AES Tiete Very Attractive, But Very Hard To Own

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Includes: AES, CIG, CPL, ELP
by: Stephen Simpson, CFA

Summary

AES Tiete is a pure generation company in Brazil, with all of its efforts now focused on free market customers.

AES has structured this company to be its growth vehicle in Brazil, and a clean balance sheet leaves a lot of flexibility for M&A.

AES Tiete looks about 25% undervalued, but most investors will have to hope that AES chooses to once again make ADRs available.

It's a real shame that when AES (NYSE:AES) restructured the ownership of AES Tiete (TIET11.SA) it chose to cancel the ADR program. AES Tiete may not only be one of the most interesting assets within AES, but it is one of the more interesting and differentiated Brazilian electrical utilities. While it is technically possible for individual American investors to own shares traded in Brazil, it is not easy - not only can it be challenging to find a broker, there are language barriers to consider and serious issues of convenience and hassle. To put it another way, I periodically approach brokers about the possibility of opening an account and more than once the response has been along the lines of "which company do you like so much that you want to do all of this?"

All of that said, I think AES Tiete looks to be about 25% undervalued today, with a very clean balance sheet and strong upside to a long-term recovery in Brazilian electricity prices. For those who can buy Brazilian equities, I'd definitely recommend a closer look. For those who can't, maybe it's worth a spot on a watch list on the off chance that AES makes ADRs available once again.

A Different, Sexier, Sort Of Beast

Unlike CEMIG (NYSE:CIG), COPEL (NYSE:ELP), and CPFL Energia (NYSE:CPL), AES Tieste is a very streamlined and straightforward business. The company owns long-term concessions expiring in 2028 for 10 hydropower plants in the state of Sao Paulo that are rated for an installed capacity of about 2.65GW. The largest of these plants, Agua Vermelha, has a rated capacity of just under 1.4GW. Unlike CEMIG, COPEL, and CPFL Energia, there is no Disco or Transco here - this is a straightforward, pure-play generation company. AES Tiete previously sold all of its output to Eletropaulo, but that contract ended in 2015 and AES Tiete is now largely tied to the free markets.

Why do I like AES Tiete so much?

First, the company has none of the volume risk of the distribution companies. CEMIG, COPEL, and CPFL Energia saw power demand shrink throughout 2015 due to Brazil's weak economy, and all three are overcontracted for 2016 - meaning they are committed to buy more power from gencos than they are likely to need, and they very may well have to take a loss on the difference. AES Tieste also doesn't have to deal with the same regulatory tariff headaches that both state-owned and private utilities have to manage - while regulations do play a role in the auctions in which AES Tiete participates, there's no "will they or won't they" uncertainty about whether the company will collect the prices they're entitled to receive - unlike COPEL and CEMIG which have, in the past, had to delay or defer previously-approved tariff increases for political reasons.

Second, I like that AES Tieste is structured as AES's growth vehicle within Brazil. While AES's other assets have their issues (Eletropaulo and Sul), AES has a very clean balance sheet and management is focused on growing the asset base. While the prospect for new hydro projects in Sao Paulo isn't great, and the area isn't necessarily well-suited for wind power, there are solar growth opportunities in the state and AES Tieste is well-placed to be an acquirer in the market.

Managing Power Risk Is Critical To Long-Term Value

One of the key risks across the generating sector in Brazil is the amount of available capacity companies have exposed to the spot market right now. Spot prices have plunged recently as hydropower reservoirs have refilled, shrinking the hydropower generation deficit, and as demand has continued to shrink. COPEL, for instance, has around 15% and 30%-40% of 2016 and 2017 capacity exposed to these low prices, while CEMIG is about 10% exposed (CPFL Energia is fine).

With the expiration of the big Eletropaulo contract, AES Tieste has to actively manage its exposure. As of the February fourth quarter earnings release, the company had locked up about 95% of its 2016 capacity at average prices around R$150/MWh, including a 50MW sold to free market customers under a three-year contract for R$170/MWh. The company is about 88% locked up for 2017 (at slightly higher average prices) and about 60% locked up for 2018.

What this means, though, is that the company is still very much exposed to improving prices. The general expectation among analysts is that spot prices will end up averaging around R$50/MWh in 2016 and R$100 or better in 2017, with long-term prices somewhere in the neighborhood of R$140, though AES Tiete management believes that incremental expansion costs will be closer to R$175/MWh in a few years. With every R$10/MWh change in long-term prices moving the fair value by around 5%, that's clearly a huge influence on future value.

Buy, Build, Or Both?

AES Tiete has contractual obligations to expand its capacity within Sao Paulo by about 15% (or 400MW), and that could be challenging. As I said before, there are few prime hydro sites left and not many attractive wind power locations. The company is pretty much ready to go with a 200MW wind power project near Vermelha, and the last solar power auction delivered attractive pricing (R$298/MWh).

AES Tiete could also move forward relatively quickly with thermal plants. The company could build two gas-fired plants (approximately 500MW and 580MW), but would first need to lock-in the gas supply. Given that management believes thermal power prices need to be at or above R$300/MWh to be competitive, the most recent auctions (in the R$200's) weren't so encouraging for this moving forward soon. It's also well worth noting that building thermal plants in Brazil is a dicey proposition now - the country can more or less meet its needs now with hydropower and renewables (solar, wind, biomas). The key "but" is that when hydropower falls short, thermal-fired generation can be extremely lucrative; on the other hand, thermal can't come close to competing with the cost of hydropower when the reservoir levels are healthy.

I would expect AES Tiete to be active in M&A. The company could likely deploy over R$ 2 billion, and Duke Energy's (NYSE:DUK) Brazilian assets (Geracao Paranapanema) would be an attractive target. Duke owns concessions for eight hydro facilities in Sao Paulo with an installed capacity of 2.1GW and full contract coverage for 2016. This would be a pricey deal, but AES Tiete is one of the few existing players with the ability to pull it off. That said, I'm sure there will be competition for these assets, including Tractebel (OTCPK:TBLEY) and probably foreign players (Brookfield Infrastructure (NYSE:BIP), Chinese entities and so on).

Assessing The Value

As I see it, AES Tiete is a relatively pure way to play electricity demand growth in Brazil. There is weather risk (if hydro generation is insufficient, AES Tiete has to buy power on the open market to fulfill contracts), but an eventual economic recovery in Brazil should lead to substantially higher prices than the recent prevailing R$50/MWh spot prices. Unlike CEMIG, COPEL, and CPFL Energia, there is no distribution business to fall back on as a steady (relatively speaking) source of earnings, but then there is also less exposure to regulatory tariff decisions. AES Tiete's cleaner balance sheet also means that it has less to gain relative to CEMIG, COPEL, and CPFL Energia from future reductions in interest rates (the current interbank rate is around 14%).

Excluding acquisitions or significant greenfield projects, I'm expecting roughly 5% long-term revenue growth for AES Tiete, a little better than my underlying assumption of 3% to 4% long-term demand growth, as I do expect better future pricing. As hydropower generation can be very lucrative (it doesn't require a lot of personnel), I expect very strong EBITDA and FCF margins, with 40%-plus margins entirely plausible. Discounted back, I arrive at a fair value of just over R$20/share today.

I would also note that AES Tiete has paid, and continues to pay, a strong dividend - unlike the aforementioned utility peers, AES Tiete doesn't have a high debt load to manage, nor does it need to conserve cash for growth projects. That leaves it as one of the best income options in the sector, though I expect "catch up" dividends from companies like COPEL and CPFL Energia in the future (and CEMIG too, provided they generate the cash flow to pay them).

The Bottom Line

It is a great frustration that AES Tiete is not more accessible to American investors. Buying AES to gain exposure to AES Tiete isn't a move I'd recommend, as although I think AES Tiete is one of AES's best assets, it's not a big enough part of AES to justify that sort of decision. Likewise, I can't in good conscience say that AES Tieste is so clearly a great idea that American investors should go through the trouble of setting up brokerage accounts in Brazil just to own this.

Nevertheless, while I like CPFL Energia and I like COPEL, I really like AES Tiete and I believe the company's leverage to higher long-term electricity prices in Brazil will serve investors well in the coming years.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within 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.