The market continues to exhibit confusion, bordering on cognitive dissonance, in placing a reasonable value on CEMIG (NYSE:CIG) the Brazilian power utility. Investors should study the 1Q 2014 earnings release and make their own determination, but CIG appears to be a deeply discounted investment opportunity paying a very attractive annual dividend (5-20%--more on this later), but carrying significant risks. CIG is not for the faint of heart or those dependent on their investments for current income, nor is it an appropriate target for traders looking for a fast buck. I am personally invested in this one for a long slow buck. Albeit a big, long slow buck.
One day prior to the current earnings announcement, CEMIG dropped by just over 6%. On the same day, Brazil's Superior Appeals Court announced suspension of judgment on the order of mandamus requested by CIG to annul a decision by Brazilian administrators to pull the plug on CIG's Jaguara power plant concession. CIG is allowed to continue to operate the Jaguara plant during the suspension. Critically, the vote at the high court was split with two justices for, two justices against and one who wanted to study the issue in more detail. From my perspective this should have been very good news for investors as it's the first chance we've had to handicap the possibility of CIG retaining this major power concession. Now we know the odds are 50/50 and can place our bets accordingly. Meanwhile, CIG is allowed to continue booking revenue from Jaguara for a longer period than expected.
The 6% drop was probably a reaction to the World Cup riots in Brazil which intensified this week. EBR, the government controlled power utility, dropped by a similar percentage. This broad-based pullback may reflect investor concern that the riots could turn into a broader disruption impacting the Brazilian economy as a whole. This is a classic trigger opportunity for value investors. If the probability of the riots impacting the wider Brazilian economy is low, then the pullback in response to this event was over the top and presents a buying opportunity.
Let's review the two major risks facing CIG and then we'll highlight the 1Q results which may argue for accepting these near term risks for the potential of a long-term return.
The largest risk is regulatory. The Brazilian government is determined to drive down electricity prices and implemented new laws governing the public power concessions granted to CIG and other Brazilian energy producers and distributors. A general sell-off of Brazilian energy stocks immediately followed. CIG chose to accept some portions of the new law, reject other concessions outright as unprofitable, and fight specific changes in court. Investors fled CIG in anticipation of reduced revenues. Curiously, revenues have not dropped. CIG's EBITDA projections remain intact and alternative investments are underway which CIG expects to fill gaps created by lost concessions.
Brazilian rulers and Brazilian regulators seem to be working at cross purposes; the President is pushing for steep tariff drops and ANEEL, the regulatory authority, is passing tariff increases of 14.6% on distribution at the same time. My strategic view is that various political factions will vie to use electricity rates to their own political advantage short-term, but long term a growing economy requires power generation growth and power generation growth requires investment with reasonable expectations of adequate returns. Long-term, market forces will wrench these competing interests into alignment and power will be priced at a level which delivers shareholder value and customer efficacy.
In addition, we now have a slight glimmer of hope CIG could win their court fight and be allowed to operate Jaguara and two smaller plants for an extended period. This would plop a nice dollop of unexpected revenue on top of the pile and, perhaps, drive a reassessment of CIG's value.
The other strategic risk is associated with CIG's play as a consolidator. CIG is likely to grow at 5% per year, the basic growth rate of power consumption in the Brazilian economy, unless they successfully execute their stated corporate vision:
"To consolidate CEMIG's position, over the course of this decade, as the largest group in the Brazilian electricity sector by market value…"
CIG points to their recent acquisition of a 49.9% interest in Retiro Baixo Energética, another hydroelectric concession holder, as an example of successful execution against this vision. However, the success or failure of CIG's consolidation strategy will depend on their ability to generate sufficient shareholder value to attract the capital required to purchase other operators. By purchasing partial interests CIG gains the revenue share, but may see little integration benefit from cost reduction. This leaves CIG dependent on rate increases to earn a premium on their invested capital, which takes us back to the regulatory risk discussed above. In addition, CIG's valuation is questionable on some purchases and they must be careful to allocate capital to projects which increase shareholder value.
Worth a closer read in the earnings announcement is the section titled "The CEMIG Group's Portfolio of Generation Assets." There are a number of new projects in various stages of implementation which are not all in CIG's current results. CIG, as one would hope, is aggressively pursuing a strategy of adding capacity to meet the needs of Brazil's growing economy (although in fits and starts) and expanding power consumption.
These two major risks carry potential rewards. If CIG wins the court case or even enjoys an extended delay, their revenue line will pop accordingly. If CIG is able to grow beyond the baseline 5% projected growth in Brazilian power consumption, they will earn an additional premium in the market.
Against the backdrop of these two risks, CIG reported very strong results for 1Q 2014. Revenue was up 29.45% for 1Q 2014 over 1Q 2013. Bear in mind that 2013 did not see increases of this magnitude, primarily due to non-recurring revenues recorded in 2012, so this jump is welcome, but not a bona fide trend, yet. Net profit for 2014 1Q was $0.57 billion, up 52.12% over 2013 with $0.92 billion cash on hand. Revenues were up 29.45% and costs were up 20.7%. The largest cost increase was electricity bought for resale as CIG and other distributors were forced to buy electricity at higher rates due to hydroelectric reservoirs depleted from the Brazilian drought. Total sales of electricity totaled 11,963 GWh, 10.72% more than 2013. Both residential and industrial customers increased their electricity consumption over 11%. And, despite the government's best efforts, the average unit charge for electricity also increased. To the extent industrial consumption continues to grow, this is a positive data point for the overall Brazilian economy.
Total debt was marginally smaller than 2013 and stood at $4.27 billion at the end of 1Q 2014.
CEMIG announced they would pay just above 50% of 2013 net income as dividends in 2014. On April 30, 2014 the Board approved a dividend of $.40. CIG lists this dividend as a 6.3% yield, but assuming the ADR trades for $7.30 my math says 5.5% yield. Still, not bad considering CIG can pay out additional special dividends every other year when money is available, and can pay out additional dividends as interest on equity at any point based on financial reserves. The dividend policy is confusing, continually changing based on net income results and agreed payout percentages beyond the mandated 50%, but lucrative. When all the dust settles, I'll take confusing and generous over crystal clear and impecunious.
There is still significant headline risk and continued volatility due to the vagaries of the government, the courts and the global economy. One quarter does not validate a long-term strategy, but a strong quarter consistent with a company's overall strategy argues for a close look with the dividend payout providing a strong incentive to wait for an appropriate return over the long term.
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.