The business of producing and supplying power in emerging market countries like Brazil isn't all its cracked up to be. While it's true that companies like CEMIG (NYSE:CIG) are poised to benefit from increasing electricity demand as Brazil continues to modernize and grow, Brazil is not the only emerging market to pursue a rather hard line with respect to regulation and tariffs. This has put CEMIG in the unenviable position of having to rely on M&A and cost efficiency for better performance, all while sporting a hefty debt load.
A Big Player
CEMIG is definitely one of the largest players in electricity in Brazil, sporting the third-largest share of total capacity at 7%. CEMIG generates about half of its EBITDA from electricity generation, powered by a large base of hydroelectric plants. The remainder of the company's EBTIDA comes from distribution and transmission, where the company sports a low-teens market share.
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CEMIG has certainly grown with the Brazilian economy. Over the past decade, revenue has increased at an annual rate of more than 13%, while operating income has grown only slightly slower. Although free cash flow growth has been considerably more volatile (not surprising given the capex burdens of a power business), the company has average a solid enough free cash flow margin of nearly 10%, while increasing per-share dividends by almost 18% over that same period.
But One With Big Problems
Although CEMIG has scale and scope, it also has multiple operating issues that investors cannot afford to ignore. For starters, Brazil's regulators are not at all passive. As investors in Petrobras (NYSE:PBR) can attest, the Brazilian government has no problem with forcing large companies to provide their goods and services at prices below what the market would otherwise allow, as well as interfering with their assets.
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In the case of CEMIG, the most recent tariff review was quite severe. While the regulators ultimately backed off from what was originally going to be a one-quarter reduction in the firm's regulatory asset base, it still wasn't a positive process. As regulators basically determine what CEMIG can earn by applying a 7.5% ROIC target to its asset base, the determination of that asset base is crucial. All told, CEMIG is getting a 2.99% rate increase, but that's less than half the going inflation rate.
CEMIG also learned that the government intends not to renew the concessions for three of its plants (which produce over 2,500 MW), and those plants have to be returned to the government. CEMIG is fighting this through the courts and recently won an injunction for the Jaguara plant, but I think the point stands that CEMIG cannot count on a positive/easy regulatory environment.
To be clear, it's not as though the government is picking on CEMIG. COPEL (NYSE:ELP), Enersis (NYSE:ENI), Enerbras (NYSE:EBR), and AES (NYSE:AES) all face largely the same challenges with tariffs and regulatory intrusion, and all have suffered in the markets as a result.
New Initiatives Will Be Challenging
CEMIG management has laid out a case for better performance through M&A-fueled growth and cost-cutting efficiencies. I fear that both of these may be challenging. CEMIG already carries substantial debt, and a recent acquisition of a stake in Brasil PCH (a small hydropower generator) came at a roughly 50% premium to replacement cost.
Likewise, I don't have a lot of faith in management's ability to cut costs. Brazil's government has been ratcheting up the pressure for companies not to layoff workers or reduce labor intensity, and labor is the only area where CEMIG would seem to have much discretion in cost-cutting.
The Bottom Line
Although CEMIG's trailing dividend yield appears quite attractive, it is quite likely that the payout is going to decline as the company reallocates cash towards M&A transactions and looks to maintain its debt ratios. I would expect the yield to settle into the range of 4% to 5%, which doesn't strike me as terribly compelling relative to the risk of further regulatory pressure on rates and the possibility of management overpaying in its growth-by-M&A plans.
That said, risk-tolerant investors may find something to like here. The stock looks about 25% undervalued on the basis of a 6x multiple to 2014 EBTIDA, and I think the Brazilian regulators understand that they can't push so far on rate cuts that building/maintaining plants is uneconomical.
Disclosure – As of this writing, the author owns shares of AES.
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