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Company Overview
Eletrobras (NYSE:EBR) is the main player in Brazil’s energy market, responsible for almost 25% of all energy production and 40% of all transmission lines when considering SPEs that do not consolidate in its financials. Considering only fully owned or consolidated entities, Eletrobras owns 75 energy plants for a total of 30,627 MW installed and a focus on hydroelectric power stations (UHEs) that comprise more than 90% of the energy produced. It’s important to note the difference in terms of Price Regime, where more than 50% of its MW installed base is currently being sold at cost and are the great focus of transformation after the capitalization process. The average price of MWh in 2022 for the quota regime was BRL 71, whereas the market prices was BRL 250 – more than 3x. As of today, Eletrobras also fully owns 67000 km of transmission lines and 7000 km through SPEs. Basically, all of the company’s contracts for UHEs and transmission lines are for 20 to 30 years and are annually adjusted by IPCA (Brazil’s CPI Index).
Number, MW Installed and Price Regime of Fully Owned Energy Plants (Eletrobras IR)
Eletrobras completed in June 2022 its process of capitalization by issuing the equivalent of BRL 34 billion in stock without any purchase by the government. This had the effect of diluting the government share from +50% to less than 33% with a maximum voting power of 10% – meaning that Eletrobras is now a privatized and fully independent company. Those BRL 34 billion will be used to renew the rights of exploring 22 UHEs, but with the advantage of selling the energy at free market prices rather than state-controlled prices. This change, plus the cost-cutting initiatives and the shedding of troubled assets should generate BRL 100 billion in FCF in the next 10 years. Given that the current market cap is BRL 93.5 billion and the company has more assets than these 22 UHEs, I believe the market is either not fully appreciating the potential of BRL 100 billion FCF generation or assuming the remaining of the company is worth zero. In my view, these results will start to appear during 2023 and should prop the stock higher.
What’s Changed?
Political risk has significantly decreased
It’s important to highlight the difference in the process that Eletrobras has been through for its privatization. What usually happens when a company is privatized is that it’s sold to a private company or a group of shareholders that then take control of the company as it is and pay the government an specified amount. In this case, Eletrobras simply sold more shares in the open market for the tune of BRL 34 billion and without any possibility of the government buying new shares during the process. The result is BRL 34 billion more in cash and a dilution of the government ownership from +50% to 33%.
To protect even more the new shareholders, the government set a few rules in the statute of the company:
Even with a 33% stake of the company, the government has only 10% of voting power. The provision limits any single shareholder to a maximum of 10% voting representation, regardless of the ownership share.
If any shareholder achieves 30% of ownership (excluding the Brazilian government), that shareholder is required to make an offer for the remaining 70% at double of the highest stock price from the previous two years.
If the government achieves 50% of ownership, it is required to make an offer for the remaining 50% at triple of the highest stock price from the previous two years.
Eletrobras Common Shares Ownership (Eletrobras IR)
Shedding troubled assets
Two assets generated a bit of turbulence during the process: Itaipu and Eletronuclear.
- Itaipu is the second largest hydroelectric power station in the world and sits right at the border between Brazil and Paraguay. It was built during the 70s and it’s jointly owned by the countries. Given its international status, the ownership must stay with the government, so the sale had to be arranged. Regardless of its size, Itaipu was designed to only charge each country enough to pay its financing costs and keep the plant running. There were no huge profits being made in Itaipu, only small fees related to selling the energy to the Brazilian grid.
- Eletronuclear is the owner and operator of the only nuclear power plant in Brazil. It represents only 3% of the total energy generated in Brazil and its third reactor has been in construction since the 80s, plagued by delays, corruption and cost overruns. It was fully owned but contributed to a mere BRL 0.1 billion in net income for FY’20 and a loss of BRL (0.5) billion in FY’21. Not the best use of capital and won’t be missed.
Cleaning up the place
Government-owned companies are known for being inefficient. Not just in terms of what they produce, but also in how many employees they have and how much they pay for them. Eletrobras is certainly no different. When comparing the company with its peer in terms of Headcount per MWh, Eletrobras has two to three times more employees. This is already being addressed: the company launched a voluntary resignation program, where it is expected to pay BRL 1 billion to around two thousand employees (20% of the workforce) for them to retire early. Payout is less than one year, so it is fair to estimate that this could help the company generate an extra BRL 1 billion per year.
Also as part of the process, Eletrobras incorporated UHE Santo Antônio, a hydroelectric power station in the north of Brazil that was already 40% owned by it. The issue here is that the company was on its own despite partially owned by Eletrobras and due to significant delays during construction, the debt ballooned to almost BRL 20 billion. Interest expense was BRL 2.1 billion in FY’20 and BRL 3.5 billion in FY’21 on Revenue of 3.8 billion. Now Eletrobras owns more than 70% of this plant and the debt has been consolidated in its Balance Sheet. I’m sure plans are already in place to pay down or renegotiate the debt (a recent uptick from Fitch Ratings is a good sign) and start making this plant a cash generator for the company.²
Below I’ve tried to project what the financial statements for FY’21 could have been if 80% of debt is paid down or refinanced. As you can see, we could be looking at a plant that will contribute to BRL 1.5 billion to BRL 2.0 billion. Of course, 80% reduction means paying down debt equal to BRL 14 billion, so management needs to review and understand if that’s the best use of capital now.
Actual and Adjusted P&L and FCF FY’21 (in BRL billions) (Santo Antônio Energia IR and Author)
The Crown Jewel: Migrating from the Quota Regime to the Free Market
This is where the BRL 34 billion that the company received makes the difference. The cash will be used to pay the Brazilian government for the renewal rights of the 22 hydroelectric power station currently under quota regime for the next 30 years, plus five new ones. These 22 plants currently sell their energy at BRL 71 per MWh and will migrate towards the BRL 250 market price gradually until 2027. Starting in 2023, 20% of those plants, per year, will shift from the quota regime to the free market and will thus sell its energy to the market at much higher prices. The other 5 will be part of the free market from the start.
Based on the initial prospect, this change is expected to generate BRL 100 billion more in revenue between 2023 and 2031. But given that this is purely a price increase for the energy that is already being generated, it could be expected that more than 90% should flow to Net Income. At the current market cap of BRL 93.5 billion, it means that the market is currently valuing the company at less than the cash generated by this change for the next 10 years, without even considering the rest of the operations.
Forecasting earnings and FCF potential
Let’s play a little bit with the numbers and think of how that company could look like in FY’27 when all the UHEs will be on the free market. I’ll assume that the remaining operations will essentially be kept without much improvement and I’ll not venture into M&A, although both could be positive catalysts for the company.
By adjusting the main accounts with what we discussed, it could be expected that Eletrobras will generate BRL 62.3 billion in revenue by FY’27, BRL 25.2 billion in net income and BRL 27.7 billion in FCF. This for a current market capitalization of BRL 93.5 billion means a 3.7 forward P/E and 29.6% FCF yield. Since by law companies in Brazil are required to distribute at least 25% of Net income in dividends, this also means an expected 6.7% forward dividend yield. However, it’s not uncommon to see utilities companies with payout higher than 50%, which would then translate to a 13.4% forward dividend yield.
P&L Walk from FY’21 Actuals to FY’27 Forecast (in BRL billions) (Author)
Clarifying the adjustments:
Eletronuclear & Itaipu: Excludes the numbers for these two subsidiaries incorporated in Eletrobras balance sheet.
UHE Santo Antônio: Adds the numbers FY’21 Adj column where I forecasted Interest Income, Taxes, Net Income and FCF, while keeping Revenue, COGS and SG&A the same.
Concessions @ Free Market Prices: Increases revenue given the transition from quota regime to free market prices, but also increases taxes paid by 30% of the higher revenue. This revenue forecast comes from the initial prospect.
Voluntary Termination: Relates to the BRL 1.0 billion in expected savings from reduction employee headcount by 20%. Doesn’t consider future initiatives of cost cutting.
Non-Recurring Items: Eletrobras balance sheet is full of judicial claims and those are expected to be solved quicker now that it has been privatized. I’d expect that the majority of it would be settled by FY’27.
Inflation: It is customary for electrical bills in Brazil to be tied with inflation. I’ve considered an increase of 4% due to inflation for Revenue, COGS and SG&A with the respective increase in Taxes as well.
Given these forecasts, we can value Eletrobras by some metrics assuming that specific valuation is achieved by FY’27.
Price to Earnings Ratio
In the second column I’ve included the actual data, with PE of 16.4 for a net income of BRL 5.7 billion and market cap of BRL 93.5 billion. Since I estimated prior that net income could reach BRL 25.2 billion by FY’27, I’m calculating the market cap based on PEs of 10, 12 and 15 and the consequent upsides and CAGRs. As shown in the table, even a conservative PE of 10 can translate to an upside of 169%, or a 21.9% CAGR.
FY’27 PE Ratio Forecast (in BRL billions) (Author)
Dividend Discount Model
The Dividend Discount Model is a very conservative valuation method, but it still shows that almost half of the scenarios could generate 100% upside. I have modelled a divided yield starting in 3% in FY’23 and moving 1p.p. up until arriving at 6% in FY’26. The yield in the table below start in FY’27 and the percentage is based on the BRL 93.5 billion in market cap.
DDM Scenarios based on DY and Discount Rate (in BRL billions) (Author)
Discounted Cash Flow
By calculating the DCF of Eletrobras, I arrive at very positive scenarios even when considering a discount rate of 14%. I have used the CAGR between FY’21 FCF Actual and FY’27 FCF Forecast to assume the FCF of each of the years below. I also added different Present Values based on different discount rates. As shown by the table below, the worst case scenario is a CAGR of 17%, and the best case scenario a CAGR of 43%. Even the worst case scenario has some margin of safety for mistakes and could still deliver a meaningful CAGR – and this calculation is only for price appreciation, not considering dividends and possible share buybacks.
FCF Scenarios based on Discount Rates and g @ 4% (in BRL billions) (Author)
This means that, regardless of which method we use to estimate the intrinsic value of Eletrobras, there is a considerable margin of safety for this investment and therefore I regard EBR as a Strong Buy.
Risks
Investments in emerging markets don’t come without risks. There is always the possibility that the recently elected left-wing government decides to interfere in the economics of utilities company, although the roadblocks included during the privatization process are strong and should be able to hold even if they are challenged in court. The new government even stated that the cost of nationalizing Eletrobras was too high and they should focus in other problems (i.e., Petrobras). FX and Interest Rates should also be considered. Given the current strength of the US Dollar and the likely recession in developed markets, there is some room for the Brazilian Real to revalue – but only if the new government take actions to support Brazil’s economic recovery. Interest Rates also seemed to have peaked in Brazil and inflation has been in a downward trend for a several months now. However, Brazil has been a country of high interest rates historically, so a high discount rate is always appropriate.
Conclusion
Eletrobras has several streams of change that will materially impact revenue, net income and FCF for the following years. The main story is the change from quota regime to free market prices that will deliver strong growth for the company. Moreover, the cost-cutting initiatives, the shedding of troubled assets, and the incorporation of UHE Santo Antônio will also play an important role. These changes should only have 100% effect by FY’27, but they will start to appear in the FY’23 financials and I expect the market to start taking notice and increase its expectations accordingly. I deem Eletrobras a Strong Buy as its financials and operations should improve dramatically.