Cemig - An Attractive Utility In The Brazilian Sector

| About: Companhia Energtica (CIG)

Summary

Cemig has lagged the recent rally in Brazilian equities.

From a fundamental perspective, the stock seems cheap and offers an interesting dividend policy.

U.S.-traded equities of Brazilian companies could benefit from progressive appreciation in the Brazilian real from a longer-term perspective.

In the short term, the stock could be affected by a negative mood toward the country in general. But that shouldn't erase its intrinsic value.

Despite the year-to-date rally of Brazilian equities, some companies --namely those with an activity profile largely focused on the domestic market -- have lagged. At the same time the foreign exchange of the Brazilian real (BRL) vs. the USD, despite some degree of appreciation, hasn't been showing a performance anywhere near to what Brazilian equity indices have experienced. The country's political and economic environment remains highly uncertain, which contributes to the prices of some equities remaining down.

While analyzing a pool of companies with business profiles more focused on the domestic market, and considering the economic challenges ahead, not all equities appear cheap. Nevertheless, some utilities show very interesting features, suggesting that for investors with a longer-term perspective, perhaps this is an interesting entry point.

Cemig (NYSE:CIG) -- Companhia Energética de Minas Gerais -- is one example. Cemig is the largest integrated utility in Brazil, present in the generation, transmission and distribution of energy with a country-wide presence and a focus on the southeast area and Chile. It ranks No. 1 in distribution (by number of consumers and distribution line extension), No. 3 in transmission and No. 3 in generation. A leading position is particularly interesting in a country the size of Brazil, even considering the current economic environment.

In terms scale, the size of Cemig's EBITDA, net income and free cash flow generation place it ahead of any of its peers listed on the NYSE -- such as CPFL (NYSE:CPL), Copel (NYSE:ELP), Eletrobras (NYSE:EBR), and Sabesp (NYSE:SBS). Cemig is also geographically more diversified than any of these companies, having recently renewed a significant pool of generation and distribution concessions -- therefore reducing political risk going forward. The utility sector in Brazil is mostly under the public sphere of control, not only in regard to concession renewal but also at the shareholder level. Most of the utilities in Brazil are held by the state or by construction companies. Given the corruption scandals under investigation countrywide, that might be an explanation for the low valuations of the sector on top of economic arguments.

Utilities, and Cemig, have been benefiting from higher tariff prices charged to customers that compensate for the loss of revenues from lower quantities sold. However, due to the acquisition of energy in the free market for resale, as reservoir levels were low and could not supply the full energy contracted, Cemig experienced an increase in operating costs. That led to EBITDA erosion in 2015. Nevertheless, Cemig is among the most efficient companies of this universe, as measured by an EBITDA margin of over 23%, ranking only behind Sabesp in this aspect.

In terms of leverage, the company is sound and its free cash flow covers total debt by more than 19% -- much better than any of its peers. Net debt/EBITDA are below 3x (below 2.5x when considering securities as part of the cash position), a conservative value given the nature of the business. Also, in this sector many companies have non-provisioned contingent liabilities, which -- even if they were a concern per se (which, in my view, they are not) -- wouldn't be a reason for the distinction between Cemig and its sector peers.

On the negative side, Cemig has some degree of short-term refinancing risk regarding its debt, which in my view is the most concerning aspect of this company's profile. This risk is mitigated by the fact that more than 80% of the debt coming due is not market debt (debentures) and is mostly held by banks. Typically, those banks have a better knowledge of the company and a longer-term relationship with customers, which contributes to the reduction of refinancing risk. Being ahead of its peers in terms of cash flow generation allows Cemig to bear increased refinancing costs as interest coverage is more comfortable (Cemig's EBITDA/net interest is at 6.7x, vs. 3x for peers -- only Copel displays a better score).

Cemig has a successful track record of acquisitions that explain its growth trajectory and geographically diversified business profile when compared to its peers, which have activities more centered in certain regions of Brazil such as São Paulo or Paraná. Statutory rules, a reflex of sound corporate governance practices, provide room for growth and try to assure a conservative risk profile of the company by limiting capex to 40% of EBITDA, net debt to 2.5x EBITDA, and net debt to 50% of total capital.

Cemig trades at US$2 on the NYSE and is among the Brazilian equities that has devalued the most from historical peak levels. At the same time, it has one of the most attractive dividend policies in the Brazilian company universe, as its bylaws establish a minimum payout of 50%. That's double the 25% established by law and what's common for other utility companies. They also allow extra dividends every two years.

In terms of multiples, it is also among the most attractive equities in the Brazilian sphere, with an EV/EBITDA of 4.4x and a dividend yield of 5.7%. The stock is liquid with a 76% free float and US$27 million daily turnover on the NYSE, according to the company's website. My quantitative analysis suggests this company is fundamentally undervalued by at least 35%, on top of the attractive dividend policy.

When investing in USD-denominated equities, they also benefit from the positive effect of currency appreciation. As mentioned in my previous article, "Is The BRL/USD Exchange Rate Reaching A Turning Point?," BRL exchange rate fundamentals seem supportive for the value of the currency from a longer-term perspective -- even if in the very short term the currency volatility resumes. This environment adds value to Brazilian equities listed on the NYSE and traded in USD instead of BRL.

On the other hand, a generalized fall in Brazilian equities could bar the materialization of a re-pricing based on fundamentals and BRL appreciation vs. the USD mentioned previously. Nevertheless, the intrinsic value of the company exists for those with a longer-term perspective and could improve with time.

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.