When the mood is positive towards a given theme such as a country, an asset class or an industry, shares trading at low values in general tend to outperform shares trading at higher prices, independently of their intrinsic value. Looking at the Brazilian companies listed on the NYSE, we see that Cemig (NYSE:CIG), Eletrobras (NYSE:EBR), Gafisa (NYSE:GFA), Gerdau (NYSE:GGB) and Oi (NYSE:OIBR) trade below 2.5 USD. Are they in fact undervalued or short-term appreciation is more the result of active trading activity?
The first characteristic that strikes attention is that with the exception of the steel company Gerdau, the remaining have a very local activity profile, mostly dependent on the domestic market. Eletrobras and Cemig are utilities; Gafisa operates in real estate and Oi is in telecommunications business. By this token, with the challenges facing Brazil, it may be difficult to get any upside value during the next year. On the other hand, this could be the best moment to acquire these shares, for those believing that analysts' expectations for Brazil's growth are underestimated.
From the universe of companies mentioned, there are two special situations that come to light.
The first is Gerdau, which trades at 2.21 USD but is not that exposed to the Brazilian market. In fact Gerdau generates the majority of its revenues outside Brazil, therefore the catalysts for this stock are different. Gerdau is more exposed to international steel sector fundamentals, which are not good, as Chinese are exporting steel and the environment is highly competitive. As referred in my recent analysis Equities of Brazilian Steel Companies Like CSN, Gerdau and Usiminas Remain Dear, fundamentals don't look good and current equity valuation multiples don't seem attractive, unless market expectations may be overreacting to the global sector situation, which I think they are not.
The second one is Oi. Oi, is one of the main integrated telecommunications provider in Brazil, but its elevated debt levels when compared to capacity of cash flow generation are a concern. Oi is already breaching some limits to financial ratios established in debt documentation. Oi also has around 7 bn USD of non-provisioned contingent liabilities, the equivalent to 25% of total assets on balance sheet. Such concerns are expressed in the share price of 0.28 USD and in secondary market yield levels of its USD denominated debt trading at 70% for bonds maturing in 3 years. Free cash flow in 2015 was negative but market analysts expect it to turn positive in 2016 and 2017. With an enterprise value mostly corresponding to the value of its debt, this company needs time and a domestic boost in activity to reestablish itself, time which may not be available given debt levels. At current and expected multiples, most utilities in the country seem more attractive.
Gafisa is a small but interesting company. It is positioned in one of the most sensitive sectors to economic recovery, real estate. This company has managed to post positive free cash flow in 2015, given relevant investment contention and is expected to remain that way in the future. It has a high level of debt, which free cash flow can only cover by 4% and net debt/EBITDA is 12x. Although the sector is typically a high leverage one, this company has a risky profile as despite being very well positioned to benefit from a positive surprise in economic activity, at the same time lacks buffers to survive a longer than expected recession. Gafisa has no exposure to USD denominated debt and therefore its sensitivity to foreign exchange volatility is lower than in the case of utilities, telecoms or steel companies, under discussion. Non-provisioned contingent liabilities are also negligible. However, given its small size and the less favorable ratio metrics like EV/EBITDA and price earnings expected until 2017, it is a somewhat risky bet, even for a Brazilian company.
This leads to the two last candidates, Eletrobras and Cemig. The utilities sector in Brazil is still mostly in public hands, at state or federal level, therefore susceptible of event risk. Also, dependence on hydrological conditions to generate electricity increases the risks of operations. Nevertheless, there are fundamentally sound companies in the sector, that may be very well positioned to benefit from economic recovery and which at these equity price levels may be an interesting buy opportunity.
Eletrobras is the largest listed utility by assets in Latin America. It is held by the Federal State, which controls 76% of the company directly or indirectly. Given the recent corruption scandal, Eletrobras is developing an internal investigation to access the existence of corruption practices, which may affect earnings reports. The investigation is still developing, posing the risk of negative and yet unquantifiable information about the company being released. Planed investments in the future will probably lead 2017 free cash flow into negative territory, despite the recovery in the domestic environment. Eletrobras is trading at around 1.91 USD, EV/EBITDA expected until 2017 may reach over 17x, so even if the economy surprises positively, it will be difficult to translate that into value given current market prices.
To finalize, Cemig, a Minas Gerais utility company, is an integrated operator present in 23 Brazilian states and Chile, trading at 2.21 USD. This company has in my view three characteristics that make it very interesting: [I] dividend policy, [ii] conservative financial profile, [III] scale.
Cemig has a minimum payout ratio of 50% of net income, which places the stock at a current 5.7% dividend yield, and is likely to pay additional dividends. The revenue stream is more predictable than in most industries, revenues grew in 2015 and are expected to continue that way. Cemig generated positive free cash flow, which covers more than 20% of debt. It has no USD debt. Among the utilities listed on the NYSE, Cemig only lags behind Eletrobras in terms of asset and revenue size.
On the other hand, Cemig has 6.1 bn BRL of non-provisioned contingent liabilities, a small cash position (1 bn BRL) in comparison to the debt coming due in 2016 (6.3 bn BRL) and the weak currency is eroding its cost structure, with negative consequences over EBITDA generation and respective margin.
Multiples of Cemig seem interesting with EV/EBITDA currently at 4x. Cemig is the most attractive stock among these companies whose shares trade around 2.5 USD, and could well benefit if the domestic economy surprises the market on the upside. However, it may not be the only company with value in the utilities universe.
That's the topic of a future report.
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.
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