven by adverse headlines.
CEMIG reported 2013 results after the market close on Friday, March 21st so this provides an opportunity to look back over the turmoil besetting the stock for the past two years and chart CEMIG's trajectory going forward.
Despite the precipitous drop in market price over the past 52 weeks the fundamentals have not really changed much if non-recurring payments are eliminated. CEMIG's price drop is primarily about the potential for future problems rather than the actuality of current issues. Despite the turmoil CEMIG has not been shy about rewarding shareholders. The dividend yield in 2012 was over 20% and 9.4% in 2013. In 2010, 2011, and 2012 CEMIG paid dividends at 92.8%, 88.7%, and 105.7% of net income.
Each year the company pays out a minimum of 50% of profits as dividends and every two years special distributions may be made; the amounts aren't fixed until the Board makes a final decision based on their review of earnings and reserves. In CEMIG's 2013 results presentation they outline their dividend proposal for 2014. The proposal has several components, but basically comes down to $497 million for dividends and $670 million for dividend reserves, which may be paid at the Board's discretion once every two years. The Board needs to approve or modify this dividend proposal at the April general meeting and the impending Brazilian court decision on power concessions could impact the ultimate payout amounts. These reserves would support an 8-10% yield in a non-bonus year and a 10-20% yield in a special bonus year. A complete history of CEMIG dividend payments can be found here. It is useful to review the actual dividend history as the dividend yield found on most sites is usually wildly inaccurate and extremely understated compared to the actual payouts.
CEMIG's 2013 results were mixed. Gross revenue was down -4.36% versus 2012 while overall electricity sales were up 3.24%. CEMIG basically grew gross revenue at the same rate Brazilian electricity consumption grew. Total electricity consumption across Brazil was up 3.5% in 2013 over 2012, although this was primarily from residential, not industrial, demand. The long-term forecast is for electricity consumption across Brazil to grow just under 6% annually over the next decade, but this depends on further recovery of the global economy. Net revenue was up 3.47%. EBITDA was up 22.38% yoy, but net profit was down -27.34%. The large gap between 2012 and 2013 was largely driven by non-recurring payments in 2012. Net profit adjusted for non-recurring items in 2012, primarily a payment from the state of Minas Gerais, was up 9.7%. CEMIG's total debt at the end of 2013 was $4.07 billion, 9.2% lower than 2012. The debt to equity ratio is 74.83% with stockholders' equity at $5.44 billion.
The single largest challenge facing CEMIG and other Brazilian power companies is the government's effort to revitalize manufacturing and constrain inflation by pushing power rates lower. The targeted changes were very significant; an 18% reduction in individual rates and a 30% reduction for industrial users. However, these targeted reductions have not fully materialized. The full effect of the changes has been difficult to see so far as water shortages drove utilities to purchase power on the spot market and run fossil fuel plants at higher costs to make up for the lost hydroelectric capacity.
The principal mechanism for the reductions was Provisional Measure 579 passed September 11, 2012 by the Brazilian government and ratified as Law No. 12,783 governing the renewal of power generation concessions. Under the new law concession operators of public generating and transmission facilities, like CEMIG, are paid to operate and maintain public concessions at a much lower rate. The new law essentially pays them as operators of the concession and not as value-added managers of a capital asset. Given the unattractive operating economics of the new law, CEMIG decided not to renew concessions up for bid between 2015-2017 at Três Marias, Salto Grande, Itutinga, Camargos, Piau, Gafanhoto, Peti, Tronqueiras, Joasal, Martins, Cajuru, Paciência, Marmelos, Sumidouro, Anil, Poquim, Dona Rita and Volta Grande. These plants expiring between 2015-2017 represent 1,065 MW of installed capacity, 641 MW of assured energy or 12.25% of CEMIG's total installed capacity.
CEMIG also challenged the legality of the government's decision to immediately reassign three hydroelectric plants expiring in 2013. The three plants, Jaguara, São Simão and Miranda represent 1819 MW of assured energy and 25% of CEMIG's total installed capacity. Merrill Lynch's analysts project a favorable decision in this court case could drive a 38% pop in CEMIG's share price. After meeting with CEMIG management Merrill Lynch reports a decision is expected in June, although no one can predict either the timing or the outcome.
All of these at risk concessions combined make up 47% of CEMIG's power output, which comprises approximately 50% of total revenue. Multiplying the 47% and the 50% factors indicates about 24% of EBITDA is at risk if all the concessions noted above were adversely impacted and CEMIG was unable to replace revenue from other sources. Keep in mind a portion of those concessions listed above are not at risk until 2015-2017. The risk in 2014 represents about 12% of EBITDA, giving CEMIG two-three years to replace lost earnings from the remaining portion. Given the stock's price drop following the announcement of the new rates it would appear most of this risk is already in the stock. Of course, if CEMIG loses the court case the stock will take an additional hit from the shock wave associated with the headlines, but a bigger fall in price may present a buying opportunity with the real economic risk substantially off the table. CEMIG presents a classic value investor buying opportunity if the price reflects heightened fear rather than collapsing fundamentals.
Despite the government's efforts to contain electricity rates there are larger forces inexorably pushing up rates. Reuters reported an effort by the Brazilian government to counter price increases driven by the current drought. As the drought reduces hydropower availability, distributors must supply electricity purchased at much higher rates on the spot market or generated by more expensive power plants. President Dilma Rousseff, up for second term election next year, is closely identified with Brazil's efforts to drive rates down while ensuring sufficient investment to avoid widespread blackouts as the economy requires more power to sustain growth. The government's latest proposal is to provide $1.7 billion in government support to the distributors and seek additional billions in private financing to avoid near-term rate hikes. The confounding element of these subsidies is taxes on electricity represent one of the largest components of the overall cost of electricity to consumers. The government imposes high taxes to support spending programs while using spending programs to subsidize lower rates. What could go wrong? For long-term investors economic growth in Brazil will drive consumption and rates higher, for short-term investors expect turmoil and confusion as economics and politics grind their hips together in this clumsy dance.
CEMIG's principle strategic direction going forward is to consolidate additional generating resources and expand in both electricity and gas distribution. To this end CEMIG established a number of investment partnerships, acquisitions and renewable energy developments. Investment income represents a larger and larger percentage of total revenue as CEMIG diversifies its revenue streams.
For this strategic thrust to work CEMIG must demonstrate to outside investors it is capable of effective capital allocation, acquisition integration and profitable partnerships. CEMIG's recent investment in the Santo Antonio hydroelectric plant raises some questions. As Bloomberg notes:
Cemig…paid $356 million to purchase the stake in Madeira Energia, the group responsible for the construction of the dam in Brazil's Amazon region, according to a company regulatory filing.
The CEMIG stake was purchased from Andrade Gutierrez at a significant premium according the Merrill Lynch analysts. Andrade Gutierrez is a major holder of CEMIG voting stock. As Stephen Simpson stated in his recent Seeking Alpha article on CEMIG:
Related party deals are bad enough, but the economics on the deal don't suggest much (if any) return potential above and beyond the company's cost of capital.
CEMIG must demonstrate their ability to make this acquisition profitable or it threatens their ability to attract capital for future expansion.
It should be recognized, among all the headlines about tariff reductions, there are also tariff increases being approved at the same time. CEMIG's guidance regarding the potential impact of all these changes to their concessions on EBITDA growth can be found in this document. My own interest in CEMIG is long term, think 10 years or more. Any growing economy needs electricity as one of the core elements supporting growth. Electricity, a capital intensive industry, requires an effective rate of return to attract sufficient capital to maintain growth. As Brazil grows, so will its power companies. CEMIG at this point still provides a reasonable dividend, given the risk, and could surprise to the upside in a major way. Investors should not expect this surprise to materialize, but I do anticipate long-term growth accompanied by appropriate returns.
Disclosure: I am long CIG. 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.