Who knows how long the safety trade will be on for, but it seems likely T-bill yields will continue to go down further given everything going on. Holding government paper will make you look intelligent in the short term, but at some point, there is likely to be an ugly reversal (granted it could take some time). I guess my underlying point is that you can do better without taking the risk of dancing with the devil. (Next Crisis)
While many utilities and other safety trade assets are at premiums, there remain a few companies with stable, above-average yields trading at very reasonable valuations. One such company is Brazilian based AES Tiete. The company offers investors a safe and predictable business currently yielding 10%, or three times current 30-year T-bills and four times that of the S&P.
As long as the water is flowing
The company operates 18 hydroelectric plants in Sao Paulo and Minas Gerias under a 30 year concession which is valid until 2029 with the option to renew for another 30 years. Virtually all of the energy (and 88% of their revenue) that AES Tiete can produce is contracted with AES Eletropaulo until 2015. It is highly likely that before the current contract expires a new one will take its place. Since 2003, the company has been controlled by holding company Companhia Brasiliana Energia, itself formed by AES Corp. and the Brazilian Development Bank.
Aes Tiete is a big player in Brazil's power market, accounting for about 2.3% of the country's total installed capacity making it the second largest private generation company. Given the abundance of natural water bodies in the country, it makes sense to use that to the nation's advantage and Brazil certainly has done that as hydropower accounts for around 71.1% of the 113,427 MW of installed power with thermoelectric, nuclear, and wind making up 26%, 1.77%, and 0.82% respectively.
Brazil's power generation by source
As high a percentage of installed capacity as hydroelectricity accounts for, the company estimates that only around 31.5% of the country's hydroelectric potential has been explored, leaving room for growth.
Are droughts the company's Achilles; heel? A double hit of mismanagement and overuse distorts the picture.
Like many geographically large countries, Brazil often experiences extreme weather conditions. Right now, where flooding in the Amazon region has forced thousands to flee their homes, while in the north-eastern part of the country the worst drought in 30 years is resulting in water rationing. While a black-swan type drought (once a century) could potentially have a drastic effect on the company's operations, Brazil goes through a "normal" drought about every four years and power generators like AES Tiete, naturally, prepare accordingly.
Over a decade ago, the company was tested in such an environment. While on the surface it appeared that drought was the culprit affecting operators like AES Tiete, the true culprit was a combination of misuse of resources and institutional mismanagement during the Brazilian financial crisis a few years before. The drought (while one of the worst in decades), had the affect of simply magnifying the problems that were created during that time. The end result for AES Tiete from the drastic drought led to the company postponing a $300 million dollar bond offering.
During 2001, the worst drought to hit the northeast in 70 years coupled with a moderate drought in the southeast resulted in reservoir storage at only about 30% of their normal level. Hydro-plants typically operate at about 55% of capacity to make sure reservoir levels are sufficient when the dry years hit. For several years leading up to 2001 however, lack of new plant construction coupled with insufficient investment to expand electric generation capacity for several years insured that capacity wasn't able to keep up with power demand. This caused hydro-plants to operate above their normal 55% capacity to handle both normal and peak loads. When the drought hit, storage levels were already below average and the result simply compounded the problem.
Given how heavily dependent the country was, and is, on hydroelectricity for power, the low reservoir levels caused the government to call for a cut in electricity consumption of between 10-35% to avoid rolling blackouts. While companies such as AES Tiete prepare for such events, during the country's financial crisis in the late 1990's tariffs were not modified and thus no fuel was purchased for the thermal power plants which supply the brunt of the remaining installed capacity. As a result, hydroelectricity had to make up for a lot of the remaining 25% power gap. This further aggravated the already very low reservoir levels which were allowed to go lower than was technically safe. National power rationing coupled with normal rain fall again began to slowly restore the depleted reservoirs and eventually enabled the country to get back to normal operating capacity.
While the power rationing nationwide and severe cost cutting led to the company postponing a bond offering, the effect it had on the economy as a whole was drastic spiraling the nation into a recession.
Would the company have been able to completely operate without issue if the thermal power plants were running at capacity and hydro-power storage reservoirs hadn't been overused for years leading up to 2001? They likely would have had some issue but it certainly would not have been as severe as it was. All in all, the company was put through a very difficult test during that time and was able to come out of it. In fact, they even maintained their dividend. Absent a completely catastrophic long-lasting drought the company will continue to put one foot in front of the other and report consistent results even in the event of a "normal" dry year.
Is the high payout ratio sustainable?
The big two questions with the dividend are: What is the payout ratio and is it sustainable? Looking back, the company has a history of high payouts due to the predictable nature of the operations. The company's dividend policy is to payout a minimum 25% of net income but since 2006 they have paid out an average of 106% of earnings.
Net income & free cash flow trend:
|Free cash flow||$775m||$833m||$761m|
|FCF % payout||106%||103%||121%|
|Cash flow from operations||$1.1b||$917m||$933m|
All figures in Brazilian reals.
The answer lies in their depreciation and amortization charges helping beef up their cash flow from operations and hence enabling them to pay out in dividends a figure greater than their net income and free cash flow. While the cash flow is adequate to cover the dividend, the payout remains high and has entered red flag territory the past two years.
Given the stability of their operations, however, I would give the company the benefit of the doubt at this point that they will continue to be able to internally fund the dividend.
With such a high payout ratio, one might think that they are completely starving their business in terms of cap ex charges, but this is not the case. From 1998 to 2011, the company invested some 8 billion Brazilian reals in its operations and plans to spend 500 million reals from 2012 to 2015 for upgrades of its generating units.
I plugged their free cash flow into my DCF model and came up with an estimated per share intrinsic value of around $14.30 or so compared to a share price of $11.82 on the OTC ordinary shares. I assumed a discount rate of 9% and used normalized free cash flow the past 3 years to help get a more realistic picture. The company has both ordinary and preferred shares with the valuation based on the current price of the ordinary. Both trade OTC and are quite thin, with the ordinary shares having a daily dollar volume of around $100,000 daily, while the preferred provide a bit more liquidity.
So far, I haven't had any luck in trying to find a replacement value for the 18 hydro-electric power plants, but I'd be willing to bet it's higher than the current enterprise value of $4.5 billion.
My own personal feelings are that a better entry price could be had in the future given the never ending Euro-soap opera and I am holding tight and waiting.