EBR - Eletrobras Stock: Political Risks Call For Caution

2023-06-27 13:21:19 ET

Summary

• Eletrobrás, a leading Brazilian electric energy generation and transmission company, faces political risk as President Lula criticizes its privatization and plans to ask courts for a judicial review to overturn the 10% voting cap.
• The company's latest quarterly results were less than impressive, with net profit retracting 60.6% due to higher debt load and obligations in new concession contracts.
• Despite the potential for long-term efficiency and value, Eletrobrás' current valuation does not provide a sufficient margin of safety given the risks in my view, making investment in the company risky in the short to medium term.

Eletrobrás ( EBR ) is the Brazilian economy's leading electric energy generation and transmission company. Its current portfolio consists of approximately 42 GW of capacity in its portfolio between hydroelectric, wind, and also thermoelectric plants, which, in addition, constitute 45% of the National Interconnected scenario in the transmission sector.

Since June 2022, during the government of the former Brazilian president Jair Bolsonaro, the company has completed the privatization process of the company's assets for a value of R$33.7 billion with the sale of extra lots of shares. With the privatization, the federal government's stake in the company was reduced from 50% to 33% by limiting voting rights to 10%.

The capital raised from privatization is, in theory, excellent news, as the company will have the advantage of using it by selling the energy at free market prices rather than state-controlled prices.

However, since then, with Brazil being presided over by Luiz Inacio Lula da Silva (Lula) as of this year, he has been a harsh critic of the privatization for quite some time and has been articulating plans to ask the courts for a judicial review to try to overturn the 10% voting cap.

In addition, the latest quarterly results of Eletrobrás have also been less than impressive. As seasonality has allowed for high availability of hydroelectricity, tariffs have not provided a margin for cash injection at the company.

From the historical peak on November 4th last year to the end of March this year, Eletrobrás shares have devalued 42% in this scenario. But since then, facing a more favorable macroeconomic scenario and better prognoses regarding the political risk under the company's privatization, shares have risen more than 44%.

Considering the fast rebound of the company in the last three months, the political risk still weighing on the investment thesis of many investors along with the difficulties in the energy sector in the short to medium term, I see the moment to buy Eletrobrás shares as very risky and with limited upside potential in the short to medium term.

Latest Results

Eletrobrás' latest results are not yet entirely free of the critical non-recurring events that have been occurring due to the company's privatization process. Still, the first quarter already showed hints of the potential the company may reap under the new governance structure.

The company reported net revenues in the first three months of 2023 of R$9.2 billion, indicating a 14.3% year-on-year advance. Something that explains the increase in the company's revenues is the restoration of the renewed contract of Eletrobrás Eletronorte, its subsidiary, and the tariff adjustment for the 2022 and 2023 cycles, among some other details. However, there was a reduction in the contractual transmission revenue due to lower inflation rates in the period under consideration.

However, the least attractive facet was the net profit, with a strong retraction of 60.6%, reaching R$1.8 billion. The leading causes were primarily the higher debt load resulting from the consolidation of Saesa and the obligations foreseen in the new 2022 concession contracts. Recurring EBITDA increased 10% in the comparison between 1Q22 and 1Q23, reaching R$5.6 billion, mainly due to lower costs and expenses and higher generation revenues.

Total costs and expenses in the quarter were down 10.7% from 1Q22, impacted by lower fuel expenses for electricity generation, grid usage, and construction charges. The main restructuring initiatives for efficiency gains, emphasizing the voluntary dismissal programs, continue at full steam. However, their effects on the figures in the adjusted results are still in full swing.

Recurring expenses with Personnel, Materials, Services, and Other Expenses increased by 17.7% in the year-on-year comparison. This increase was caused by the fees of the collective labor agreement costing R$113 million and the maintenance services and consolidation of Saesa in Eletrobrás Furnas, weighing in an additional R$51 million to the company's coffers.

The company also reported a net debt of R$36.7 billion, an increase of 78.6% compared to the first quarter of 2022. At the same time, the rise in Eletrobrás' net debt/EBITDA ratio for the last 12 months, from 1.6 times in Q1 2022 to 2 times in Q1 2023 due to the post-privatization leverage opportunity, is not yet an appropriate level of concern since Eletrobrás continues to maintain a high cash generation.

Political Risk, Restatization Noises

The big problem causing the recent volatility in the prices of Eletrobrás is explained by the restructuring noises constantly circulating in Brasilia coming from the current president of Brazil, Lula, and his government team, which has a political bias towards more state intervention in the economy and strict regulation of private companies.

However, based on the skyrocketing share price of Eletrobrás since the end of March, the market seems to have priced that these noises coming from Brasilia are, in fact, just noises.

Lula vehemently defends the idea of the government once again becoming the "owner" of Eletrobrás and guarantees that "it won't be just like that" regarding the sale of the most significant stake in the company to private investors. The president also made it clear that he would ask the courts for a judicial review in an attempt to annul the 10% limitation on the federal government's voting rights in Eletrobrás.

Based on the company's bylaws, the government is unlikely to succeed since the limit to hold up to 10% voting rights is part of the law governing the electric company's privatization, and the company has incorporated it into its bylaws. This limit ensures that each shareholder has only 10% of the voting rights, regardless of their stake in the company.

Eletrobrás also has a strategic defense "poison pill" clause with a specific offer price calculation if a shareholder – even the federal government –decides to add a stake in the company that is 30% and 50%, making a takeover offer impossible.

On the other hand, the limitation of voting rights could be a solid legal argument for Lula's government to use in court, and considering the public interest in the privatization, it is very likely that the federal government will not extend efforts toward its goal.

The legal dispute will not be ideal for Eletrobrás or the national electricity sector. An increased perception of interference in the legislation could bring catastrophic repercussions for the industry, likely to scare away investors en masse. Moreover, should the federal government succeed in overturning the voting cap, it would question the Corporation's legislation, affecting other listed companies and their policy of establishing voting rights.

It is worth remembering that in Brazil; there have already been cases of state-owned companies that were privatized and later revitalized. Vale ( VALE ), formerly known as Vale do Rio Doce, was privatized in 1997. However, in 2007, during the government of the same Lula, the Brazilian government decided to revitalize part of Vale. However, it is essential to note that Vale was not completely renewed but rather subjected to new regulations and government intervention.

Valuation, Not Attractive

When analyzing that Eletrobrás currently trades at a forward price-to-earnings ratio multiple of 43.6 times, which implies something around 140% above the energy industry average, it is undeniable that the stock trades at a premium.

Estimates among analysts point out that based on the difficulties the company should face due to the privatization process and a more challenging energy cycle this year, Eletrobrás will report an EPS drop of 81% for 2023, helping explain such a high valuation multiple.

For 2024 however, the most optimistic scenario after at least two years of privatization, the forecast is for a vast improvement in the company's operational focus and efficiency. The consensus for the end of 2024 is that there will be an EPS growth of almost 200% compared to 2023, and thus, Eletrobrás would trade at much more attractive multiples of 14.6 times.

On the other hand, should the noises of the federal government in favor of the Eletrobrás restatization be compacted into a complex legal process, I foresee that this could come to bear if state interference occurs shortly. And in my opinion, the current multiples do not leave a wide enough safety margin for this scenario.

The Bottom Line

Eletrobrás' post-privatization undoubtedly excites investors based on a greater focus on the company's operational efficiency, a more significant cost reduction, and a more results-oriented mentality. In most cases, this reverts to higher net income, dividend distribution, and, consequently, a higher company valuation.

The political risk in Brazil should be one of the primary focuses when considering investments in the country, particularly concerning Eletrobrás. The presence of security clauses in the Eletrobrás statute makes it improbable for the federal government to reprivatize the company. Nevertheless, there is a likelihood that the government will seek legal avenues to overturn the voting power ban shortly. Once the matter reaches the Supreme Court, anything could happen.

Finally, although Eletrobrás is poised in the long term to optimize its efficiency and deliver significant value to its shareholders, the currently stretched valuation does not provide a sufficient safety margin given the investment thesis risks. For now, I believe that other Brazilian companies in the energy sector can return more excellent shareholder value, especially concerning dividend distributions.

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