Brazil is a market that attracts me as I like to look for bargains around the world that give interesting risk reward opportunities. I have recently analyzed the Brazilian market and these three utilities came as interesting plays for Brazil. As investing in a resource rich country that is pounded with bad economic news from political issues to low commodity prices requires a lot stamina to withstand the possible volatility the required potential returns must also be extraordinary. In this article I will analyze the potential risks and rewards related to investing in Companhia Energetica de Minas Gerais - CEMIG (NYSE: CIG), Companhia Paranaense de Energia - COPEL (NYSE:ELP) and CPFL Energia S.A. (NYSE:CPL).
I have already written about CIG and here you can find more about its business, current issues like the loss of concession contracts for three hydro power plants that generated about 40% of CIG's energy, debt, economic influences and a limited downside valuation analysis with a minimum price of $2.44. With CIG's price now being $1.14 you can skip the valuation part as it is clear that fundamentals do not matter in this environment. A few months later I had written an update on the previous article stating that the new downside limit is $1.44. In this article to keep myself from further valuation embarrassment I will immediately say that the downside limit for CIG is $0.00. That aside, we can continue with the analysis.
My colleague found another risk for CIG, the weather and the low water levels in CIG's hydro plants in the state of Minas Gerais. I must say that he was a little bit off here as rainy season in Brazil only starts at the end of November and lasts till May. The current situation is improving and the below figures account for that.
Figure 1 Last 30 days anomalies in rainfall for Brazil
Source: Brazil Climate Prediction Center (CPC)
The 30 days anomalies are still not looking good but in the last 7 days things seem to be improving, especially in the state of Minas Gerais.
Figure 2 Last 7 days anomalies in rainfall for Brazil
And on the weather sight things seem to be improving too, well, not if you like sunshine.
Figure 3 Weather forecast for Belo Horizonte
The expected rain should give some relief to CIG and increase the reservoir levels for CIG's hydro plants.
On the field of the distribution and production concessions investors must understand that CIG runs an intricate business with 73 hydro plants, 23 wind mills, 1 telecom network and 3 thermal plants and also runs 532 thousand km of electricity distribution lines and 9.5 thousand km of power transmission lines. In such a business that is also controlled by authorities it is very normal that some concessions will be lost and some will be won. Therefore the lost concessions might not be such a big issue as the company will continue to do business as usual but will have to find generation sources elsewhere. The good news is that the Brazilian Mining and Energy Ministry extended CIG's electricity distribution concession for another 30 years, from January 1, 2016. This should allow for long term investments that should lower operating costs and increase margins.
Another attempt to valuate CIG
CIG's EBITDA guidance for 2016 is from R$4 billion for the lower limit and R$5.3 billion for the upper limit. I will use the lower limit for my calculations. As the company has 0.4% of its debt in foreign currencies the Real does not present a threat to the business remaining an ongoing concern and as most of the revenues are inflation protected inflation also does not play a crucial role. With EBITDA of R$5 billion in 2014 the company generated EPS of R$2.49. Translated into dollars and proportionally reduced to the lower limit guidance this would mean that CIG could generate EPS around US$0.5 in 2016. This would give a PE ratio of 2.3 and if 25% of the EPS is distributed in income a dividend yield of 10.8%. The current book value per share is US$2.91 per share.
A positive investment scenario could be that CIG continues with EPS of around $0.5 and when things stabilize its PE ratio could go to a normal 10 or just to the historical average of 6. The PE ratio of 10 would give a share price of $5 or an 400% increase from current prices. The PE ratio of 6 would give a share price of $3 or a 200% increase from current prices. Can that happen in the next 5 years? Well, it is possible and both are not bad returns. The risk is of course to lose everything. I would attach a 20% probability to losing everything and a 40% probability of hitting the $5 mark and also a 40% probability of hitting the $3 mark in 5 years. This would give a future valuation of $3.2 and a yearly return of 22% just from capital gains. Do not forget that potential dividends should be added to this.
You can read my analysis where I estimated US$4.4 as a safe entry price for ELP when the share was trading at $7.63. The current price is US$4.67 so not far from what I thought will be a safe entry price. It can be assumed that ELP will maintain its current earnings level in the following years that is around US$0.9 giving a PE ratio of 5.11 and a dividend yield of 6.4%. A PE ratio of 5.11 gives a yearly return of almost 20%. As the story here is pretty much the same as with CIG, just without the lost concessions issue, the same valuation methodology can be applied. ELP is a little bit less risky than CIG as it has a debt to equity ratio of 0.46 while CIG has a debt to equity ratio of 0.65. Also from a generation point of view ELP's energy stream is much more stable and secure than CIG's (Figure 4).
Figure 4 ELP's assured energy stream and % of electricity to be sold on the spot market
Source: ELP's IR
If we make a quick valuation assuming stable earnings and a normal PE ratio of 10 for a Brazilian utility the current value of ELP's stock should be $9 thus a potential upside of 100%. Unlike with CIG, with its lower debt and no major concession issues I would not give ELP any default probability but I would give it at least a 50% short term downside potential related to the current Brazilian market turmoil. The best way to approach ELP, if you are happy with a 20% yearly return from earnings and a potential 100% capital appreciation should be to start buying and then average down if possible.
CPL is similar to CIG and ELP, a holding company that, through its subsidiaries, distributes, generates and sells energy, but unlike the other two companies CPL is private. Its PE ratio is currently 12.9 even if it has the highest debt to equity ratio of 2.4. Its current EPS is R$2.4 or US$0.6 that should according to the statutory requirements result in a US$0.3 dividend giving a yield of 4.3%.
Figure 5 Stock performance in the last 2 years for CIG, ELP and CPL
I still do not understand why the market gives three completely different valuations to the three companies. It seems too easy to be truth that CIG is the best investment with its PE ratio of 2.3 followed by ELP with 5.11 and CPL with 12. As these are utilities it is not possible expect CPL to grow at a double rate than ELP and at a quadruple rate than CIG in order to justify its price. Historically the three PE ratios show almost the same difference as the current one. The 10 year average PE ratio for CIG has been 5.78, for ELP 8.33 and for CPL 14.8. Their operating margins are not similar but again they do not reflect the difference in valuation. ELP has had the worst operating margins with an average of 13.2% for the past 5 years, followed by CPL with an average 18.3% while surprisingly CIG has and has had the best operating margin with an average of 25.24%.
We will have to leave it to time in order to see which of the above mentioned companies will be the best performer. I would go for CIG, then ELP and leave out CPL because the first two have the best upside potential while the downside is pretty much the same for all of them as it is related to the sentiment around Brazil and not to fundamentals.
As Brazilian stocks have detached themselves from fundamentals and are in a free fall mode I am looking forward to your comments so that we can at least estimate the market sentiment related to Brazil.
Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in CIG over the next 72 hours.
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.
Additional disclosure: This article was provided for informational purposes only. Nothing contained herein should be construed as an offer, solicitation, or recommendation to buy or sell any investment or security, or to provide you with an investment strategy, mentioned herein. Nor is this intended to be relied upon as the basis for making any purchase, sale or investment decision regarding any security. Rather, this merely expresses my opinion, which is based on information obtained from sources believed to be accurate and reliable and has included references where practical and available. However, such information is presented "as is," without warranty of any kind, whether express or implied. The author makes no representation as to the accuracy, timeliness, or completeness of any such information or with regard to the results to be obtained from its use should anything be taken as a recommendation for any security, portfolio of securities, or an investment strategy that may be suitable for you.