CSAN - Cosan: Long-Term Payoffs From Efficient Capital Allocation

2023-09-23 02:26:54 ET

Summary

• Cosan is a Brazilian conglomerate operating in various sectors including agribusiness, fuel distribution, natural gas, and lubricants.
• Despite its complexity and history of mergers and acquisitions, Cosan maintains a consistent track record of financial results and efficient capital allocation across its portfolio of businesses.
• The company's key subsidiaries, such as Raízen, Rumo, Compass, and Moove, contribute to its overall performance, with growth and profitability varying by segment.
• While Cosan's unique investment thesis focuses on long-term returns, potential investors should be aware of its capital allocation strategy, debt management, and the intricacies of its diversified holdings in the natural resources sector.

Cosan ( CSAN ) is one of Brazil's largest companies. It operates in various sectors, including agribusiness, fuel distribution, natural gas, and lubricants, with leading companies in their respective industries.

Cosan has a moderate and continuous growth history, even in challenging economic scenarios marked by economic recessions, currency volatility, and political crises. This is a notable achievement, considering that Cosan is a capital-intensive company with a diversified revenue base, and its various segments react differently to economic cycles.

As a result, the company has maintained a consistent track record of financial results and cash generation.

Yet, it's important to note that Cosan's diverse business portfolio makes it a complex investment case, and its history of mergers and acquisitions adds an extra layer of complexity to understanding its current business landscape.

Therefore, Cosan strongly emphasizes managing its debt and associated costs, particularly as it embarks on growth initiatives within its subsidiary and holding companies.

Considering the promising long-term prospects and the ample growth opportunities within Cosan's asset portfolio, adopting this mindset is advisable for those considering an investment in the company.

Cosan: The Brazilian Conglomerate Across Diverse Sectors

Note that Cosan's investment thesis is not easy since it is the sum of its holdings in several companies, Raízen, Vale ( VALE ), Compass, Rumo, Moove, and Cosan Investimentos, and with a very long-term vision in its investments, out of step with most investors.

Cosan is one of Brazil's largest industrial groups. Its history began in the sugar and ethanol sector, but over the years, the holding company has expanded into several sectors. It can be seen that Cosan's investment thesis is not easy since it is the sum of its holdings in various companies and has a very long-term vision in its investments, which is out of step with most investors.

Cosan is currently made up of six main businesses:

• Raízen (a joint venture co-controlled with Shell ( SHEL ) with a 44% stake): one of the largest sugar and ethanol players and fuel distributors in Brazil, with an audacious long-term plan to expand into 2nd generation ethanol ("E2G") and biogas;
• Rumo (subsidiary with a stake of around 30%): company resulting from the merger of ALL (América Latina Logística) and Rumo Logística, mainly focused on the rail transportation of agricultural products from the Brazilian states of Mato Grosso to the Port of Santos (São Paulo), with the Lucas do Rio Verde Project to expand its network further;
• Moove (70% stake subsidiary): production and distribution of lubricants, with sales and operations, spread across several countries in the Americas and Europe, to further consolidate Western markets;
• Compass (subsidiary with a stake of around 90%): the natural gas distribution business started with Comgás (in the state of São Paulo) and is now looking to replicate this success in other concessions in Brazil, while an NGL terminal will allow the company to expand further into gas trading;
• Cosan Investimentos (100% stake): a holding company designed to seek out new ventures within the holding company. Currently, the short-term focus is mainly on land management and a possible mining joint venture;
• Vale (with a minority stake of up to around 6.5%, depending on how the derivatives are settled): the most recent of Cosan's investments and the only one the group does not control. One of the largest mining companies in the world, Vale will provide Cosan with more foreign currency to balance the group's cash flow.

Cosan's Latest Results

There are multiple approaches to analyzing Cosan's financial performance. One of these methods involves evaluating the holding company independently, treating each business as a separate entity, considering all transactions at 100% (given Raízen's co-control with Shell), and assessing the proportionate share of each company.

In the second quarter of 2023 , the holding company recorded a net profit of R$145.2 million, marking a turnaround from the R$178.6 million loss reported in the same period the previous year. This improvement occurred despite a 19.4% decline in net revenue, which amounted to R$34.4 billion.

Raízen faced challenges, particularly with ethanol losing competitiveness against gasoline and Russian diesel. This resulted in a 26% drop in revenue to R$48.8 billion and a 44.8% decrease in EBITDA, amounting to R$1.6 billion. However, other subsidiaries, including Rumo, Compass, and Moove, demonstrated better operating performance.

Rumo's EBITDA increased by 20.9% to reach R$1.4 billion. Compass, the gas and energy company, saw a 10.3% increase in EBITDA to R$968.2 million, while Moove, the lubricants and base oils company, experienced a 30.3% growth in EBITDA, reaching R$302.4 million.

Rumo's performance was driven by an expansion in transported volumes and the consolidated average fees, reflecting the competitiveness of the rail transportation mode. Compass benefited from a richer mix, with growth in the residential and commercial segments offsetting the drop in industrial volume during the quarter. Moove's growth was fueled by higher volume and an improved product mix across all markets.

Cosan Investimentos reported a 66.3% increase in EBITDA, reaching R$174.2 million. This growth was primarily attributed to the Land segment, with the appreciation of the agricultural property portfolio and increased lease revenues contributing positively to the results.

On the downside, Cosan recorded general and administrative expenses of R$83.9 million, marking a 20.6% year-on-year increase. This increase was due to the implementing of a new long-term compensation plan at the beginning of the year and inflation during the period, which aligned with expectations for the year. Other operating expenses totaled R$21 million, primarily associated with legal and tax contingencies.

Cosan's overall EBITDA reached R$4.4 billion, reflecting a 6.7% year-on-year increase. Finally, the financial result was subtracted from the balance sheet, resulting in a negative balance of R$387.7 million. This marked a significant improvement compared to expenses of R$1.25 billion in the second quarter of 2022.

During the quarter, the cost of gross debt fell to R$455 million, mainly impacted by the R$336 million improvement in Perpetual Notes due to the appreciation of the Brazilian real against the U.S. dollar in the first half of the year.

Cosan concluded June with a net debt of R$13.8 billion, compared to R$12.6 billion in 2022. The group's primary focus is on leverage and the cost of debt. The leverage ratio (net debt/EBITDA) decreased from 2.4 times in the second quarter of 2022 to 2 times in the second quarter of 2023, primarily due to increased EBITDA over the last 12 months.

In 2023, Cosan successfully raised R$4.7 billion, enhancing liquidity and ensuring the payment of debt amortizations until 2025, including the first installment of the operation to acquire a stake in Vale. The company ended the quarter with a gross debt of R$19.3 billion, representing a 34% increase compared to the first quarter of 2023. Nevertheless, the debt amortization schedule remains manageable.

Lastly, a buyback program of up to 6.19% of the total shares available on the market was approved, hinting at a possible undervaluation of the company's share price.

Risks: Complexity Overwhelm

Over the years, Cosan has evolved into one of Brazil's most complex investment cases. Its diversification across various sectors necessitates the involvement of numerous analysts to gain a comprehensive understanding of the holding company.

Additionally, the extensive schedule of mergers and acquisitions adds to the challenge of keeping track of the current status of its businesses. The unique structure of the minority stake acquisition in Vale, while strategically clever from Cosan's perspective, further complicates the analysis of the holding company's shares.

Leverage and the cost of debt have become focal points for Cosan. The group is currently in a growth phase within its investee companies and at the holding company level. This expansion has been a concern, particularly in the context of high-interest rates in Brazil. Cosan's adjusted net debt, which includes all aspects of the Vale acquisition, currently stands at approximately R$37 billion. This translates to around R$5 billion in annual interest payments at the Brazilian interest rate (Selic), exceeding Cosan's current market capitalization of approximately R$34 billion ($6.8 billion).

Cosan is addressing this challenge through a combination of strategies. It involves prioritizing capital allocation within its subsidiary companies, with some having room to increase leverage, such as Compass. At the holding company level, Cosan employs tactics, including selling non-core assets, divesting non-controlling stakes in Compass and Moove, focusing on operational efficiency resulting from recent mergers and acquisitions, and using innovative financial engineering to manage debt.

Nevertheless, there are compelling reasons to consider direct investment in the holding company. It's worth noting that there may be a potential mismatch in investment timeframes. Cosan's capital allocation strategy is geared toward generating returns over years or even decades, while most investors typically have a much shorter investment horizon.

The Bottom Line

Cosan's investment thesis is centered on the holding company, a diversified platform comprising unique and irreplaceable assets.

In Brazil, companies associated with the natural resources sector typically enjoy a competitive advantage. This advantage extends to Cosan's investees, including Compass (in natural gas distribution), Raízen (in sugar and ethanol production), Vale (in mining), and Rumo (in grain transportation). Furthermore, the company has demonstrated an impressive track record of efficient capital allocation over the past ten years.

When valuing Cosan, one approach is to consider the sum of all its parts. Given that the company operates in capital-intensive industries and some of its businesses are cyclical, it can be insightful to examine the Price-to-Cash Flow (P/CF) ratio. Currently, Cosan is trading at a P/CF ratio of 3x, indicating that the market is willing to pay one dollar for every three dollars of cash flow generated by the company. Significantly, this metric is 28% below the average for the Energy sector and considerably lower than in recent years.

However, it's important to consider that Cosan is in a growth phase within its investee companies and at the holding company level. This growth occurs in the context of declining interest rates in Brazil, which should lead to reduced investor risk aversion, particularly starting in 2024.

Considering Cosan's long-term mindset and the various growth opportunities across its assets, it is advisable for investors to align their expectations accordingly.

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