2023-10-09 22:48:06 ET
Summary
- Cemig's valuation appears undervalued compared to state-owned and private peers, driven by strong financial performance and dividend history.
- The core thesis for Cemig revolves around potential privatization, which could lead to increased operational efficiency and value appreciation.
- However, a Discounted Cash Flow (DCF) model suggests potential overvaluation, with a 13.2% downside from the current share price if current performance and increased CapEx continue.
In my most recent article about Cemig (Companhia Energética de Minas Gerais) ( CIG ) ( CIG.C ), I maintained a neutral position towards the company despite recognizing its discounted valuation compared to its peers.
At the time, I also had concerns about potential negative impacts on installed generation capacity as the relevant concession contracts approached their expiration dates. This raised uncertainty regarding the execution of the long-term energy pipeline, especially given the current lower energy prices.
Since then, the company's shares have depreciated by approximately 10%. This decline occurred in the context of a broader downturn in the Brazilian stock market (Ibovespa), which has been downward since late July.
The thesis surrounding Cemig, however, remains the same, centered around the potential positive impact of the privatization of the company owned by the Brazilian state of Minas Gerais. If privatization occurs, Cemig will likely undergo a significant operational efficiency turnaround.
Over the past few months, other state-owned utility counterparts such as Sabesp (Companhia de Saneamento Básico do Estado de São Paulo) ( SBS ) and Copel (Companhia Paranaense de Energia) ( ELP ) have made substantial progress towards privatization, with expected completion by next year. While the privatization of Cemig is slightly behind its peers due to greater legislative complexity in the state of Minas Gerais, it continues to be a central focus of the current government, reinforcing shareholders' hopes.
Taking into account Cemig's consistent track record of strong financial results in recent quarters and its positive outlook for Q3, I currently find that the company's current valuation presents a relatively low level of risk in terms of its potential long-term return compared to its key domestic peers. However, based on my analysis using the Discounted Cash Flow ((DCF)) model, which considers the expected investments Cemig should undertake in the future, the company might be overvalued while awaiting privatization. As a result, I am inclined to maintain a neutral stance on Cemig.
Breakdown of Recent Results
In its most recently reported quarter, 2Q23, Cemig exhibited progress in net revenue, totaling R$8.8 billion. This marked a 7.4% increase compared to 2Q22, primarily driven by rising revenue from TUSD (Charges for Use of the Network), heightened gas supply, and increased energy sales volume.
Consolidated EBITDA reached R$1.8 billion, reflecting a year-over-year increase of 430%. The financial result amounted to R$39 million, reversing a loss of R$870 million in 2Q22. This variance can be attributed to the tax refund executed last year. Ultimately, the company reported a net profit of R$1.25 billion, representing an 11% decline from 1Q23.
Operating costs and expenses decreased by 13.5% compared to 2Q22, totaling R$7.3 billion. This cost reduction can be primarily attributed to the inflationary impact in 2Q22 when ICMS (a type of value-added tax) was temporarily excluded from energy tariffs, a situation that has since been rectified. Additionally, there was a decrease in the "personnel" expense category due to the company's cost-saving measures implemented during the quarter.
Cemig's IR
For Q3, the Brazilian market has been anticipating an increase in energy consumption, which tends to benefit distributors like Cemig. Consequently, this scenario is expected to yield robust volume data in Cemig's third-quarter results, reflecting the impact of the seasonally driven heatwave.
Cemig continues to maintain consistent cash generation, contributing to the execution of its investment program, which includes an expected CapEx of R$780 million for this year with Gasmig, its natural gas subsidiary. This, in turn, enhances the company's liquidity.
The company also maintains a healthy leverage ratio, concluding the first half of 2023 with a net debt/EBITDA ratio of 1.1x.
Privatization Continues to Be the Key Driver of the Thesis
The state governments of São Paulo, Paraná, and Minas Gerais have reintroduced privatization discussions to the financial market's agenda. They have plans to transfer control of state-owned Brazilian utilities such as Sabesp, Copasa, Copel, and Cemig. This shift is primarily driven by state governors adopting less statist policies.
The stock market has already demonstrated investor approval of these initiatives: shares in the concerned companies are expected to increase by at least 10% by 2023.
Copel is the furthest along in the privatization process in the current landscape. Shareholders have already approved modifying the company's bylaws to convert it into a corporation without a controlling shareholder.
In the Southeastern states, the processes are expected to take longer. In São Paulo, Sabesp is anticipated to advance its privatization by March of the following year. However, Copasa (sanitation) and Cemig (energy) depend on an amendment to the Minas Gerais state constitution, recently proposed by the administration of Romeu Zema, the current Governor of the State of Minas Gerais.
One factor that instills optimism in the private credit market is the potential for increased investment. Operating outside of state management provides companies with greater flexibility, allowing them to issue shares and debentures to raise funds for investment.
There is a significant need for investment, but there are limits to the indebtedness of Cemig and its state-owned counterparts. With the government relinquishing control, these companies can raise substantial funds through share issuance or debt.
However, optimism is tempered because these companies may remain under state governments' ownership, which, according to experts, could impose restrictions on their debt. The increase in private sector participation helps alleviate some constraints on public companies, but with mixed ownership, they will still be subject to government regulatory oversight.
With more prominent companies issuing debt, the market for tax-exempt debentures is expected to expand, potentially increasing liquidity for these securities, which is currently limited in the secondary market. Privatizations would be another positive factor for the capital market, in addition to the sanitation framework and the New PAC , the federal government's infrastructure investment program.
According to the Governor of the State of Minas Gerais, Romeu Zema, who is a liberal, privatization is only a matter of time as the outlook remains optimistic with the approval of the bill, which has been sent to the State Legislative Assembly of Minas Gerais (ALMG). This amendment aims to facilitate the privatization of Cemig and Copasa.
The bill is currently under review by the Legislative Branch and aims to simplify the process of selling state-owned companies. It also revises the requirement for a simple quorum to approve a law authorizing changes in the corporate structure or spin-off of a mixed-capital or public company.
Presently, three-fifths of deputies must vote in favor of such changes. Additionally, the bill exempts the state from holding a referendum on privatization.
Dividends
Historically, Cemig is a company that has consistently provided attractive dividends. It has maintained a historical yield of 10.7% over the past decade. This achievement can be attributed to Cemig's average payout ratio of 47.5% during the same period, which closely aligns with its primary industry peers.
However, with the outlook pointing to lower profits due to a higher CapEx in 2023 and more modest growth in 2024, the projection is that Cemig may experience an impacted yield over the next two years. It is worth noting that if privatization occurs, improved operational efficiency is likely to lead to higher profitability in the long term, potentially resulting in increased dividends for its shareholders.
Nevertheless, Cemig surpasses its domestic peers, both private and state-owned, currently boasting the highest yield at 9.6%. This is particularly attractive considering the backdrop of lower interest rates in Brazil, significantly affecting the Brazilian fixed-income market.
Valuation
Cemig, a state-owned utilities company controlled by Minas Gerais, could currently be undervalued by the market. Despite experiencing growth in CapEx, Cemig has been consistently delivering solid results.
While there are still uncertainties surrounding the privatization of Cemig, contingent on political factors, the company has been projecting robust profit growth. It anticipates an EPS increase of 24% for 2023, primarily driven by the conclusion of the tariff review in May, expected gains in the generation and transmission business, positive performance from Gasmig, the continuation of an efficiency program, asset disposals, and improved capital allocation as catalysts.
One potential disadvantage Cemig holds over its industry peers is that its distribution segment is exposed to the risk of concession renewal, unlike other integrated companies in the sector.
Cemig is trading at an implied Internal Rate of Return ((IRR)) of 12.2%, surpassing the segment average of 11.6%, and trading at 5.1x EV/EBITDA in 2024-2025. The company trades at a discount when comparing Cemig's valuation multiples, particularly to other Brazilian electricity companies, such as its state-owned peer Copel. Copel has forward EV/EBITDA multiples of 6.98 times. However, when comparing Cemig to its private domestic peers, the company also trades at a discount relative to Eletrobras, which has a forward EV/EBITDA of 5.9x, Engie Brasil ( EGIEY ) with a forward EV/EBITDA of 6.73x, and Equatorial ( EQUEY ), which has a forward EV/EBITDA of 7.7x.
Given that this is a state-controlled company, a notable political risk exists associated with valuing Cemig. This risk is complex to quantify and may help justify the substantial discount the company is currently trading, as indicated by my DCF analysis.
When constructing my model, I relied on revenue growth estimates provided by Seeking Alpha for Cemig, which project a growth rate of 4.2% in 2023E, 2.9% in 2024E, and 8.6% in 2025E. Additionally, I established a stable gross margin of 14.5%, based on the company's five-year historical average, and an effective tax rate of 23%, also considering the company's five-year historical average.
In my model, I incorporated a cost of equity of 11%, derived from Brazil's long-term interest rate curve (TJLP), currently at 6.55% per year. Additionally, I included a cost of debt of 10%, as provided by the company's data. I utilized a leveraged beta of 0.65 for the utilities sector and considered Brazil's equity risk premium of 9.6%. As a result, this calculation led me to a WACC of 11.8%.
Company's data, chart compiled by the author
Over the next three years, considering that the company is expected to report a CapEx of approximately $156 million in 2023, in line with the company's guidance , and assuming more conservative investments for 2024 and 2025 by maintaining the exact figures as 2023, along with changes in working capital corresponding to the five-year historical average, I have calculated an unleveraged free cash flow growth rate as follows: (6.1)% in 2023E, (15.1)% in 2024E, 5.2% in 2025E, and 2% in perpetuity.
As a result, considering a terminal value of $3.586,3 billion and discounting it to present value using the WACC of 11.8%, we arrive at a present value of the terminal value of $2.359 billion and a Total Equity Value (TEV) of $4.413,2 billion. When divided by Cemig's 2.2 billion outstanding shares, this yields an implied value of $2.01 per share. This would mean a downside of 13.2% compared to the share price of $2.31 on October 6th.
Conclusion
While the primary thesis for Cemig revolves around a specific catalyst, namely the company's privatization, Cemig continues to show strong performance in its financial results and remains poised to deliver solid dividends. It's worth noting that regarding the privatization process, Cemig lags behind some of its domestic peers in the utilities sector, such as Sabesp and Copel.
When assessing the valuation of Cemig, the company is undervalued compared to other state-owned peers and even more so when compared to its private peers. However, in my Discounted Cash Flow ((DCF)) model, assuming the company maintains its recent five-year performance and allocates more capital towards CapEx spending in the coming years, the estimated intrinsic value is approximately $2.01 per share, indicating potential overvaluation. This suggests a downside of 13.2% from the current share price.
If privatization proceeds over the next two years, it will likely increase operational efficiency, cost reductions, and potentially even more significant value appreciation. Additionally, the dividend yield could experience growth projections shortly.
Considering these factors, I will maintain my neutral recommendation for Cemig's shares.
For further details see:
Cemig: A DCF Evaluation With Limited Upside Pre-Privatization