Bright prospects for Brazilian utilities

Earlier this year, while he still had his health, Fidel Castro declared that 2007 would be "the year of the energy revolution". The Cuban government had just imported 4,158 electric generators at a cost of $800m in an effort to end the power cuts and blackouts that have plagued Cuba for years. The same story is being played out across Latin America. In Argentina, where the power grid and fuel systems are collapsing, ministers made a similar desperate bid, assuring the public that "it will rain diesel" as soon as they got the power system back online. Governments in the region are finally realising they will have to bite the bullet on infrastructure investment. After years of neglect, it looks like the companies building and supporting Latin American's power system are set to be jolted back into life.

The issue is particularly important for regional powerhouse Brazil, where the big worry is that power outages will short-circuit economic growth. Brazil's economy grew 3.7% last year and demand for power is surging as industry booms and an emerging middle class fills their homes with fridges, televisions and washing machines. Acende Brasil, an electricity industry body, predicts a 28%-32% chance of blackouts by 2012. Unsurprisingly, President Lula da Silva has made dealing with power outages the top priority of his second term, agreeing to the building of two huge hydroelectric dams at a cost of $9.5bn in the Amazon (Brazil relies on hydro power for 80% of its electricity) and setting out plans to back up its thermoelectric plants with 20 million cubic metres a day of liquefied natural gas by 2009.

But the government won't be able to bring capacity online quickly enough on its own to stave off power shortages, says Andrei Khalip on Reuters, which means attracting private companies and foreign investment. This is something that the Brazilian government has been working on for some time. During the 1990s, Brazil embarked on major reforms of its utility sector, notes Ryan McLean on Morningstar.com. Power distributors and generators were privatised, price controls were scrapped and centralised auctions for power supply contracts were introduced. The government even managed to improve the murky business of navigating the country's courts, which had earned a reputation for not upholding contracts for private companies. The resulting more-business-friendly environment saw private sector investment start to pour in. Almost two-thirds of Brazil's electricity distribution network is now in private hands and foreign power giants such as Spain's Terna continue to snap up Brazilian grid operators today. Spain's Endesa, attracted by the increasingly progressive stance in the region in general, plans to invest $3.3bn in Latin America in 2009.

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"A lot of the time, countries don't give in to business-friendly regulatory models until they have no choice," says Rowe Micels from Bear Stearns. With rapid growth in electricity demand and a power system that is hostage to regular rainfall for keeping its reservoirs full, Brazil has little choice but to maintain its business-friendly approach. Lula da Silva will be aware of the discontent of those who have had to sit through hot summer nights with no air conditioning or lights. His support and interest from foreign power groups means that prospects for Brazilian utilities remain bright. We look at some stocks set to benefit below.

The two best bets in Brazilian utilities

Electricity generator and distributor CPFL Energia (NYSE:CPL) is Brazil's largest privately owned utility, and "stands above its peers", according to Ryan McLean on Morningstar.com. The company's difficult-to-replicate distribution networks are concentrated in the economically powerful southern states of Sao Paulo and Rio Grande do Sol, serving 5.9 million customers. CPFL is expected to scale up its business by acquiring a few local utilities and its operating costs should remain in check because the government's revised regulatory scheme rewards efficiency, says McLean. The company's shares are valued on a p/e of 10.4 and pay a very attractive 9.4% dividend yield.

Another Brazilian utility that will benefit from the country's efforts to restructure its utility sector is government-controlled Paranaense de Energia (NYSE:ELP). The company distributes electricity and also runs 17 hydroelectric power plants and one thermoelectric plant. Bear Stearns has a $20 price target for the company, but that may be too conservative, according to the Beris column on Seeking Alpha particularly when you consider its low debt, very strong cash flow and the fact that the government has been only too happy to green light its tariff hikes in recent years. The shares, which are currently trading at around $15.50, are trading on a forward p/e of 11.