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Southern Energy’s Investment in CEMIG

Southern Energy’s Investment in CEMIG. Matt Michaud Judd Murphy Tory Noto Matt Palasek. Outline. Project Description Southern Energy Brazil CEMIG Project Overview Solution. Project Description. Partnership to purchase 33% of CEMIG voting stock from Minas Gerais AES (65%)

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Southern Energy’s Investment in CEMIG

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  1. Southern Energy’sInvestment in CEMIG Matt Michaud Judd Murphy Tory Noto Matt Palasek

  2. Outline • Project Description • Southern Energy • Brazil • CEMIG • Project Overview • Solution

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

  4. 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

  5. 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

  6. Brazil

  7. 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

  8. Brazil

  9. 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

  10. 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

  11. Brazil

  12. 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

  13. CEMIG

  14. Project Overview • Southern’s share would cost $276 million • $126M in cash • $150M in dollar-denominated debt • Thus exposing SEI to currency risk

  15. Project Overview

  16. Project Overview • Consortium would be given • Veto power on expenditures > 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

  17. 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

  18. 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%

  19. 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

  20. 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

  21. 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 partnership’s control through local courts • 2000 – Partnership wins in court • 2001 – CEMIG upgraded to ADRs on NYSE

  22. 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.

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