|Shares Out. (in M):||151||P/E||0||0|
|Market Cap (in $M):||1,470||P/FCF||0||0|
|Net Debt (in $M):||60||EBIT||0||0|
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Central Puerto (NYSE: CEPU)
Link to PDF: https://www.dropbox.com/work/CEPU%20VIC?preview=CEPU+VIC.pdf
1) New Energy assets have legally binding PPA’s (15-20 yr. length) and remuneration cannot be legally changed by the government.
2) Any changes impacting remuneration for power generation assets impacts the government’s ability to incentivize future generation capacity, which we believe carries strong political importance.
3) We can envision a scenario, perhaps over the next 5 years, in which the government changes Base Energy remuneration policy to remove inefficient assets from the system (i.e. those that use high cost fuel sources or inefficiently use low cost fuel sources). However, for that to happen the government will need to 1) auction off additional capacity at New Energy rates (CEPU should win its proportionate share additional capacity that carries a higher EBITDA/MW than inefficient capacity at Base Energy rates) and 2) improve Argentina’s natural gas shortage in the winter months, which causes efficient generation assets to switch to significantly higher cost fuel sources.
4) If the government allows a TERM market, in which private energy users can contract directly with generators, for thermal assets, like they do for renewable assets, we believe that CEPU could potentially realize pricing for its Base Energy assets closer that which is received for its New Energy assets.
5) CEPU expects to benefit from an additional operating margin if fuel purchasing responsibility is shifted back to generators, as opposed to the current regime in which CAMMESA, Argentina’s wholesale energy market administrator, is responsible
*Currency is in USD unless otherwise noted.
CEPU has a total installed power generation capacity of 3,663 MW (100% owned), representing 10% of the country’s capacity, which was 36.5 GW as of 2017. Measured another way, CEPU had a 19% market share among private sector power generators as measured by total power generated (Figure 1). CEPU owns a balanced portfolio of generation units, including thermal (2,223 MW) and hydro sources (1,440 MW), located close to high demand centers.
Figure 1: CEPU is the largest private energy generator in Argentina as measured by power generation in 2017
Figure 2: CEPU has a diverse installed base of power generating assets in high demand centers
Existing Thermal Assets
The company consistently prints high availability rates supported by a rigorous maintenance program. The average availability of CEPU’s thermal assets (91% in 2017), is 12% higher than market average (79% in 2017). CEPU’s units are favorably positioned along the system’s power dispatch curve and rarely turned down by the dispatch administrator. Importantly, 92% of thermal capacity is flexible (can run using natural gas or fuel oil/gas oil), insulating CEPU from natural gas shortages in winter months. CEPU’s efficiency levels compare favorably to those of its competitors due to efficient technologies (Figure 3). CEPU’s existing thermal assets are remunerated under the Base Energy regime (Capacity payment of US$ 7,000 per MW per month; and Energy payments US$ 7 per MWh for generation with natural gas and US$ 10 per MWh for generation with fuel oil/gas oil). The thermal plants operate under an indefinite concession and fuel is provided from CAMMESA. CEPU’s assets have a low level of maintenance capex, expected to run $7M/yr., because long-term maintenance contracts with turbine manufacturers flow through OPEX.
Figure 3: Efficiency level measured by heat rate, which is the amount of energy used by an electric power plant to generate one kWh of electric power, for the period between February 2018 and April 2018. CEPU’s efficiency levels measure favorably compared to its main competitors
Existing Hydro Asset
Thermal Assets Under Development
CEPU is currently constructing 423 MW of cogeneration thermal plants (100 % owned; 15-year PPA with CAMMESA). Importantly, the energy prices received are under the New Energy pricing regime, which is significantly higher than the Base Energy pricing. The thermal plants will be completely financed with internally generated cash flows/cash on hand.
Wind Assets Under Development
CEPU is currently constructing 371 MW of wind farms, 234MW of which through the RenovAR program (20-year PPA with CAMMESA) and 137 MW of which thought the MATER term market (likely 20 yr. PPA with large industrial users). The renewable projects are held within the entity CP Renovables, which is 70.19% owned by CEPU and 29.81% owned by Guillermo Pablo Reca, CEPU’s largest shareholder. The new wind plants will be 70% financed with non-recourse project debt and 30% financed with cash on hand. The Castellana and Arichas project debt was taken out with International Finance Corporation (“IFC”) and Inter-American Investment Corporation (“IIC”) (rate of Libor +5%; amortizable over 13 years).
Term Market (MATER
FONI Asset Ownership
CEPU holds equity stakes in three thermal generation plants (combined capacity 2,554 MW). CEPU participated in an arrangement known as the FONINVEMEM. These plants are owned by the FONI trust and operated by private generators. The prior Argentine government’s administration created the FONINVEMEM with the purpose of repaying power generation companies, like CEPU, the existing receivables for electric power sales between 2004 and 2011 and funding new power capacity. For the 1st 10 years after COD, these assets have a PPA with CAMMESA and equity holders collect a receivable stream equal to the principal plus interest for the initial receivables contributed. After 10 years, the remuneration rate will convert to the Base Energy rate and private shareholders will receive the asset’s property rights with the condition that the Argentine government be incorporated as a shareholder, effectively diluting private generators’ equity stakes. These FONI holdings do not have any debt on them and the government will be looking to sell its pro-rata equity interest in FONI holdings.
Figure 4: CEPU’s cash flow stream from FONI receivables.
We believe that CEPU, trading at $9.70/sh., remains significantly undervalued. CEPU has a predictable revenue stream denominated in USD. It’s cost structure OPEX (30% USD) and Capex (80-90% USD) benefits from the FX depreciation occurring in Argentina. We believe that CEPU’s existing assets (at the current Base Energy rate, which is higher than it was in 2017) generates $192M of Adj. EBITDA. This number is inclusive of $40M of corporate SG&A, which we expect to be flat going forward (minimal SG&A required for future projects will be largely offset by ARS depreciation). Given messiness of CEPU’s financials we define EBITDA as gross margin less SG&A plus D&A. The new projects CEPU has coming online between now and Q2 2020, should add $162M of incremental EBITDA. We believe that by H2 2020 CEPU should be generating $354 M run rate of EBITDA. We capitalize this EBITDA stream at 6x, in line with other LatAM GenCo’s, then make the following balance sheet adjustments to arrive at our equity value:
Figure 5: CEPU Valuation Overview
With exception of Brazilian GenCo’s, LatAm (Mexico, Colombia, Chile, Peru and Argentina) power prices are set in USD. We believe that a fair EV/EBITDA multiple for CEPU is at least 6x, in-line with other LatAm GenCo’s, which is below the 7-9x that US merchant generators trade, and significantly below the 10-12x that regulated utilities trade. We also note that that LatAm GenCo’s are trading at the bottom of the 6-8x range they have traded in over the past few years. By our calculations, CEPU trades at a material discount to other LatAm GenCo’s despite having USD denominated revenues and a better EBITDA growth profile. After making the appropriate balance sheet adjustments, CEPU trades at 2x our 2021 EBITDA vs. our target of 6x. Our target value of $19.14 implies a 12% levered FCF yield vs. 23% at the current price.
Figure 6: Comparable Multiples of LatAm GenCo’s
CEPU’s underleveraged balance sheet and strong track record put CEPU in a strong position to bid for projects in new capacity auctions as well as bid for government’s equity stakes in its power plants. Assuming 2-3x leverage, we believe the company has $700-1,000M of debt capacity, which could add $147-218 M in EBITDA (Figure 7).
Figure 7: CEPU’s debt capacity assuming 2-3x leverage
Upside to CEPU’s Valuation
We believe that the impacts of regulatory normalization are skewed to the upside. For CEPU, we believe it is more likely that new project wins will fully offset the removal of inefficient assets. Further, the regulatory impacts of Base Energy tariff normalization and fuel purchase normalization would be viewed positively. We see a path to an additional $8.87/sh. in upside from our base case target if regulatory normalization occurs as detailed below.
3) Macro Overview
We are still constructive on the medium/long term structural story of Argentina, Latin America’s third largest economy, but acknowledge the cyclical speed bumps that Argentina has hit and the challenges to macro stability that remain over the short-term. Argentina chose a gradual approach to macro normalization: specifically, to tame high inflation, stimulate growth, and reduce the fiscal deficit. The delicate balancing act to simultaneously accomplish all three goals, while maintaining political capital, was derailed by a confluence of factors, both domestic and external.
For context, current president Mauricio Macri, who was elected in 2015, inherited a large fiscal deficit from the prior regime. Argentina had been in the eye of the perfect storm for quite some time, allowing stagflation to spread and the fiscal deficit to spiral out of control. Macri’s solution was policies aimed at lowering inflation through the Central Bank, increasing social spending to guarantee governability, and reducing government expenditures by cutting subsidies, particularly those for public transport, utilities and other public goods. The lynchpin of this plan was that economic growth would reverse the fiscal deficit and finally tame inflation. To stimulate growth Macri focused his efforts on opening Argentina’s capital markets. Most importantly, Macri settled with creditors from the 2002 bond default. This settlement effectively opened Argentina to the international bond markets after having been shut out for well over a decade and allowed Argentina to finance its debt externally. Macri continued this capital markets reform by lifting currency controls, opening borders for trade and passing tax reform. These policies have been validated through MSCI’s upgrade of Argentina from frontier market to emerging market status in June 2018.
When Macri took office in December 2015, inflation was running around 30% and the fiscal deficit was 5.4% of GDP. When Macri allowed the peso to float, it quickly devalued by 29%. Consequently, he gave the central bank freedom to raise rates to target inflation. The government raised large amounts of foreign-denominated debt to cover the fiscal deficit. Over 70% of the country’s debt is foreign denominated. Capital flowed into government bonds on the back of ultra-high interest rates, artificially strengthening the peso against the dollar. That kept imports high and made it hard for exports to compete. The worst drought in 30 years and weakness in Brazil, Argentina’s main trading partner, caused a further reduction in Argentina’s exports. The combined effect caused the current-account deficit to rise to more than 5% of GDP. At the same time, inflation remained persistently high. As the Central Banks inflation targets moved further out of reach, the Central Bank’s credibility began to be challenged.
The US Federal Reserve’s interest rate hike in May caused both the dollar to strengthen and a reversal in the liquidity conditions in emerging markets. The Argentine peso devalued sharply. The central bank hiked interest rates to 40% and tried to prop up the peso using foreign reserves. When that failed Mauricio Macri, secured a $50bn credit line from the IMF. Although IMF credit line means most of Argentina’s external-financing requirements are covered until 2020, it is tied to austerity measures. Specifically, Argentina is required to cut the budget deficit, which reached 3.9% in 2017, to 1.3% of GDP by 2019 and to zero by 2020. The savings are supposed to come from postponing infrastructure projects; cutting subsidies and transfers to the provinces; and shrinking the federal payroll.
We expect the downturn in activity in 2Q18 to continue into 3Q18 amid high inflation and a tighter policy mix. We believe this will negatively affect sentiment and politics in Argentina. Moreover, the acceleration of fiscal consolidation objectives will remain a drag on growth for the foreseeable future, reducing the likelihood of a sharp recovery.
While a recovery in Brazil remains a wild card, the drought should be a one-time event. One positive about this backdrop is that, with tighter fiscal policy and a subdued growth outlook, the needed correction in external accounts may end up materializing sooner than anticipated. The Argentine consumer is still under levered and Argentina’s debt to GDP ratio is still manageable. Absent another bout of sizable currency volatility, and assuming fiscal objectives are met this year and next, the economy would be on more solid footing, and therefore more likely to be able to sustain growth in the next political cycle, provided there is no significant change in policy direction.
While we don’t preclude the possibility of things getting worse before they get better, we do believe that a lot of the carnage is behind us. After being one of the best performing markets in 2017, Argentina is the worst performing market in 2018 YTD. The MSCI Argentina benchmark (USD denominated), Merval Index (ARS denominated) and Argentine Peso have lost 53%, 25% and 38% YTD, respectively. The two biggest risks to the recovery are a deterioration in the social and political dynamics that undermine overall governability conditions/the current regimes political prospects in the 2019 election; and a risk-off scenario that could eventually trigger another episode of currency depreciation.
4) Argentina Macro Implications on CEPU
Major EM currency crises typically ignite broad-based equity sell-offs that are followed by a selective and powerful recovery of high quality stocks. We think earnings from the Argentine utility sector should be supported by a) macro protection (FX and inflation passthrough; GenCo’s revenues dominated in USD), and b) capacity expansions.
Although there was a change in leadership of the Energy Ministry in June 2018, we believe that the current administration remains committed to the normalization of tariffs and prices, as well as the removal of unnecessary subsidies from the power sector. Importantly, we understand that all contracts and tariff review processes will be honored, which removes an important concern and overhang.
Importantly, electricity prices in Argentina are not yet extremely high vs. both other LatAm countries and vs. other average monthly bill for consumers (in Buenos Aires, average June 2018 electricity bill stood at US$19 vs. the US$27 cost of a mid-range broadband package and US$40 for Pay TV). This suggests policy execution, and not affordability, is the key constraint for further tariff normalization in the country.
Figure 8: Cost of electricity in LatAm
Further, the current administration should continue to incentivize domestic generation capacity. We believe investment should be the fastest growing segment of the economy. We also believe that 60%+ of the capex backlog in Argentina is energy intensive. Thus, we think Argentine utilities are poised to benefit not only for tariff normalization, but also from pent-up power demand, regardless of the macro economic cycle. The Ministry of Energy still needs to auction ~10 GW of new projects by 2025, of which ~5 GW will be thermal projects and ~5 GW will be renewable projects.
Figure 9: Expected capacity growth in Argentina. There is a direct correlation between GDP growth and electricity demand
5) Market Structure
The Argentine electricity sector is formed by a variety of distinct generation, transmission, distribution, commercialization and central load dispatch entities. Cross-ownership in these activities is strictly limited, with the transmission entities being forbidden to own any part of a generating or distribution enterprise and cross-ownership of distribution and generating assets is limited to ten percent of the entire market. Most of these companies are in private hands, with only minor participation by the federal government in the generation sector.
Figure 10: Structure of wholesale electricity market
6) Brief History of Argentine Power Market
7) Prior Auctions
The Argentine government is targeting 10GW of additional thermal capacity by 2025, of which 4.7GW have already been auctioned off.
The Argentine government is promoting the production of energy from renewable sources. The government has mandated that the minimum renewable energy share of total consumption increase from 8% in 2018 to 20% by 2025. Larger users (+300kW) will need to gradually increase the purchase of energy from renewable sources, meeting specific goals. The Argentine government is targeting 10GW of additional renewable capacity by 2025, of which 5.1GW has already been auctioned off.
8) Counterparty Risk
CAMMESA is the off taker of almost all CEPU’s electricity generation and as such, is CEPU’s primary creditor. CAMMESA collects cash from power distributors and the government (i.e. subsidies) and pays generators and fuel producers. Since the government subsidizes electricity costs and has been known to backstop any temporary cash flow shortfall at CAMMESA, we believe that CAMMESA should have the same credit profile as the Argentine government. Argentina has a credit rating of (Fitch: B; Moody’s: B2; S&P: B+) and its USD denominated sovereign bonds yields 10%. Assets remunerated under the New Energy regime, which have legally binding PPA’s, have priority over Base Energy assets in CAMMESA’s cash flow waterfall.
Renewable assets (wind/solar) in the RenovAR program, which also have PPA’s with CAMMESA, have secondary credit enhancement through a credit backstop by the World Bank (Figure 11). We believe this secondary credit enhancement could lessen the interest rate risk on the project debt that CEPU expects to use to finance the next four wind projects.
Figure 11: RenovAR counterparty flow chart
9) Regulatory Trajectory:
Over time we believe that the Energy of Ministry will shift the power generation policy back towards a market regime. In other words, the energy price received by GenCos would be determined according to the system marginal cost, instead of being fixed by the regulator as it is now. While CAMMESA dispatches power plants based on marginal cost, including fuel, the Base Energy structure incentivizes inefficient assets to stay in the market. This is because 1) CAMMESA provides fuel to Base Energy generation assets and 2) roughly speaking, the Base Energy variable remuneration rate covers the operators fixed costs and the capacity payments are the generators’ margin. Thus, inefficient assets that don’t produce any power are still economical. Over time, we expect the government to shift fuel supply responsibility back to generators and shift the remuneration rate mix to more of a variable rate policy (i.e. incentivizing efficient generation).
Given Argentina still lacks sufficient systemwide capacity, Argentina must add additional efficient power generation capacity before it can remove inefficient power generation capacity from the system. Units that run exclusively on high priced gas oil (5.5 GW of system capacity, of which CEPU has 0 GW) would be the first to be removed by the system, followed by those that run on fuel oil (CEPU has 1 GW of Steam Turbine capacity that can switch between natural gas and fuel oil).
Figure 12: Argentine Generation Supply Curve
In the short term, we do not expect a change to current policies because Argentina is short 45mcm/d of natural gas in the winter. Argentina imports gas in the winter using 2 LNG fuel ships and by pipeline from Bolivia and Chile. While domestic gas production and imports will continue to increase, so will thermal capacity. Argentina will still need to use liquid sources (fuel oil/ gas oil) to meet production needs over the forgeable future (Figure 13). When Argentina is short of natural gas, particularly in the winter, efficient units that run exclusively on natural gas cannot run if they do not have access to an adequate fuel supply. Further, the efficiency dynamics change when there is fuel switching. As result of differences in fuel prices, a CCGT that would typically run on natural gas could switch to gas oil, making it less efficient than steam turbines that switched from natural gas to fuel oil. The price of gas oil ($15/mmbtu) is significantly above the price of fuel oil ($7/mmbtu; import parity with LNG).
Figure 13: Argentina is short natural gas in the winter. Argentina will continue to need liquid fuel sources to meet power demand for the foreseeable future.
The Argentine government hiked the remuneration scheme for “old energy” by >100% (average hydro and thermal) between 2016 and 2017 and converted it back to USD. The Secretariat of Electric Energy cited the fact that WEM prices have been distorted and discouraged private sector investment in power generation. It concluded that it was necessary to raise tariffs to partially compensate for increasing operation and maintenance costs and to improve the cash flow generation capacity of generators. We believe that the Argentine government will continue to normalize tariffs in the future to gradually restore economic rationality and price equilibrium. Currently, old capacity sells for an average of $18/MWh versus $60-70/MWh for new capacity. The reopening of the term market for thermal assets would be one mechanism to reduce the price disparity between Base Energy and New Energy pricing.
Figure 14: Base Energy vs. New Energy Prices and Base Energy Pricing of Thermal vs. Hydro
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