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Summary Political and economic uncertainties do not aid CIG’s position and potential. The three hydro plant concessions are definitely lost and new terms could be agreed, but the cost of this is uncertain. Brazil is the world’s 8th largest economy by GDP and thus there should be a turnaround, and CIG is a great play to grasp that turnaround. The long term potential downside is getting smaller (25%) and the potential upside is getting bigger (600%). Introduction About two months ago I wrote an article about Companhia Energética de Minas Gerais (NYSE: CIG ). The stock price at the moment of writing that article was US$3.3. I assumed that the downside risk was down to US$2.24 and deferred buying in order to wait for better opportunities. At the moment the price is US$1.93 with the low of the year at US$1.81. It was a good call not to buy two months ago. In this article I want to discuss the possible effects of the new developments that happened in the last two months and see if the falling knife can fall lower or it is time to start buying in. Latest news and developments In August CIG reported Q2 results. Figure 1 shows that the net revenue increased but EBITDA and net income were down. Figure 1 CIG’s Q2 results (click to enlarge) Source: CIG’s investor relations The main issue for the decline in net income was a lower spot price and a big increase in financing costs. In figure 2 we can see the development of the interest rate set by The Central Bank of Brazil Monetary Policy Committee (COPOM). Figure 2 Interest rate – Brazil from 2005 to 2015 (click to enlarge) Source: Tradingeconomics The current set interest rate is very high with a goal of curbing the high inflation in Brazil. The high interest rate affects CIG by lowering its cash flow and net income. Figure 3 shows that the cost of debt is going up but the debt to equity ratio is stable. Figure 3 CIG’s cost of debt and leverage ratio (click to enlarge) Source. CIG’s investor relations. The increase in the cost of debt resulted in a 60% increase in interest expenses in relation to the previous 1H , from R$654 million to R$1,067 million. All these negative effects did lower the net income in Q2 but the total net income in 1H 2015 is 1.5% higher than in 1H 2014, from R$1,990 million to R$2,018 million. Unfortunately this is not of the greatest importance to international investors because if we translate the results into US currency the net result is lower by 39% in comparison to last year, from US$850 million to US$525 million. In figure 4 you can see the depreciation of the Real in relation to the US dollar. Figure 4 Brazilian Real per 1 USD (click to enlarge) Source: xe.com I believe such a chart is the nemesis for every investor because of the uncertainties that it brings with. Nobody can know how low can the Brazilian Real go in relation to the US dollar and when will it hit bottom. As a normal consequence of the falling currency and high inflation the downgrade Brazil got from Standard & Poor’s should not be a surprise to anybody. The fear and uncertainty concerning Brazil plus the junk rating the country got make it difficult for investors to assess the risks and estimate future scenarios. Apart from political and economic issues, we must not forget the legal issues related to CIG. Legal issues and news in Q3 In July Fitch downgraded CEMIG to AA- with a negative outlook and CIG definitely lost the concessions of the three hydro plants that were under dispute with the government. CIG will appeal but let us not rely on that. If the government provides CIG favorable new conditions, they will continue operating the plants but that is something we will know more about in the near future. In any case CIG will have to find ways to cover the 35% to 45% of revenues that were coming from the three hydro plants. CIG’s management is already looking for ways to grow in the future despite the loss of the concessions and one example of that is the cooperation with SunEdison (NYSE: SUNE ) and the possibility to develop solar power plants in the future. One of them is the R$ 4 billion solar plant in the state of Minas Gerais with one of the best solar radiation factors in the world. This is also an opportunity to lower the hydrological risks attached to the weather and rainfall. CIG has also shown interest in the new transmission lines that will go through the state of Minas Gerais. The company added 120,000 new customers in the first half of the year and it won a dispute with the government to prevent the adjustment of the Energy Reallocation Mechanism about the sharing of hydrological risks of hydroelectric plants. Good news is that recently the Federal Audit Court authorized the government to renew for 30 years the concessions of electricity distributors whose contracts expire between 2015 and 2017. Fundamental perspective The current book value is R$11.19 per share translates to US$2.84. With the current inflation being 11% in Brazil and the rapid depreciation of the currency, this number cannot be of any guarantee to us. A deeper look at the balance sheet shows that long term assets are R$23 billion, short term assets R$13.5 billion, while long term liabilities are R$13.5 billion and short term R$ 9.4 billion giving a good debt to assets ratio of 0.61. As a business like CIG is capital intensive and difficult to replace; thus we can assume that there is real value behind CIG’s books. As a very conservative estimation we will take 50% of the current book value to be the value under which CIG should not go, thus $1.4. Earnings for the last four quarters are at R$3,146 million, which translate to US$800 million or US$0.64 per share. If the management keeps the dividend payout policy of 25%, then it should result in a US$0.16 dividend per share. But I would not bet on that because of the deteriorating financing circumstances in the Brazilian financial markets. Two scenarios for CIG’s stock I will start with the negative scenario. The current earnings are US$0.64 where we have to deduct the effect of the loss of the three concessions that should cut about 50% of that. Higher financing costs are also an issue because the current financing costs are 50% of net income thus if they continue to increase as they increased in the last quarter, they could quickly take another 50% of earnings. In a worst-case scenario earnings could go down to US$0.16 or even go to zero for a period. The risk of lower earnings with a risky political and economic situation could bring the value of the stock even lower than the levels it is now. We cannot know how low will the market go or where will the Real stop its decline in relation to the US dollar, and the negative ratings for both Brazil and CIG are a tough storm to withstand for every investor as there might be more institutional selling along the way. Further economic pressure and depreciation could lower the price of the stock, but I do not believe it to be much because CIG is a very important business in Brazil. I will put my long-term downside risk to the conservative book value of $1.44. This makes the potential downside 25%. In the short term it could go anywhere due to panic in the emerging markets. The second scenario is a brighter one and more long term orientated. Brazil and CIG are getting cheaper and cheaper and we are talking here about the world’s 8th largest economy. The fact that it is so cheap at the moment will certainly increase foreign investments and increase exports as soon as the political situation stabilizes. Also if we look at CIG from a pure business perspective, the increase in the number of customers plus the plans for future growth through more distribution and solar shows that CIG is a good company. The future plans and possible long term turnaround in Brazil make CIG a good long term opportunity, but the investor must be willing to take 25% or more downside risk due to the deteriorating political and economic situation in Brazil. From just attaching the trailing earnings to a PE ratio of 10 we get a price of US$6.4 that gives us a 330% upside. CIG’s stable economy dividend policy is to payout 50% of earnings that would currently be US$0.34 giving a 17.5% dividend yield at current prices and 5.3% at US$6.4. If the situation in Brazil changes or stabilizes, the currency strengthens, interest rates fall and CIG shows a bit of earnings growth, we could see earnings at US$1.28 – that attached to a PE of 10 gives us a price of US$12.8. That is a potential long-term positive return of 663%. Conclusion I reiterate my standing that investing in CIG is a pure bet on Brazil and its currency. Every investor should estimate what is his best strategy in such cases. The easiest thing to say is not to catch falling knives but if you do not try the potential upside is lost. Remember to be greedy when others are fearful and be fearful when others are greedy. I will compare CIG to other opportunities and then make a decision about investing. Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in CIG over the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. Additional disclosure: This article was provided for informational purposes only. Nothing contained herein should be construed as an offer, solicitation, or recommendation to buy or sell any investment or security, or to provide you with an investment strategy, mentioned herein. Nor is this intended to be relied upon as the basis for making any purchase, sale or investment decision regarding any security. Rather, this merely expresses my opinion, which is based on information obtained from sources believed to be accurate and reliable and has included references where practical and available. However, such information is presented “as is,” without warranty of any kind, whether express or implied. The author makes no representation as to the accuracy, timeliness, or completeness of any such information or with regard to the results to be obtained from its use should anything be taken as a recommendation for any security, portfolio of securities, or an investment strategy that may be suitable for you. Scalper1 News
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