COPEL: Value Thesis Taken Shape, Best Yet To Come (NYSE:ELP)

In this quarterly update on Companhia Paranaense de Energia – COPEL (NYSE:ELP), I’m upgrading the company’s shares from a neutral position to a buy.”

As highlighted in my previous article, my initial investment thesis centered on COPEL’s privatization, which transitioned from a state-controlled entity in Paraná, Brazil, to a private company.

Although uncertainties surrounded this process, including a follow-on offering to dilute state ownership, COPEL allocated a significant portion of the raised funds to secure generation concessions for the next thirty years, ensuring stability for the company’s future.

Following this development, COPEL’s shares have experienced substantial growth, with the company’s value increasing by more than 50% over the last twelve months.

In the fourth quarter of 2023, COPEL reported results as a private entity for the first time, demonstrating improved operational efficiency, increased profitability, and a positive cash flow, indicating potential for future profit distributions.

While I initially had reservations about COPEL’s transition to private ownership and its impact on the income stock thesis, especially in the short to medium term, I am now changing my recommendation from neutral to buy. This shift is based on a value thesis for COPEL, which trades at an IRR of 11%, a desirable rate. This positions the company well to capitalize on its ongoing internal improvements and efficiency, potentially making it a strong dividend payer in the long term.

COPEL‘s Q4 and 2023 Full-Year Results

The fourth quarter of 2023 marked COPEL’s first reported results after a full quarter as a privatized company. The company exceeded market expectations, reporting an EPS of $0.26, surpassing the anticipated 0.13 cents. Additionally, revenues reached $1.12 billion, exceeding analysts’ projections by $102.6 million.

Net income for the quarter stood at R$942.8 million, representing a significant 51.2% increase compared to the same period last year. Notably, this result surpassed the market’s initial expectations by a wide margin.

However, it’s important to note that COPEL’s strong performance was partly attributed to non-recurring items, such as the reversal of impairment at the Araucária Gas Power Plant (UEGA) totaling R$258.6 million. This move also solidified COPEL’s position with a nearly 100% renewable generation matrix.

A key highlight was COPEL’s adjusted EBITDA growth, which increased by 10.1% year-on-year to R$1.48 billion, excluding non-recurring items. Over the last twelve months, COPEL’s Distribuição’s adjusted EBITDA reached R$2.11 billion, indicating an efficiency of R$461.5 million, surpassing regulatory EBITDA by 28%.

The improvement in EBITDA reflects COPEL’s progress in streamlining operations post-privatization, bolstering its long-term prospects. Despite a 20% increase in total consolidated debt to R$14.96 billion, the company’s debt metrics exhibited resilience, with a net debt/EBITDA ratio of 1.9 in 2023, down by one percentage point compared to 2022.

Regarding costs, manageable expenses saw a 1.1% increase in personnel and management in Q4 2023 compared to Q4 2022 and a 0.9% increase in 2023 versus 2022. However, COPEL’s cost reduction initiatives had a limited impact on the 4Q23 results. While the company reduced headcount by only 70 employees in 2023, an additional 1,400 employees (25% of the workforce) are expected to leave by August 2024 through a voluntary redundancy program, with the cost of layoffs provisioned for in 3Q23. With their departure, a gradual improvement in the company’s operating expenses is anticipated.

In Q4 2023, manageable costs increased by 16% compared to Q4 2022, and 2023 witnessed a 42.6% increase compared to 2022. However, it’s important to note that these figures include non-recurring items, reflecting the company’s evolving efficiency and headcount reduction initiatives.

During the fourth quarter earnings call, COPEL indicated its intention to sell its 51% stake in Compagas, its subsidiary, potentially worth R$800 million according to Bradesco BBI. CEO Daniel Slaviero emphasized that the company will not divest at any price, considering Compagas a “super-premium” asset. Slaviero stated that COPEL is awaiting more binding proposals from the market and will decide on the sale by the end of June.

Regarding acquisitions, COPEL is currently focused on other priorities post-privatization and plans to evaluate acquisition opportunities closely starting in 2025, particularly in renewable assets, including hydroelectric plants.

The Generation Concessions Provide A Sense Of Tranquility For The Next 30 Years

COPEL has allocated R$2.2 billion in investment and plans to invest an additional R$2.4 billion by 2024, primarily in energy distribution. The company’s distribution lines are secured by long concessions, providing stability.

Moving on to generation, COPEL has also secured lengthy concessions since privatization. Last year, the company conducted a follow-on offering involving the sale of the controlling shareholder (in this case, the government of Paraná), resulting in a significant capital infusion of R$5.2 billion. This included the sale of additional shares, leading to a dilution of approximately 56.3%.

However, the follow-on offering wasn’t solely for selling existing shares. COPEL also issued more shares to raise funds for renewing generation concessions. Of the R$5.2 billion raised, R$3.2 billion came from the secondary offer by the State of Paraná, while R$2.0 billion constituted the primary offer. This latter amount will be utilized to pay the grant bonus for the complete renewal of concessions for COPEL’s three largest hydroelectric plants: Foz do Areia, Salto Segredo, and Salto Caxias. These plants contribute approximately 4.2 GW of installed capacity, representing roughly 60% of the company’s total capacity.

This substantial capital infusion gives COPEL a secure outlook for its generation concessions over the next 30 years. Notably, this capital wasn’t wasted, and the dilution resulting from the share issuance wasn’t necessarily negative. Instead, the increased number of shares facilitated the financing of concession renewals, alleviating future concerns for the company.

Typically, share dilution might have a bearish impact in the short term. However, due to the sensitive nature of concession renewals in the electricity sector, the effect was somewhat softened for COPEL, mainly because of its privatization.

Over the past twelve months, COPEL’s share price has appreciated by approximately 55%. This reflects market confidence in the privatization process, COPEL’s follow-on offering, and its strategic capital allocation to enhance efficiency.

Robust Dividends Still Remain Distant

Now that COPEL has transitioned into a corporation, meaning it no longer operates under state control, there is a strong likelihood that the company will maintain its track record of performance and steadily improve efficiency. This improvement should lead to increased profits and, consequently, the potential for higher dividend payouts. However, patience is vital, given that the company is still transitional. It’s important to remember that COPEL now holds long concessions for the future.

According to the company’s bylaws, COPEL’s dividend policy is currently tied to its level of indebtedness. If the debt-to-EBITDA ratio is less than 1.5, the dividend payout is 65%, limited by available cash flow considering investments. If the leverage falls between 1.5 and 2.7 times EBITDA, the payout decreases to 50%. Beyond 2.7 times, the company only distributes 25% of net profit. In periods of no profitability, dividends are not paid out. As of the first quarter of this year, COPEL’s financial leverage stood at 1.9 times, resulting in a payout of 50%.

The high yields reported by COPEL in 2021 and 2022, which exceeded double digits, were not replicated in 2023 due to the company’s transitional phase. Recent yields have been around 3.02%. The consensus estimate by S&P Global Intelligence via the Koyfin platform suggests an expected net profit of $491 million for COPEL in 2024. A payout ratio of 50% would result in a dividend yield below 1%.

Even with ongoing efficiency improvements, I don’t foresee a significant profit increase or a substantial reduction in leverage shortly. Even if the company achieved a 22% profit growth by 2026 and distributed a 100% payout, the dividend yield would remain below 3%.

Valuations

As COPEL undergoes this transition from public to private ownership, there has been a natural fluctuation in its recent earnings results, primarily due to non-recurring effects that have distorted the price-to-earnings valuation multiples. This has caused the company to trade well above the industry average, currently at around 56 times earnings.

However, when considering its forward multiple, even though COPEL is trading at a P/E ratio of 16.3 times, this is still not very attractive compared to its historical average over the last five years, which was 7.2 times.

Looking at its PEG ratio, COPEL trades at 3.5 times, almost 40% above the industry average, which does not signal attractiveness at this level.

However, when examining cash flows, S&P Global Intelligence, which utilizes the Koyfin platform, estimates that COPEL will report negative free cash flows in 2024 of R$325 million and subsequently in 2025 and 2026 of R$483 million and R$659 million, respectively, as the company continues to enhance its efficiency post-privatization.

Based on this data and using a discount rate of 11%, which I consider fair for Brazilian equities given the long-term interest rate in Brazil and the country’s risk profile, the approximate present value of the cash flows with a discount rate of 11% is approximately R$644.25 million.

Since the present value is positive, it suggests that the discount rate of 11% results in a positive net return on the initial investment of R$325 million. This indicates that the internal rate of return (“IRR”) is likely close to 11%, which is quite acceptable given the softer macroeconomic scenario in Brazil, with prospects of a potential drop in interest rates from double digits to single digits by the end of the year.

The Bottom Line

COPEL reported consistent results in its first quarter after privatization, with EBITDA growing by 10% year-over-year, reflecting more significant efficiency. Additionally, the company doubled its annual profit, even after considering non-recurring events. It also generated free cash flow with a healthy margin for future dividend payments. Furthermore, COPEL Distribuição showed efficient operating results, with EBITDA coming 28% above regulatory expectations.

Despite the company’s share price rising by 56% over the last twelve months, COPEL maintains a real Internal Rate of Return (“IRR”) of over 10%. This suggests the potential for the company to resume dividend payments shortly, especially after securing another 30 years of concessions following the follow-on offering that reduced state control of the company.

Therefore, believing in a value thesis for COPEL, rather than dividends alone, I am cautiously inclined to take a more optimistic stance on the company by upgrading my neutral position to bullish.