Southern Energys Investment in CEMIG

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Southern EnergysInvestment in CEMIG
Matt Michaud Judd Murphy Tory Noto Matt Palasek
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Outline

• Project Description
• Southern Energy
• Brazil
• CEMIG
• Project Overview
• Solution

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Project Description

• Partnership to purchase 33 of CEMIG voting stock
  from Minas Gerais
• AES (65)
• Southern Energy (25)
• Opportunity Fund (10)

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Southern Energy

• The unregulated subsidiary of The Southern
  Company
• Southern Energy is a major Independent Power
  Producer (IPP) in Asia, Europe, and South America
• Seeking large returns in international investments

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Southern Energy

• SEI has assumed both minority and majority
  positions and has gained valuable operating
  experience
• Invests in both developed and emerging markets
• Southern takes a long-term view of investments in
  emerging markets
• In emerging markets Southern looks to gain
  first-mover advantage

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Brazil
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Brazil

• 10th largest economy in the world
• Annual inflation reached peak of over 2500 in
  1993, now down at 7.3
• Foreign direct investment increased from 25
  billion in 1994 to 52 billion in 1996

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Brazil
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Brazil

• Brazil is widely regarded as the best nation in
  Latin American for utility investments
• By 2007, Brazil will need an additional 30,000 MW
  of generating capacity, requiring an investment
  of 20 billion
• Now on cusp of full sector privatization
• Electricity demand growing at 5 per year
• 10 guaranteed return to utilities ended in 1995

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Brazil

• Generating capacity about 62,000 MW.
• Electric generation components
• Hydro 91.02
• Fossil Fuels 4.92
• Nuclear 0.99
• Other 3.07
• Total Production 317 billion kWh
• Total Consumption 336 billion kWh
• Total Imports (Paraguay) 42 billion kWh

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Brazil
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CEMIG

• State-owned utility of Minas Gerais
• Federal government has large minority investnment
• Fully integrated generation, transmission, and
  distribution
• Has exclusive rights to sell to 96 of Minas
  Gerais
• Generally considered best utility investment in
  Brazil

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CEMIG
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Project Overview

• Southerns share would cost 276 million
• 126M in cash
• 150M in dollar-denominated debt
• Thus exposing SEI to currency risk

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Project Overview
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Project Overview

• Consortium would be given
• Veto power on expenditures gt 1 million real
• 4 of 11 seats on the board
• 3 key executive positions
• Ability to pass through costs
• Southern brought in partnership for industry
  expertise

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Real options

• Delayed investment wait to see how regulatory
  situation develops, then expand capacity
  accordingly
• Invest in gas-fired-plants hedge against hydro
  power, Bolivian pipeline makes this possible
• Delayed bid given that they are the only bidder,
  they could delay their initial bid until the
  regulatory situation is clear
• But, the ship may sail without them

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Solution Discount Rate

• Base case cost of equity was 24.8
• Adjustments
• Assumed beta of .4 for average utility investment
• Adjusted up/down for idiosyncratic risks
• Extreme reliance on hydro (Up)
• Uncertain regulatory framework (Up)
• Weak judicial system and unsettled political
  climate (Up)
• Cemig is fully integrated (Down)
• Privatization trend (Down)
• Improved operating margins after investment
  (Down)
• Adjusted cost of equity is 18.9

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Solution NPV Analysis

• Free cash flows to common equity
• Used consensus analyst cash flow estimates and
  adjusted to reflect operating efficiencies
• Assumed minimum purchase price as initial
  investment
• Accounted for optionality of delayed investment
• NPV without option (14.7M)
• NPV with option 44.7M
• Assumptions for delayed investment option
• 50 chance of deregulation (at least of wholesale
  market)
• 1,500 MW capacity investment
• Return (cash flow) per MW in-line with
  projections

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Solution - Comparables

• Comparable Acquisition
• Implied price of 34.72
• Light SA purchase by AES in 1996, Light is a
  distributor
• Bovespa index has improved 40 since that time
• P/E Multiples
• Average Brazil utility implies 43.79
• Weighted average implies 51.92
• Weighted more heavily on fully integrated peer

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What Happened?

• Acquisition went through at 56.15/share
  (minimum)
• Economic crisis hits Brazil in 1998
• Abandoned peg to USD
• Caused by Asian currency crisis, Russian default
• Since beginning of 2001 the real has depreciated
  by more than 20
• Random
• 1998 New governor of Minas Gerais sued to
  remove partnerships control through local courts
• 2000 Partnership wins in court
• 2001 CEMIG upgraded to ADRs on NYSE

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What Happened?

• 2001-02 Energy crisis in Brazil
• Drought led to lack of hydro-generation
• Consumers asked to cut consumption by 20
• Inadequate transmission system means electricity
  cannot get to underserved markets
• Government ordered 50 thermoelectric plants to be
  built, but lack of guarantee led to dearth of
  investors
• Thus far 36 plants are in process of being built
  (14,200 MW) and Brazil entered into a power
  contract of 2,800 MW from Paraguay and Argentina.