EWZ - WEG: Updating To Strong Buy After Impressive Q2 Earnings

2023-07-27 13:33:15 ET

Summary

• Brazilian company WEG has been upgraded to a "strong buy" following robust Q2 results, including a significant increase in revenues and positive margins despite a lower average FX.
• The company's Q2 results showed a 45.9% YoY increase in EBITDA and a 50% YoY growth in net profit, demonstrating strong operating performance and business expansion.
• Despite its high valuation, I maintain a positive view on WEG due to its solid fundamentals and the improving Brazilian macroeconomic scenario.
• These factors combine to make it an attractive investment opportunity, especially in the early stages of a lower-interest-rate cycle.

In my previous article on WEG (WEGZY), I rated the company as a "buy" due to its competitive advantages as a Brazilian company, particularly its extensive exposure to external markets, with a significant portion (almost 30%) of its business revenues coming from North America.

"WEG is probably one of the best publicly traded Brazilian companies from the standpoint of its business fundamentals. The company has almost doubled its profits in a couple of years, has a robust cash generation, and has virtually no debt. I attribute much of WEG's success to the global diversification of its revenue, which reduces the risk of dependence on the Brazilian economy."

Following the release of WEG's second-quarter results, the outlook became even more promising. The company achieved a significant increase in revenues year-over-year and quarter-over-quarter while also showing positive margins and Return on Invested Capital ((ROIC)) growth, despite a lower average FX than the previous quarter.

The market reacted positively to these surprising results, as WEG's shares have already appreciated by almost 14% since the results were announced on 19th July.

Despite WEG's valuation remaining higher than the capital goods sector average, the second-quarter results showcased significant improvements in the company's financial performance across all aspects. These positive developments reinforce my belief in adopting a long-term investment strategy, as WEG's strong profitability growth trend has the potential to yield exceptional rewards. As a result, I have upgraded my recommendation to a "strong buy."

A very solid Q2 earnings

WEG's second-quarter results were virtually flawless, especially considering the challenges posed by surging commodity steel and copper prices earlier in the year.

Despite a lower average exchange rate than the previous quarter, WEG achieved growth in dollar revenues, maintained strong local market revenues, increased operating margins, and improved its Return on Invested Capital, which reached 34.4% compared to 31.4% last quarter.

The Domestic Market segment saw an upswing in local industrial activity, particularly in short- and long-cycle equipment, supported by critical sectors such as mining, pulp and paper, oil and gas, and utilities. Additionally, WEG received strong demand from the US and Mexican markets for transformers in renewable energy projects, leading to a healthy order book for future quarters.

The External Market continued to exhibit strong demand, particularly in the GTD (Generation, Transmission, and Distribution) segment for renewable energy projects, oil and gas, and mining, which experienced growth compared to the first quarter despite a drop in demand year-on-year due to the end of tax exemptions for distribution fees.

WEG's EBITDA stood out in Q2, reaching R$1.83 billion, marking a remarkable 45.9% YoY increase and 8.5% QoQ growth. This result was primarily driven by a surprising EBITDA margin of 22.4% YoY, attributed to the stabilization of commodity prices, an improved product mix, and ongoing efficiency gains.

The company's net cash increased by nearly R$0.4 billion, thanks to a solid operating performance, albeit partially offset by an increase of around R$0.7 billion in working capital requirements. WEG also invested approximately R$0.4 billion in capex to modernize and expand its manufacturing capacity.

WEG's net profit for the quarter amounted to R$1.37 billion, reflecting a substantial 50% YoY growth and a 4.7% QoQ increase. This positive bottom line demonstrates WEG's commitment to reinvesting over half of its profits into business expansion while distributing the rest through dividends, which is essential for long-term shareholder value generation.

Brazilian macro: Interest rates in a downtrend

The last three months of 2023 brought a positive turnaround for Brazilian equities, significantly impacting WEG's strong performance, with the company's stock growing by almost 30% this year.

At the beginning of the year, Brazilian equities faced challenges as they underperformed compared to global peers. The pressure on Brazilian assets was due to high political and fiscal uncertainties. However, these risks gradually diminished as the year progressed, improving market sentiment.

This rebound can be attributed partly to the improved economic outlook, as evidenced by better-than-expected economic data. Brazil's GDP grew by 1.9% in the year's first quarter and 3.3% over the last four quarters. The Brazilian Central Bank's latest report projects a GDP growth rate of 2.18% for the end of this year, 1.83% for 2025, and 1.92% for 2026. Nevertheless, the unemployment rate increased by 1% to 8.8% by the end of the first quarter of 2023 compared to the previous quarter.

Fiscal and political risks have also decreased as the impacts of the fiscal framework were less severe than anticipated by the market, thanks to the efforts of Brazil's new economic team under the new administration of President Lula. However, uncertainties remain regarding the approval of the tax reform , as it may significantly affect Brazil's private sector with measures like the taxation of dividends.

An essential factor contributing to the optimistic sentiment in the Brazilian market is the improvement in recent inflation readings, which has raised expectations of an upcoming interest rate cut cycle. Inflation in Brazil currently stands at 3.16%, a significant retreat from its peak of 12% in May 2022, while the interest rate has remained at 13.75% since September of the previous year.

With domestic pressure finally showing signs of easing, Brazil had a strong performance in Q2 2023. The iShares MSCI Brazil ETF ( EWZ ) is up 31.7% in tandem with the deceleration of the U.S. Dollar against the Brazilian Real and is well above the S&P 500, which is up just under 20% over the same period.

There are still significant uncertainties regarding the pace at which the Brazilian Central Bank will implement a more dovish stance. At the last meeting, the Central Bank lowered expectations of a cut soon, reinforcing that it will persevere until it consolidates not only the disinflation process but also the anchoring of expectations around its targets.

The impact is that there is little chance that Brazilian equities, like WEG, will rise without a lower interest rate. But still, the projection is that the basic interest rate (Selic) will end the year at 12.25%.

Valuation lies at the main risk

As WEG has demonstrated robust fundamentals, its valuation appears stretched, reflecting the market's recognition of its strong performance. However, it is essential to consider the risks associated with Brazil, including political and fiscal uncertainties, which can influence stocks with higher multiples.

Following the rally and the release of Q2 results, WEG's forward P/E ratio stands at 33x, and Seeking Alpha Quant ratings give it a discouraged "D-" valuation grade.

While WEG's valuation has eased slightly since my last analysis, with the company's share price declining approximately 10% ahead of Q2 earnings, I want to emphasize that valuations have significantly de-risked over the past two years. This could present a compelling opportunity, especially considering the company's robust fundamentals during this period, as evidenced by the positive Q2 results.

In conclusion, buy more WEG

My bullish thesis on WEG has become even more optimistic following the release of the robust second-quarter results posted by the company. One of the key factors contributing to this positivity is WEG's efficiency optimization, as evidenced by its improved Return on Invested Capital, despite a slowdown in forex compared to the previous quarter.

Furthermore, the overall improvement in the Brazilian macroeconomic scenario, with controlled inflation, suggests a potential for lower interest rates to unfold next year. Considering that WEG's valuation is still well below the levels reached two years ago, I view it as an attractive investment opportunity, especially in the context of an anticipated lower-interest-rate cycle.

As a result, I am upgrading my bullish thesis on WEG from "buy" to "strong buy" as the company's fundamentals continue to improve, and its current forward valuation multiple remains lower than in my previous analysis.

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