Is it time to buy in to Brazil’s thriving utilities?

Brazil's electricity generating companies are in good shape. The industry has been completely overhauled recently, and the market is forecast to grow at 4.5% a year for the next few years. Eoin Gleeson examines the sector, and picks the best bet for investors.

In the past, global economic turmoil has been bad news for Brazil. During the Great Depression, the country suffered a military coup. When Argentina defaulted on its debt in 2001, Brazil's economy went into cardiac arrest. So by now, you might have expected Brazilian industry to have ground to a halt and for its politicians to have barricaded themselves into the houses of parliament. But as Brazilians return to work after carnival season, the signs are that the economy is doing just fine. Take demand for electricity. In China, a slump in power demand in recent months is stoking fears that the economy is imploding. Yet while Brazilian factories are cutting back electricity use fell 4.6% from October to January household consumption rose 5.4%, reflecting widespread optimism of a kind Brazil has rarely experienced before.

ANEEL, the Brazilian electricity regulator, reckons that Brazil's market for electric power will grow at an annual rate of 4.5% over the next few years. That may sound over-optimistic with industrial production on the wane, but the truth is that Brazil has a great deal going for it. Exports of food and industrial commodities have helped the country amass more than $200bn in foreign reserves in the last few years, says Jonathan Wheatley in the FT. And having made a huge oil discovery in the Tupi field, it will soon be one of the world's biggest producers of oil. Brazilians' low consumption of electricity per head 2,000 KWh to 2,500 KWh compared to 13,000 KWh in America is bound to escalate when oil and commodities start pumping the economy again.

That will place huge demands on Brazil's thriving private utilities. They have already taken a tight grip on the country's electricity supply as the government seeks to bolster its fragile power grid. With 80% of its electricity coming from hydroelectric dams, Brazil is very susceptible to blackouts during droughts. In 2001, after a couple of unusually dry seasons drained the country's reservoirs, the government had to resort to electricity rationing. This caused enough dissatisfaction to unseat the former president, Fernando Henrique Cardoso, in the 2002 election.

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Unsurprisingly, the current president, Lula da Silva, is determined not to let that happen again and has opened the door to the private sector to improve the grid. In fact, the industry has been completely overhauled since reforms began in the mid-1990s, says Morningstar's Ryan Mclean. Power distributors and generators have been privatised; price controls were scrapped and centralised auctions for power-supply contracts were introduced. The industry is still dominated by lumbering state companies such as Electrobas (40% of capacity), but 25% of Brazil's electricity generation is now in private hands and that is likely to hit almost 44% over the next five to six years, according to the World Bank. Two-thirds of the distribution network is now private as utilities continue to take over the grid.

These private utilities are in a sweet spot. While their counterparts in America are forced to slash dividends as credit dries up, conditions in Brazil are far less harsh. Brazil's private banks, with huge reserve requirements and taxes on funding, were far more conservative than their global peers. "So far, credit in Brazil has been lightly chewed, not crunched," says The Economist. With interest rates sitting at 12.75%, there's also scope for looser monetary policy, which will facilitate the recent bout of consolidation in the industry. The debt profiles of Brazil's power players have improved greatly on the back of rising electricity rates, says the Dow Jones's Kenneth Rapoza. So the big dividends that Brazilian utilities pay look pretty secure. Below, we look at one group on course to be a large player in Brazil's thriving electricity industry.

The best bet in the sector

CPFL Energia (NYSE:CPL) is the largest private outfit in Brazil's electricity sector. It distributes, generates and commercialises electricity, serving 6.3 million customers, largely in the states of Sao Paulo and Rio Grande do Sul.

CPFL is in a unique position to lead the consolidation of this industry, says Zacks analyst Claudio Freitas. The acquisition of CMS Energy Brazil has positioned it for greater access to the growing energy needs of Sao Paulo, and it already has a captive market in residential (35.8% of revenues), industrial (32.4%) and commercial (19.6%) customers in the densely populated industrial centre. The biggest risk is that with the Brazilian economy slowing, industrial and commercial demand may fall off significantly. And although government tariffs on electricity are expected to be a big boost this year, there is regulatory risk, as with any industry that is prone to government intervention. But the very healthy dividend of 9% is likely to be maintained, says Freitas. After a recent sell-off, the company's shares now look attractive on a forward p/e of 9.8.

Eoin came to Money Week in 2006 having graduated with a MLitt in economics from Trinity College, Dublin. He taught economic history for two years at Trinity, while researching a thesis on how herd behaviour destroys financial markets.

Eoin acts as managing editor of MoneyWeek's newsletters.