EBR - Eletrobrás: Shines In Q2 Yet Re-Nationalization Risks Grow

2023-09-02 06:11:29 ET

Summary

• Eletrobras reports positive Q2 results, demonstrating the impact of privatization on efficiency.
• The Brazilian Attorney General's Office advocates for increased voting power for the State within Eletrobras, raising concerns about privatization.
• The CEO's resignation and the company's potential re-nationalization contribute to escalating risks, prompting a neutral stance on Eletrobras.

The Brazilian energy company Eletrobras ( EBR ) has reported consistent results in the second quarter, demonstrating the positive impact of privatization on the company's efficiency.

However, as outlined in my previous article on the company, political risks and ongoing discussions surrounding privatization continue to be the primary concerns for potential investors. In recent weeks, the threat of privatization has taken a new turn, with the Brazilian Attorney General's Office advocating for the Union to have increased voting power within Eletrobras.

Compared to other private peers, Eletrobras still maintains an attractive valuation. However, the persistence of influential politicians, who were expected to diminish with privatization, has become more evident, especially considering the interventionist stance of President Lula's current government in Brazil.

Therefore, while I acknowledge Eletrobras as an excellent company with significant growth potential, and it continues to demonstrate quarter-by-quarter improvements in efficiency, my skepticism regarding the growing political risks leads me to maintain a neutral position.

Q2 results show progress

Eletrobras' recent results bring positive news in the Brazilian energy industry, marking another significant step in the company's transformation and efficiency improvement journey.

Several key highlights emerge from the Q2 earnings results:

• Santo Antônio plant (SESA) consolidation : The acquisition of the Santo Antônio Plant substantially impacted the financial figures compared to the previous year. This contributed to a net revenue of R$9.2 billion. The consolidation of the Santo Antônio Plant and higher contracts at advantageous average prices were critical drivers of this revenue.
• Contracting growth : Eletrobras saw a significant increase in its contracting activities in the Regulated Contracting Environment (ACR) and the Free Contracting Environment (ACL). This reduced its uncontracted capacity to only 6% to 17% for 2023 and 2024, with attractive prices (R$206-200/MWh for 2023 and 2024)
• Recurring costs : Total recurring costs reached R$6.5 billion, marking an increase compared to the previous year's R$4.1 billion. This increase was primarily attributed to the consolidation of the Santo Antônio Plant, which affected the basis for comparison.
• EBITDA performance : The company reported an EBITDA of R$6.59 billion, increasing 59% year-over-year. This performance was influenced by a non-recurring event resulting from the reversal of provisions related to compulsory loans.
• Voluntary Dismissal Program : The Voluntary Dismissal Program, launched in July 2023, had positive impacts. A total of 1,475 employees joined the program at a cost of R$688 million. The program is expected to yield returns in less than 9 months.

• Provisions reversal : Provisions totaling R$1.6 billion related to court settlements regarding compulsory loans were reversed during the quarter. This led to a total reduction of R$2.1 billion compared to the initial provision of R$22.2 billion, thanks to the agreements reached and payments made.
• Net income : Net income for the period was R$1.6 billion, up 16% year-over-year, reflecting a significant increase in financial expenses – a loss of R$3.2 billion compared to a loss of R$1.4 billion in Q2 2022. This increase was primarily attributed to the consolidation of the Santo Antônio debt, the high cost of the current debt, and the updating of the financial cost related to CDE payments.

These highlights showcase Eletrobras' performance and ongoing transformation efforts, highlighting specific factors impacting its financial results.

Risks of re-nationalization increase and CEO resignation

The Brazilian Attorney General's Office (called PGR) has issued an opinion advocating for the Union's increased voting power within Eletrobras, stemming from a direct action of unconstitutionality filed by the Federal Attorney General's Office.

In essence, the dispute revolves around voting rights in the company's privatization legislation, wherein each investor's voting power would be capped at 10%, regardless of their ownership stake in the company. In other words, even if an entity held more than 40% of the company's shares, the Federal Government would wield only 10% of the voting authority.

It's worth noting that this measure played a pivotal role in gaining investor approval and ensuring the feasibility of the privatization. The federal government had incorporated this proposal into the bill during the tenure of former President Jair Bolsonaro. Until the law's passage, there was no indication of its unconstitutionality.

Presently, under the leadership of Lula da Silva, the Brazilian federal government, via the Ministry of Mines and Energy, has cited the recent blackout in Brazil on August 15 as grounds to bolster its request for enhanced voting rights. The initial incident occurred in assets operated by Companhia Hidro Energética do São Francisco (Chesf), a subsidiary of Eletrobras. The Ministry has expressed concerns about the potential impact of the departure of key personnel on the continuity of the company's service provision.

To add to the complexity, CEO Wilson Ferreira Junior resigned after serving for less than a year. Interestingly, his departure doesn't seem to result from political pressure. Executives have conveyed to local media that the primary reasons behind his departure were challenges such as delays in executive changes and initiatives like divesting the company's assets. The Chairman and former Petrobras (PBR) president Ivan Monteiro will step in to replace Ferreira Junior.

It is crucial to mention that the privatization of Eletrobras was executed through a bill approved by Congress and the Senate, which had the same leadership at the time of approval and had its constitutionality fully validated by the Supreme Court – which had maintained mainly the same composition as when the bill was approved. It would be a remarkable and drastic change of stance by these authorities in such a short span.

Beyond the merits of the executive's argument, it's essential to consider how market participants would interpret the broader Brazilian market if this executive request were granted.

Should the rules undergo alterations, this could impact various facets, including risk premiums, interest rate effects, the exchange rate, demand for future auctions in diverse infrastructure sectors, and more, due to potential interpretations of changes to long-established regulations.

It's crucial to remember that the privatization process raised over R$30 billion, involved recurring payments to the Energy Development Account, and relied on the Guarantee Fund for Length of Service (a mandatory benefit in Brazil that serves as a form of job security and financial assistance for workers) of numerous Brazilians.

Valuations appear inexpensive, but there's a rationale behind it

It is essential to recognize significant short-term challenges for Eletrobras, as such the enduringly low long-term energy prices and recent political discussions regarding the potential re-nationalization of the company.

Considering current price levels, Eletrobras is trading at a Price/Book value ratio of 0.7x and an EV/EBITDA ratio of 6.1x for 2023. When we compare these multiples to one of its private peers, Engie ( ENGIY ), which is trading at a Price/Book value ratio of 1.2x and an EV/EBITDA ratio of 6.1x for 2023, it becomes evident that Eletrobras' valuation offers a significant discount.

The fact remains that Eletrobras is still trading at levels reminiscent of a state-owned company, and recent developments have highlighted potential risks associated with treating it as such.

While the current valuation of Eletrobras may already account for a significant portion of the more pessimistic scenarios and could potentially yield substantial gains as its efficiency measures come to fruition, my skepticism persists as long as political uncertainty looms, particularly with Brazil's Lula government leaning towards interventionist policies.

Therefore, despite the company's improved financial results in Q2, indicative of enhanced operational efficiency, the heightened political risk summoned by the recent drastic change in the company's management continues to deter me from issuing a bullish recommendation on Eletrobras shares.

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