Central Puerto Is Still Cheap And A Buy For Me (NYSE:CEPU)

Central Puerto (NYSE:CEPU) is an Argentinian electricity generation utility.

In April 2021 I recommended the company, based on an analysis of its regulatory situation and perspectives. Since then, the stock has returned 215%.

In this revision of CEPU’s condition, I find that the company’s situation has developed as expected: its regulatory environment is neither friendly nor hostile, the company has not invested heavily, it has reduced leverage, and maintained profitability.

Despite the company’s stock price increasing so much, the company is still cheap compared to my long-term projections of profit from operational sources. These projections do not incorporate any new investment in capacity, nor an additional price increase above inflation or above the rate of currency depreciation.

Note: Unless otherwise stated, all information was obtained from CEPU’s filings with the SEC.

Summary of previous article

As always, I recommend readers to revisit my previous article for a detailed description of the company’s operations and history.

A big player in Argentinian energy: CEPU generates almost 10% of Argentinian electricity. The company has a diversified asset base composed of thermal, hydro and renewables.

Regulation is the main profit driver: Argentina has changed its regulatory framework 3 times in the last 10 years. The country has not respected established contracts in the past, and some governments have reduced the utilities’ profitability to its minimum.

Current regulation is neutral: Although the current regulatory framework is provisional (as the country solves its inflation and debt problems), it has consistently (albeit discretely) updated energy prices so that profits are not eaten away by inflation.

Currently, CEPU derives revenues from two sources. Some assets sell to the wholesale market, whose price is fixed by the regulatory agency (updated with some regularity to cover inflation). Other assets sell in long term PPA contracts, at much higher margins. PPA contracts eventually end and the assets start selling in the fixed price market.

Hedged against fuel prices: In all of Argentina’s regulatory framework, the state company at the center of the wholesale electricity market provides fuel to electricity generators, at its own expense. This reduces CEPU’s earnings volatility.

Downside scenario limited: The possibility of the current or a future government returning to an anti-profitability framework is low. The reason is that the strategy is now widely criticized as being the reason behind Argentina’s lack of electricity supply in the middle of the previous decade. Only a leftist portion of the current government advocates for stricter regulation against utilities. The rest of the political spectrum thinks otherwise.

Financially strong: As of 3Q22, CEPU’s leverage (assets over equity) stands at 1.44, not extremely high. The company has about $353 million in debts, mostly dollar denominated, $100 million of which mature in the next year, and the rest maturing after 2026.

Against these debts, the company holds the equivalent to $326 million in cash and securities (at the official rate), $120 million of which are dollar denominated. On top of that it has a $300 million (dollar denominated) receivable account (the FONINVEMEM account) from which it receives $50 million yearly.

Although the company has an exchange rate mismatch (more dollar liabilities than assets), it is currently able to purchase dollars to the Central Bank at the official exchange rate to pay debts.

Difficult to understand financials: Argentina sustains an inflation rate close to 100%, and its currency depreciates at a similar step. This generates a lot of accounting noise in CEPU’s peso-based financial statements. The exchange rate movements generate profits because the company has a net asset exposure to the dollar. Inflation generates losses because the company also has a net asset exposure to the Argentinian peso.

To better understand CEPU’s long-term profitability, I translate its operating statements to dollars using the official rate (the one used to pay debts and imports). I then subtract interest expenses in dollars, and then apply a 35% income tax rate to the remaining figure.

Recent developments

Operating profitability is maintained: The Argentinian government has increased the wholesale electricity market prices more or less in line with inflation. This means CEPU’s profitability at the operating level has been sustained, for the most part. The updates are applied bi yearly or yearly, so the company does suffer some inflationary effects. The previous price adjustment was enacted in April 2022, and the next one occurs in January 2023 (120%).

A note on operating profits: CEPU considers that the exchange rate effect on its FONINVEMEM receivables is an operating profit. Obviously I do not think the same, and therefore remove that effect from operating income in order to facilitate operational comparisons.

The company is not investing: CEPU has invested $5 million for the 9M22 period, compared with depreciation charges of almost $70 million. This is understandable given the lack of a long-term regulatory framework and the lack of regulatory stability in Argentina. However, no investment means no growth at the operational level.

Nowhere to put the pesos: Because the FX market is restricted or more expensive for treasury purposes, CEPU is accumulating pesos. With investments strategically out of the table, CEPU has found other uses for those pesos: paying debts when possible (anticipated repayments are restricted), paying a dividend for the first time since going public ($0.16 per ADR), purchasing government bonds and treasuries ($170 million) and purchasing a forestry company for ESG purposes ($70 million) .

No framework, no investments, no growth: Without a stable regulatory framework in which CEPU’s management trusts, the company will not invest in new generation capacity. The trust part is almost as important as the existence of a long-term framework. The latest LT framework was established in 2017, only to be amended by the same government two years later. This made CEPU’s management wary.

Without investment in new assets, no new generation capacity is put online, which then means no new operationally-based profitability. I am not a growth by growth itself advocate, and I prefer to look at incremental ROIC rather than growing EPS. However, knowing that the company is not investing, I cannot incorporate growth into my long-term assumptions.

Profitability going forward

By removing the FX and inflationary effects on financial assets, I concentrate on CEPU’s operational profitability by line of business.

Conventional business: Currently generating about $440 million in revenues. The addition of a new turbine (Brigadier Lopez steam) and the removal of another one from PPA (Brigadier Lopez gas) should generate a net loss of $23 million in revenue, against $15 million from increased capacity at the T6 terminal. Finally, if the hydro plant Piedra del Aguila’s concession is removed by the end of 2023, the company could lose another $40 million. In the optimistic scenario (no PdA removal), with all capacity online, the company should generate about $430 million from conventionals. The operating result of the segment should be around $200 million then.

Wind and solar: These assets are much less volatile because they all operate tied to 20 year PPA dollar-denominated contracts. I anticipate $80 million in operating profits from these assets yearly.

Interest expenses: CEPU’s debt is expensive and tied to LIBOR. I assume a 10% rate to be conservative. Considering the repayment of $100 million in 2023/4, the company should generate $20 million (from a base of $200 million) in interest charges.

Taxes: Argentina’s corporate income tax is 35%.

After tax profit: $200 million (conventional) + $80 million (wind and solar) – $20 million (interest charges) = $260 million. Applying a 35% tax rate leaves $170 million in net profits.

What is left aside: Peso inflation and dollar FX effects on financial assets and liabilities are not considered. These are volatile and changing, so they cannot be incorporated in a long-term profit calculation. However, in risk terms, the company is protected against devaluation by its net asset exposure.

Cash flows: CEPU’s following years FCF is going to be higher than net income by at least $70 million in depreciation, considering the low level of investment seen. Also, the conversion of the FONINVEMEM receivables (from which CEPU derives $50 million yearly) is not considered income, but adds to FCF.

Value and price

CEPU is currently trading at $6 per ADR, or a market cap of $900 million (1.5 billion shares, and each ADR represents 10 shares). This market cap yields 18% against my long-term profitability calculations. In terms of FCF the yield is even higher considering the lack of CAPEX.

In my opinion, the biggest risk ahead is that the government decides to reduce the rate of adjustment for the fixed market, therefore diluting CEPU’s profits. This possibility seems remote to me, given that most political sectors believe profitability is necessary for investment.

Although a long-term framework may still take a few years to form (considering that Argentina holds elections this year), the company’s current situation is acceptable. The margin over expected long-term earnings more than offsets the company’s lack of an investment plan.

For that reason, I believe CEPU is still a buy, despite the tremendous increase in share price that it has shown in the last two years.