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.

SEE: Trust In Utilities

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.
 
SEE: The Power Of Dividend Growth

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. 
 

Related Articles
  1. Investing News

    What You Can Learn from Carl Icahn's Mistakes

    Carl Icahn has been a stellar performer in the investment world for decades, but following his lead these days could be dangerous.
  2. Stock Analysis

    Is Now the Right Time to Buy Coty? (COTY)

    Find out whether fragrance and color cosmetics powerhouse Coty deserves a place in your portfolio. Will recent acquisitions help turn the company around?
  3. Personal Finance

    Zika Virus: Latest Advice on Staying Safe

    Zika has hit the U.S. Here’s the most recent update on what’s known about the virus, how it spreads, who’s at highest risk and how to avoid it.
  4. Stock Analysis

    Analyzing Altria's Return on Equity (ROE) (MO)

    Learn about Altria Group's return on equity (ROE) and analyze net profit margin, asset turnover and financial leverage to determine what is causing its high ROE.
  5. Fundamental Analysis

    Is Brazil Currently in a Depression?

    Find out if Brazil, the world's seventh-largest economy, may have finally slipped into an economic depression, and learn the reasons why.
  6. Investing News

    Brazil's Latest Export To China: Soccer Players

    Why are Brazilian soccer players moving to China?
  7. Investing News

    Icahn's Bet on Cheniere Energy: Should You Follow?

    Investing legend Carl Icahn continues to lose money on Cheniere Energy, but he's increasing his stake. Should you follow his lead?
  8. Stock Analysis

    Analyzing Google's Return on Equity (ROE) (GOOGL)

    Learn about Alphabet's return on equity. How has its ROE changed over time, how does it compare to its peers and what factors are driving ROE for the company?
  9. Investing News

    Is Buffett's Bet on Oil Right for You? (XOM, PSX)

    Oil stocks are getting trounced, but Warren Buffett still likes one of them. Should you follow the leader?
  10. Investing News

    Chipotle Served with Criminal Probe

    Chipotle's beat muted expectations and got a clear bill from the CDC, but it now appears that an investigation into its E.coli breakout has expanded.
RELATED FAQS
  1. How do dividends affect retained earnings?

    When a company issues a cash dividend to its shareholders, the retained earnings listed on the balance sheet are reduced ... Read Full Answer >>
  2. What is the difference between called-up share capital and paid-up share capital?

    The difference between called-up share capital and paid-up share capital is investors have already paid in full for paid-up ... Read Full Answer >>
  3. Why would a corporation issue convertible bonds?

    A convertible bond represents a hybrid security that has bond and equity features; this type of bond allows the conversion ... Read Full Answer >>
  4. How does additional paid in capital affect retained earnings?

    Both additional paid-in capital and retained earnings are entries under the shareholders' equity section of a company's balance ... Read Full Answer >>
  5. What types of capital are not considered share capital?

    The money a business uses to fund operations or growth is called capital, and there are a number of capital sources available. ... Read Full Answer >>
  6. What is the difference between issued share capital and subscribed share capital?

    The difference between subscribed share capital and issued share capital is the former relates to the amount of stock for ... Read Full Answer >>
COMPANIES IN THIS ARTICLE
Trading Center