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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

Southern Energy’sInvestment in CEMIG

Matt Michaud

Judd Murphy

Tory Noto

Matt Palasek

outline
Outline
  • Project Description
  • Southern Energy
  • Brazil
  • CEMIG
  • Project Overview
  • Solution
project description
Project Description
  • Partnership to purchase 33% of CEMIG voting stock from Minas Gerais
    • AES (65%)
    • Southern Energy (25%)
    • Opportunity Fund (10%)
southern energy
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
southern energy5
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
brazil7
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
brazil9
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
brazil10
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
cemig
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
project overview
Project Overview
  • Southern’s share would cost $276 million
    • $126M in cash
    • $150M in dollar-denominated debt
      • Thus exposing SEI to currency risk
project overview16
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
real options
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
solution discount rate
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%
solution npv analysis
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
solution comparables
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
what happened
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
what happened22
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.