EDP ENERGIAS DE PORTUGAL COMPANY REPORT · EDP – Energias de Portugal is a Portuguese electric...

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EQUITY RESEARCH

EDP is a leading company in the energy sector, since it is

among the major European players in this market; it is also one of

the largest energy operators in the Iberia and the third largest wind

energy producer in the world.

EDP is a highly regulated company, having more than

85% of its operational revenues coming from its regulated activity.

This fact contributes for the status of low-risk Company, as well as

the stability and predictability of revenues. Moreover, it enables

EDP to leverage itself to finance such striving investment plan.

Actually, the company has a target Capex of €2.1 billion until 2016,

being 80% of it is for expansion purposes.

EDP is highly committed in becoming a greener company,

due to an increasing environmental concern. It has an ambitious

investment plant in greener sources of energy, as hydro (mainly in

Portugal) and wind capacity, through its stake in EDP Renováveis.

Until 2012 EDP intends to have an installed capacity equal to 23.9

GW, being 65% powered by wind and hydro.

The entry of a new shareholder, Three Gorges, as a

consequence of the privatization process, will enable EDP to

strengthen his position in the renewable sector, and also develop

its business in the Asian market, namely in Macau.

All in all, we consider EDP a solid company that creates its

own growing opportunities through its investment business plan,

increasing the diversification of the company’s portfolio.

Company description

EDP – Energias de Portugal is a Portuguese electric utility company that focus its operations in the generation, distribution and supply of electricity and gas in both Portugal and Spain. Also the company has a stake in EDP – Energias do Brasil, which operates in the Brazilian market, and in EDP Renováveis focused on production of energy through renewable sources.

EDP – ENERGIAS DE PORTUGAL COMPANY REPORT

ELECTRIC UTILITIES 06 JANUARY 2012

STUDENT: VANESSA NAVE [email protected]

A distinctive story

Proven track record in efficiency improvement

Recommendation: BUY

Vs Previous Recommendation BUY

Price Target FY12: 3.16 €

Vs Previous Price Target 2.90 €

Price (as of 6-Jan-2012) 2.48€

Reuters: EDP.LS, Bloomberg: EDP PL

Market Cap (€m) 9,043

Outstanding Shares (m) 3,657

Source: Bloomberg

Source: Bloomberg

(Values in € millions) 2010 2011E 2012F

Revenues 5,404 5,507 5,778

EBITDA 3,613 3,621 3,831

Net Profit 1,235 1,118 1,262

EPS 0.34 0.31 0.35

P/E 9.24 8.01 9.27

PBV 1.06 0.81 1.1

Quick Ratio 0.89 1.04 0.99

Current Ratio 0.94 1.09 1.05

Debt/Assets 0.44 0.45 0.43

ROE 0.11 0.10 0.10

ROA 0.05 0.05 0.06

Source: EDP and Analyst Estimates

60%

70%

80%

90%

100%

PSI20 EDP




PAGE 2/33

Table of Contents

THE ENERGY SECTOR ........................................................................... 3

COAL ..................................................................................................................... 4 NATURAL GAS ....................................................................................................... 5 ELECTRICITY GENERATION ................................................................................... 6 SUMMARY ............................................................................................................. 7

GROUP EDP – ENERGIAS DE PORTUGAL ........................................... 8

COMPANY OVERVIEW ........................................................................................... 8 SHAREHOLDER STRUCTURE ............................................................................... 11

EDP – BUSINESS AREAS ......................................................................12

GENERATION IN IBERIA ....................................................................................... 12 Long-term Contracted Generation .................................................... 12 Liberalized Generation ........................................................................ 14

DISTRIBUTION IN IBERIA ...................................................................................... 15 SUPPLY IN IBERIA ................................................................................................ 17 EDP RENOVÁVEIS .............................................................................................. 19 ENERGIAS DO BRASIL ......................................................................................... 21

VALUATION ............................................................................................23

METHODOLOGY................................................................................................... 23 Gross Profit ........................................................................................... 23 Operational Costs ................................................................................ 24 Capex .................................................................................................... 24 Weighted Average Cost of Capital (WACC) .................................... 25

SCENARIO ANALYSIS .......................................................................................... 27 Worst case scenario ............................................................................ 28

SUM OF PARTS ................................................................................................... 29

FINANCIALS ...........................................................................................30

INCOME STATEMENT ........................................................................................... 31 BALANCE SHEET ................................................................................................. 31 STATEMENT OF CASH-FLOWS ............................................................................ 31 SUMMARY ........................................................................................................... 32

DISCLOSURES AND DISCLAIMER .......................................................33

RESEARCH RECOMMENDATIONS ........................................................................ 33




PAGE 3/33

The Energy Sector

According to the U.S. Energy Information Administration (EIA) it is expected the

world marketed energy consumption to grow around 50% until 2035, mainly driven

by developing countries (non-OECD nations) where demand is correlated with the

strong long-term economic growth. The non-OECD nations that were the least

harmful by the crisis, and therefore continue to grow, were China and India.

The global recession of 2008-2009 had a negative impact on world energy

consumption since prices were constantly increasing until 2008, with oil prices

peaking the $140 per barrel, the highest level ever since. When the crisis installed,

not only oil prices declined but also the prices of raw materials, as coal and natural

gas, as a consequence of the demand decrease verified in 2009. Nevertheless, as

nations recover from this downturn, world energy demand is showing a robust and

sustainable growth due to

economic recovery and the

increasing population in

developing countries. However,

this economic growth is not

similar between all nations. The

countries that show a higher

pace of recovery are the non-

OECD economies, mainly driven

by capital inflows and high commodity prices. However, high inflation is a major

concern in these nations. Regarding OECD nations the economic recovery is

variable, since the upturn has been slower in USA and Europe when compared to

past recessions due to concerns about both fiscal and financial sustainability. In

some European economies, as Greece or Portugal, some intervention measures

have been adopted by the European Union in order to prevent a future default. In

the case of Japan, it is facing some uncertainty as a consequence of the

overwhelming earthquake of March 2011.

It is important to highlight, however, that this expected increase in world energy

demand has as assumption no future changes in both regulation and policies that

affect energy markets. This might not happen since there is an increasing concern

regarding environmental issues, mainly focused on CO2 emissions reduction. In

some countries are being adopted energy efficiency measures in order to reduce

greenhouse gas emissions, according with commitments expressed at the Durban

Graph 1 - World Energy Consumption by fuel (Quadrillion btu)

Source: EIA, International Energy Outlook

Debt world crisis trembled the energy market...

The increase of world energy consumption brings severe consequences to the

environment...

0

200

400

600

800

2008 2015 2020 2025 2030 2035

Other

Nuclear

Coal

Natural

Liquids




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Climate Change Conference. Basically, this conference put together the 17th

Conference of the Parties to the United Nations Framework Convention on

Climate Changes and the 7th Session of the Conference of the Parties from the

Kyoto Protocol. In this conference was agreed that countries should start working

on a new climate deal, based on a legal force, which would affect both developed

and developing countries to cut their carbon emissions. The terms of this gradual

process will have to be agreed by 2015 and come into effect by 2020. As we

know, developed countries, as the United States and China (the two world largest

emitters) have now targets to cut their emissions by now until 2020; however,

these targets are voluntary and not legally binding. The objective of this

conference is to settle legal targets so that all countries get the same

responsibility. Additionally, this conference has the objective to help developing

countries in this issue, since they have few resources to fight this global concern

and also because the major stake of carbon emissions will come from their part

due to their high expected growth1.

Coal

If we do not account with changes in policies regarding the greenhouse gas

emissions reduction, it is expected world coal consumption to increase from 139

quadrillion Btu in 2008 to 209

quadrillion Btu in 2035, which

represent a 1.5% growth per year in

the considered period. This growth

will be mainly driven by non-OECD

nations, as we can see in Graph 2,

since OECD countries share an

environmental concern. Regarding

the electric power sector, it is likely to verify a decline in usage of this fuel for

electricity generation until 2020, since there is increasing use of renewable energy

sources for this purpose. From 2020 on, the share of total energy consumption is

expected to remain stable. Total consumption of coal in OECD Europe will decline

in both industrial and electric power sectors as well as the installed coal-fired

electricity generation capacity from 200 gigawatts (GW) in 2008 to 169 GW in

2035. This decline is due to the progressive use of sources less harmful to the

environment. In Iberia the major installed capacity of coal-fired plants is in Spain,

1 Source: United Nations Framework Convention on Climate Changes

Graph 2 - Coal world consumption (Quadrillion Btu)


Although the increasing concern on the environment, the consumption of coal will

continue to increase...

0

50

100

150

200

2008 2015 2020 2025 2030

OECD Non-OECD




PAGE 5/33

while there is only two in Portugal, which one of them is under Power Purchase

Agreements (PPA contracts).

We know that there is an increasing environmental concern that will affect the

consumption of the most polluting sources, as coal. Coal mining has associated

several environmental issues, namely soil erosion, noise, water pollution and dust,

as well as impacts on local biodiversity. In addition, its utilization is related with

prices of alternative sources, as natural gas or nuclear. In the past, coal has been

used in a high proportion, since its price has been lower and more stable than oil

or gas prices, and also because the majority of installed capacity for energy

generation was coal-fired ones2. Nowadays, as a consequence of environmental

concerns and in order to avoid a decrease in coal consumption and the increase

in its price, some changes have been made. There have been adopted new and

more efficient technologies that limit the release of pollutant gases, such as

greenhouse gas (carbon dioxide and methane). According to World Coal

Association, the adoption of this new technology is the major part of the solution

related with climate changes, since it has a fast growing use in many large

economies, as China and India. But these technologies are very recent and some

of them are still under study, which compromises their application. Also, they

could turn out to be quite expensive. In our valuation model we considered that

the utilization of coal will remain as predicted in what concerns electricity

generation, with a decreasing path in the long run.

Natural Gas

The overall consumption of natural gas is expected to increase by approximately

1.6% per year until 2035, being the

world’s fastest-growing fossil fuel. The

major source of this growth comes

from non-OECD countries, where

increasing demand is a consequence

of economic growth. In many regions

of the world natural gas is the fuel of

choice in both electric power and

industrial sectors, due to its lower carbon intensity when compared to oil and coal,

and also due to its lower price. In Europe governments have been acting in order

to reduce their concern about the nuclear power in the wake in Japan, which may

2 Source: World Coal Association

Graph 3 - Future coal prices ($)

Source: Bloomberg

Graph 4 - Natural Gas world consumption (Trillion cubic feet)


Natural gas will experience

a huge growth

68

72

76

80

Jan-1

2

Mar-

12

Mai-12

Jul-12

Set-

12

Nov-1

2

Jan-1

3

Mar-

13

Mai-13

Jul-13

Set-

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Nov-1

3

Jan-1

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0 50 100 150 200

2008

2015

2020

2025

2030

2035

OECD Non-OECD




PAGE 6/33

lead to a higher usage of natural gas in the electricity generation in the future. In

Iberian Peninsula it is used mainly for electricity generation through combined

cycle power plants (CCGT).

Electricity Generation

The debt crisis had devastating effects, and electricity generation market was not

an exception. The 2008/2009

recession slowed growth rate

of electricity usage in 2008

which led to a change in

electricity use in 2009. In 2010,

demand started to increase

again, mainly guide by the

economic recovery in

developing nations. From the

OECD countries the growth is

much slighter, since this is a mature market and there is not so much space for

robust growth. Therefore, the world net electricity generation is expected to

increase approximately 80% until 2035, according to EIA. In OECD countries net

generation is supposed to increase 1.2% per year in the given period.

Regarding the sources of electricity production, general prices will tend to increase

since we are returning to pre-crisis levels. Also, there is an increasing concern

about environmental issues, thus renewable sources are likely to be the fastest

growing sources of electricity generation. The majority of this growth will be driven

by hydroelectric power and wind power. Natural gas will be the source that will

also show a speedy growth, being the second fastest growing source in power

generation, lead by the increase in unconventional natural gas in North America,

which will keep global markets well supplied and maintain competitive prices.

About nuclear power, contrary to forecasts from previous years, the future of this

source is fairly unknown due to the devastating earthquake in Japan, since the

biggest stake of nuclear installed capacity is in this country. Governments will

have to deal with several issues regarding plant safety and radioactive waste

disposal, and the policies that they might resort to may compromise future

projections for nuclear power. Still, we may expect an increase in the usage of

nuclear energy as it is a green source and helps facing the growing greenhouse

gas emissions.

Graph 5 - World Electricity Generation by source (Quadrillion Btu)


Nuclear power has not a

sure path of evolution...

0

2.000

4.000

6.000

8.000

10.000

12.000

14.000

2008 2015 2020 2025 2030 2035

Liquids

Natural Gas Coal-Fired

Nuclear

Hydro




PAGE 7/33

Summary

The current economic recession brought a lot of instability to the markets.

Although forecasts accounts with a market recovery in the near times, we believe

that it will be much slower than the one considered in projections, since there is an

increasing uncertainty about financial and economic positions of some nations, as

Greece, Spain, Portugal and Italy. The future for these nations is quite unknown

which trembles financial markets. As a consequence, several companies had to

stop their investments in the energy field, due to this uncertainty. EDP was not an

exception, as during 2011 the company decided to postpone the construction of

Alvito plant, which represented an investment of €360 million. The fact is that

prices are showing an upward trend as well as demand, though slow. However,

we believe that prices of both fossil fuels and electricity will go up since it is

expected an increase of demand in energy markets, and also because companies

will continue their stopped investments in the energy field.

Regarding EDP, it surpassed quite well this downturn due to its regulated part of

the business (more than 85% of EBITDA comes from regulated area), which

allows the company to have predictable and stable operational cash-flows. and

also an effective risk management policy. For the future years, until 2016, EDP

has an ambitious investment plan of €2.1 billion per year. Around 80% of this

value will be invested in expansion, i.e. repowering of 8 hydro plants, and the

remaining for maintenance. Two power plants under construction, Bemposta and

Picote, will be finished by the end of 2011, beginning their activity in 2012, and the

repowering in Alqueva will be ready in 2013. Still, we know that energy market is

facing some changes, namely in Portugal, since there will be a decrease in the

regulated area due to the liberalization of the supply activity, increasing the

uncertainty and the exposure to trade markets.

We believe that these investments in hydro are due to several strategic points.

Firstly, hydro plants have no variable productions costs associated, thus

generating high margins. Also meets the environmental concerns, since its

pollution rate is lower when compared to other sources. But it does not represent

a fixed source of electricity as it depends on weather conditions. As a result, EDP

needs other sources for electricity generation with similar advantages of hydro,

like CCGT plants, that uses natural gas. EDP made a few investments in the

previous years in both Portugal and Spain, in order to be able to substitute the

coal-fired plants gradually, since they have a high level of CO2 emissions.

The uncertainty about financial stability of some countries difficult projections about a future stable overall economy...

Hydro investments are very advantageous for EDP




PAGE 8/33

According to EIA, the CO2 emission rights have an upward trend in the future,

meaning that will they become more and more expensive; this fact justify the

gradual passage from coal-fired plants to CCGT ones.

Since the liberalized activity is a matter for EDP, we also need to refer the Iberian

Electricity Market (MIBEL), which represents a liberalized regional electricity

market, formed by both Portuguese and

Spanish governments. MIBEL allows any

Iberian consumer to buy electrical energy

from any seller, under market conditions. The

objective is to benefit all consumers through

the integration of both markets, resulting in a

unique reference price for the Iberian market.

But this does not always happen, because

when there is too much consumers

(overcapacity) the market splits in two, Portuguese one and Spanish, which led to

different prices in both markets. As we can see by the Graph 6, one year ago this

difference (spread) in energy prices was more significant than nowadays. In 2010

the spread reached values of €1.5 per MW; currently the spread is around the

€0.5 per MW.

Group EDP – Energias de Portugal

EDP is a result of a merger between 13 companies in 1976 that were nationalized

at that time, conferring to EDP the status of a state owned company. Its main

objective was the electrification of the whole country as well as the modernization

and extension of the distribution network. In the 1990s the Government decided to

change the legal status of EDP and emerged the EDP Group.

EDP – Energias de Portugal is listed on the Lisbon stock exchange, and EDP

Group’s activities are focused on generation, distribution and supply of electricity

in Iberia and Brazil. Also, some companies within the group are responsible for the

distribution and supply of Gas and the business of renewable energies.

Company Overview

EDP is a leading company in the energy sector, since it is one of the largest

energy operators in Iberia. In this market the company is well represented by

several important holdings. In Spain, EDP is represented by HC Energía

Graph 6 – Difference between PT and ES electricity prices (EUR/MWh)

Source: OMIP

Graph 7 - EBITDA per business area (9M2011) as a % of Total EBITDA

Source: EDP

Well diversified electric company

MIBEL allowed the creation of an integrated and unique

Iberian market

-1,5

-0,5

0,5

1,5

Jan-1

0

Mar-

10

Mai-10

Jul-10

Set-

10

Nov-1

0

Jan-1

1

Mar-

11

Mai-11

Jul-11

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11

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31%

21%

0%

8%

20%

20% Gen IB

Dist IB

Supply IB

Gas IB

EdB

EDPR




PAGE 9/33

(Hidroeléctrica del Cantábrico) which is in control of generation, distribution and

supply of electricity. In the Portuguese market the electricity generation and

distribution is represented by EDP Produção and EDP Distribuição respectively.

Yet, EDP Distribuição is only responsible for the distribution network, as REN is

responsible for the transportation grid since 2007 as a consequence of the

liberalization process in the Portuguese energy market. In what concerns the

supply activity EDP is present in both regulated and liberalized markets though

EDP Serviço Universal and EDP Comercial respectively. However, this segment is

passing through a liberalization process and thus it is expected that all consumers

in the regulated market to be in the liberalized one until January, 2013. In other

words, the supply activity will be under market conditions (prices will be set in the

market and not through regulated tariffs) and will be represented exclusively by

EDP Comercial.

Regarding the Gas business in Iberia, we find EDP Gás in Portugal and Naturgas

in Spain, both responsible for distribution and supply activities. In Portugal the gas

business is working fully under market conditions since 2010.

EDP Renováveis (EDPR) is representing EDP in the renewable sector. At this

point, EDPR is the third largest producer of wind energy and its objective is

becoming the largest player in this market. In 2010 it increased its total capacity

by 1,101 MW (+19.7%) and held a market share of total wind capacity of 4.1% in

Europe and 8% in the USA.

Last but not least, EDP Group is present in the Brazilian market through Energias

do Brasil (EdB). In this country, EDP is the third largest private company of

electricity distribution. In the first half of 2011 EdB acquired the exploration rights

of Santo Antônio do Jari Hydro Power Plant with 300 MW of installed capacity.

Also, EDP launched a public offer in which it sold 14% of its position in EdB,

holding at the moment roughly 51%.

Summary

EDP is a leading company in the Iberian market, having around 20 GW of installed

capacity. It is becoming a greener company as a consequence of all investments

in renewable energies (in 2010 it represented 29% of the Group’s total installed

capacity compared to 3% in 2005) and also the increasing usage of greener

sources of energy. In the near future, EDP expects to use both hydro and wind to

produce the majority of the total electricity generation, instead of coal, since it is

Graph 8 - EBITDA per country (except EDPR)

Source: EDP

Sustainable growth driven by business diversification

EDP is facing a change in its supply business due to liberalization

53%

22%

25% PT

ES

BRA




PAGE 10/33

becoming a more expensive source and also does not contribute positively to the

legal constraints regarding carbon emissions. To achieve such ambitious

objectives EDP has a strong investment plan that accounts with a Capex of

approximately €2.1 billion per year until 2016, 80% of that amount allocated to

expansion projects.

Nevertheless, it is important to highlight all changes the company is facing. The

market liberalization process that has to be concluded until 2013 will imply that the

supply of electricity business will be fully under market conditions. Due to

regulation, EDP had a very stable level of revenues since it was not exposed to

changes in market prices; from 2013 onwards this will not happen anymore, and

thus the revenues of EDP will be affected by this volatility in market prices.

Additionally, EDP went through a privatization process. The companies evolved in

this process were E.ON, Electrobras, Cemig and Three Gorges Corporation

(CTG), being the last one the winner of Párpublica stake. The company paid €2.7

billion for the 21% Government stake in EDP. Three Gorges is a Chinese

company that has the world’s largest power station in terms of installed capacity

(21,779 MW in the end of 2010). This company is responsible for the construction

and management of hydroelectric plants. Its interest in EDP is mainly related with

the opportunity the company has to enter in the European market of renewable

energies, more specifically in wind, where EDP has a strong position. Goldwind, a

subsidiary of the Chinese group whose business is related to wind energy

production, will build in Portugal a production facility of wind turbines. This facility

is expected to be ready in the summer of 2013, and will contribute to national

exports with €500 million. According to Goldwind, this interest in Portugal is

related to the excellent natural conditions for the production of wind energy, the

country’s strategic location to export to occidental markets and its ambitious

energy policy based on objectives defined by the European Union. Goldwind is

one of the greatest producers of wind turbines facilities and the second major

company in the Chinese sector. The company contributes annually to the

installation of around 4,000 MW of wind power, value equivalent to the Portuguese

wind installed capacity3.

3 Source: Bloomberg, Goldwind Corporation

Párpublica sold its 21% stake on EDP to Three Gorges Corporation, a

Chinese company

Through the privatization process EDP can improve

its business’ operations




PAGE 11/33

Shareholder Structure

EDP Group comprises a total of 3,656,537,715 shares with a nominal value of 1€

each. 80.30% of these shares (2,936,222,980) are Category A, whereas the

remaining 19.70% are Category B. The difference between these two categories

is related to voting rights. Class A shares are limited to a maximum of 5% of total

voting rights, and are detained by private investors. Class B shares, on the other

hand, are the type of shares held by the Government and thus the ones that were

reprivatised, since they have no restrictions concerning transferability. Moreover,

they have no limitations regarding voting rights. As a consequence of this

difference in voting rights enabled the Government to have a huge control of the

company, since it owned around 20% of the voting rights, through Parpública and

CGD. Yet, as stated before, EDP went throughout the 8th stage of the privatization

process, in which the Government had to sell a minimum of 5% and a maximum of

21.35% of EDP’s share capital, with a minimum reference price of €2.2 billion. In

fact, Párpublica sold the total of 21.35% for a price equal to €2.7 billion. According

with the terms specified in DL n. º 106-A/2011 CTG will be obligated to maintain

its position on EDP for a minimum of three years and maximum of five years.

Through this alliance with CTG EDP is able to take some advantages. Firstly, EDP

will be among the electric companies with the lowest debt levels. This partnership

will allow EDP to reduce its Debt/EBITDA ratio by 41%; moreover, it will enable

EDP to be much closer to the Asian market. According with the written

communication made to the Portuguese capital regulator, Comissão do Mercado

de Valores Mobiliários (CMVM), the partnership with CTG includes a financial

commitment from a Chinese financial institution that amounts €2 billion with a

maturity of 20 years. Besides this, EDP credit profile will be reinforced, since the

company will have a financing viability until 2015 without needing to go to the

market4. Also, the fact that EDP is more connected with the Asian market will

enable the company to develop its business in Macau, through its participated

company Companhia de Electricidade de Macau (CEM), more related with clean

sources of energy. Another major change that is still under consideration is the

incorporation of EDPR in EDP’s business, as it happened with Iberdrola and

Iberdrola Renewable in May, 2011.

4 Source: Bloomberg

Table 1 - Voting rights (new shareholder structure)

CTG 21.35%

IBERDROLA 6.79%

CAJA ASTURIAS 5.01%

JOSÉ DE MELLO 4.82%

SENFORA SARL 4.06%

BCP 3.37%

NORGES BANK 2.76%

SONATRACH 2.23%

BES 2.12%

Qatar Holding LLC 2.02%

MFS 2.01%

Source: EDP




PAGE 12/33

EDP – Business Areas

Generation in Iberia

Long-term Contracted Generation

This is one of the most important areas since the beginning of EDP, given that it

was responsible for the production and distribution of electricity in Portugal.

Because it held the market of electricity production, it was subject to regulation,

and for many years all production of electricity was made under Power Purchase

Agreements (PPA). This scheme allowed EDP to face the minimum risk regarding

its revenues, since it faced no risk on volumes produced and it was not exposed to

market conditions regarding prices. Due to this low risk, EDP had great conditions

and incentives to expand its generation capacity in Portugal.

The PPA contracts were simple bilateral contracts, in which EDP had to sell its

overall production to REN, i.e. the electric system operator in Portugal. They were

remunerated according a capacity charge that is calculated based on a ROA

(Return on Assets) equal to 8.5% plus both depreciation and maintenance costs,

updated to inflation. Also it takes into account an energy charge minus fuel costs

that is a pass-through process.

In 2004 began the liberalization process of energy market between Portugal and

Spain, and agents verify that the basis of PPA contracts were against the concept

of a competitive and open market in Iberia. As a consequence, PPA had to be

replaced by other types of contracts that corresponded to the ideal of a liberalized

market, but at the same time that would ensure the NPV (Net Present Value) of

PPA contracts. These new agreements were called Contract for Maintenance of

Contractual Equilibrium (CMEC). Their creation was proposed in 2004 but the

replacement took place in 2007, the year that MIBEL initiated its activities. The

value of CMEC is just the difference between the annual remuneration under PPA

and the revenues obtained under market conditions. If this difference is positive

EDP is entitled to return the difference, otherwise it will receive compensation.

Under CMEC EDP ensures stable gross profit since allowed revenues are the

ones under PPA contracts, and the pass-through process eliminates the market

volatility on fuel prices and volumes. However, there is an operational risk related

with the availability of plants that work under PPA. If there is any plant that is not

Table 2 - PPA Maturities

Miranda 2013

Bemposta 2013

Picote 2013

C. de Bode 2015

V. Nova 2015

Cabril 2015

Alto do Rabagão 2015

Caniçada 2015

Bouçã 2015

Salamonde 2015

Sines 2017

Fratel 2020

Vilarinho 2024

Alto do Lindoso 2024

Source: EDP

LT contracted generation represents approximately

22% of Group’s EBITDA




PAGE 13/33

available, for instance because the plant is passing through maintenance, this will

result in an adjustment in the gross profit.

Integrated in this business segment we have also generation of electricity in

Portugal and Spain through Special Regime (PRE), which includes Small-Hydro

(Portugal), Cogeneration (Portugal and Spain) and Biomass (Portugal). This area

has experienced some growth in installed

capacity, as we can see by Graph 9, still it is

expected some decrease in electricity

generation through these sources in 2011

onwards due to the slow of economic activity,

as shown in Graph 10. Hence, this segment has

inherent some economic risk, but also

environmental and regulatory risks. Regarding

the first source of risk, it impacts cogeneration

because plants work at a lower level, diminishing the amount o heat produced by

its activity. The same happens with biomass. The slow of economic activity entails

that less biomass residuals will be produced, and therefore its availability for

electricity production will be lower. About environmental risk, it affects mainly the

mini-hydro source, since it is highly dependent on weather conditions. Last but not

least, there is some regulatory risk as the future regulation in this segment can

change anytime. Nevertheless, this segment has no volume risk as all production

is acquired by EDP Serviço Universal, the last resort supplier. Besides all these

risk, Special Regime production provides to EDP a fairly stable gross profit since

the price depends on the characteristics of each source, i.e. it is known in

advance, and also depends on inflation, for which we have forecasts.

Analysis

By the analysis made before, we see that this business area has been important

for EDP, because it provides to the company a stable gross profit and a stable

source of cash-flow, known in advance without major risks associated. Because

this is true it leaves EDP without margin to manage any extra revenue from this

segment. Moreover, some plants are close from the ending period, as shown in

Table 3, and they will be operating in the liberalized market or will be shut down.

Due to this fact, the revenue that comes from this segment is decreasing over

time, which makes EDP more and more exposed to the market, meaning that over

the years revenues coming from the liberalized market will increase. This has

inherent a growing risk (the market risk), which may compromise the stability of

Graph 9 - Installed Capacity of PRE (MW)

Source: EDP

Graph 10 - Electricity Generation through PRE (GWh)


CMEC as a source of stable revenues until

2017...

Special Regime production is highly affected by economical conditions

0

100

200

300

400

500

2007 2008 2009 2010

Biomass (PT)

Cogeneration+Waste (PT and ES)

Small-Hydro (PT)

0

500

1.000

1.500

2.000

2.500

3.000 Biomass (PT)

Cogeneration+Waste (PT and ES) Small-Hydro (PT)




PAGE 14/33

this business segment. A way to decrease the exposure to this growing risk is to

continue to invest in this segment but only if the cost of investing is lower than the

ROA it has intrinsic; however it is subject to regulatory approval.

Liberalized Generation

This business segment has experienced a huge growth in installed capacity as the

company has been investing a lot on it, namely in greener and more efficient

sources. This was a very important decision since the least efficient and greener

sources, like coal and

gasoil, will be penalized in

terms of CO2 emissions,

since their costs will

increase in the future,

according to EIA. In

Portugal EDP has been

increasing hydroelectric

installed capacity due to

both facts pointed before.

Table 3 shows the hydro

projects that are under

construction, being the majority of them repowering of existing plants. Also, there

are some plants that are currently working under PPA contracts that will shift and

contribute to liberalized production, since EDP has secured the concessions after

their expiration. As we can see from Table 2, there are 3 plants with a production

capacity of approximately 2.5 TWh that will shift from regulated to liberalized

market in December, 2013 (Miranda, Bemposta e Picote), and 7 plants, with 1.8

TWh production capacity, that will shift in December, 2015 (C. De Bode, V. Nova,

Cabril, Alto do Rabadão, Caniçada, Bouçã e Salamonde), which also contributes

to the increase in hydro installed capacity. By investing in hydro, EDP is creating a

strategic advantage in Portugal since it has major unexplored potential, mainly

due to the specific conditions of the country. However, we know that this source of

energy has inherent an environmental risk, since it depends on weather

conditions. It has also some operational risks related to transportation costs, as

plants are usually situated far from consumption centres.

Table 3 - Hydro evolution (MW)

2011 2012 2013 2014 2015 2016 2017

Salamonde (Rep) 207

Vendas Novas III (Rep) 736

Picote (Rep) 246

Bemposta (Rep) 191

Alvito (Rep) 224

Alqueva (Rep) 256

Fridão 237

Foz Tua 251

Baixa Sabor 171

Total 0 437 256 0 422 1.167 237

Source: EDP

Graph 11 - Hydro Installed Capacity (MW)

Source: EDP and Analyst estimates

Liberalized production has an important role on EDP business

0

1.000

2.000

3.000




PAGE 15/33

Analysis

By doing these investments in new hydro plants, securing the concession of

existing plants working under the regulated market and the repowering of some

plants, gives EDP some room for growth in

the liberalized market. These actions are

crucial since it is expected a boost in the

liberalized market, due to increase of both

prices and demand. Looking to Graph 12

we see the growth of this business

segment and the implications for EDP

revenues. Nonetheless, we know that this

pace is not sure and perhaps it will be

slower than predicted since the economy

has been struggling to surpass this economic crisis. Moreover, because the hydro

source has an environmental risk, the path of the load factors5 is quite unsure. For

these reasons, the load factors considered were in line with the previsions of both

EIA and EDP. Regarding the other sources of electricity working in the liberalized

market, as Coal, CCGT and Nuclear, we took into account previsions published by

EIA as well, but also the evolution of EDP’s installed capacity. Coal is a source of

energy that has many negative implications for the environment. In our forecasts

we considered that the usage of this source will decrease over time (according to

EIA), however at a very slow pace, since it represents a high percentage of the

installed capacity in EDP. For CCGT is expected a huge growth for being a green

source of energy, and because it does not have high costs associated with CO2

emissions. Regarding the nuclear power, we do not know how it is going to evolve

over time, since this source was highly affected by the earthquake in Japan. We

considered that the load-factor will remain stable, according to historical data.

Distribution in Iberia

This business segment includes the distribution of both electricity and gas, and is

fully regulated by ERSE (Entidade Reguladora dos Serviços Energéticos), the

regulator entity that defines the tariffs, parameters and prices for electricity,

controlling and assuring the levels of quality and service demanded by DGGE

(Direcção Geral de Geologia e Energia). In Portugal EDP Distribuição is in charge

of the business of electricity and is responsible for the Portuguese distribution grid;

5

Graph 12 - Regulated and Liberalized Production (PT & ES)


The investments made in hydro leads EDP to accomplish its target related to the reduction of

CO2 emissions

A fully regulated activity...

0%

20%

40%

60%

80%

100%

% Regulated

% Liberalized




PAGE 16/33

EDP Gás is in the gas business, which operates in the low-pressure natural gas

distribution grid in Porto, north of Portugal. However, EDP is not responsible for

the transportation of the electricity or its management. Instead, we have REN

(Rede Eléctrica Nacional) that is in charge of this area. In Spain we have HC

Distribución that operates in the Spanish distribution grid, and Naturgás also

operating in the Spanish distribution and transportation grids of natural gas. Yet,

the organization of the networks in Spain is quite different from the one in

Portugal. In Spain there is REE that has the same responsibilities as REN, but

some parts of the network are operated by the Spanish subsidiaries.

Analysis

Due to its regulated nature, this area provides EDP a stable gross profit, since it is

not dependent on market conditions or fluctuations on demand. The gross profit

for these areas is calculated based on a Regulated Asset Base (RAB) and a

return based on these regulated assets, which we will call Return on Regulated

Asset (RORA), also settled by the regulator. Also, regulator accepts working

capital expenses that usually are indexed to inflation. In January, 2012 will start a

new regulatory period for electricity business in Portugal, in which the regulator

will define the regulatory framework applied for the next 3 years (until 2015).

According to ERSE, RAB will be stable, €2.8 million, and RORA will be around

9.5%. The calculation method for RORA changed due to changes verified in the

market. Previously, RORA was calculated based on 10-year Portuguese

Government Bond plus 400 basis points. For this regulatory period ERSE decided

to use Portuguese 5-year CDS (Credit Default Swaps). According to ERSE this

new indicator incorporates the risk perception by the market agents regarding our

economy. In other words, Portuguese CDS prices will be a proxy for the

difference between the risk-free rate in the euro area and the risk perceived by

the market for the national economy. They used a 5-year period since it is closer

to the regulatory period length, and because ERSE considers that it may

incorporates the medium and long run evolution perspective for Portugal6. The

costs accepted by ERSE are around €1 billion. In Spain, the regulator reviews the

method of calculation yearly, which creates uncertainty about the future. Still, the

calculation process is the same. Regarding the Gas business the regulatory

periods also differ from the ones in electricity, in Portugal and Spain. In Portugal

the regulatory period for this segment is equal to 3 years and the next review of

the regulated parameters will occur in July, 2013. In Spain, the regulatory period is

6 Source: ERSE

Table 4 - Regulatory Periods for Distribution of Electricity and Gas

Reg. Period

Next Reg. Period

Electricity PT 3 years Jan-12

Electricity ES 1 year Jan-12

Gas PT 3 years Jul-13

Gas ES 4 years Jan-14

Source: ERSE

Positive regulatory outlook

for both Portugal and Spain




PAGE 17/33

equal to 4 years, and the next revision is expected to happen in January, 2014.

Although it has a stable gross profit free from market fluctuations due to

regulation, this segment experiences a regulatory risk that does not leave EDP

room for growth. But the length of the regulated periods enables EDP to develop

strategies to take the best part of each these segments. Related with this area we

have the tariff deficit of both Portugal and Spain. Regarding the first, we know that

great part of it was securitized contributing to the decrease of EDP’s risk in this

slice. Still, Spanish tariff deficit does not passed through this process and is has

becoming a much serious problem. At the moment the Spanish tariff deficit

amounts €22 billion, and EDP holds €549.1 million through its Spanish subsidiary.

In the beginning of 2011 EDP received €102.5 million from the Spanish Electricity

Deficit Amortization Fund7.

Supply in Iberia

As the distribution segment, EDP is responsible for the supply of electricity and

gas, in Portugal and Spain. Conversely, this segment is much less regulated than

the previous one. Regarding the electricity business in Portugal it is represented

by EDP Serviço Universal and EDP

Comercial in the regulated and

liberalized market respectively. In

Spain the supply of electricity is fully

liberalized, and EDP is represented in

this segment by HC Energía. In the

gas business, we find EDP Gás in

Portugal and Naturgas in Spain. The

supply business is almost fully liberalized. Gas business in Portugal is quite

recent, since it began in 2009; therefore it has room for growth. The gas business

in Spain, however, is a much more consolidated business, since it had

experienced some acquisitions in 2009/2010.

Analysis

As stated before, supply of electricity in Portugal is passing through a liberalization

process, which means the regulator (ERSE) will not influence revenues of this

business segment, and prices will be settled by the market. Under this scenario,

EDP clients have two alternatives. The first is to shift their services to the

liberalized market and pay the prices that EDP proposes to them. On the other

7 Source: EDP

Graph 13 - Gross Profit of Supply PT (€ thousand)


160.000

170.000

180.000

190.000

200.000

210.000

2010 2011E 2012E 2013E 2014E 2015E

Gross profit less predictable due to business exposure to

the liberalized market...




PAGE 18/33

hand, they can shift supplier, going to other company. At this moment, we have

other companies operating the Portuguese market, as Endesa. We believe that

this process of liberalization is a consequence of the complex interaction between

the regulated and open market. Basically, demand on the liberalized market was

closely connected to prices settled by ERSE. If electricity prices were higher than

the one on the liberalized market, consumers would shift to regulated market. If

the contrary situation was verified, consumers would shift to the liberalized market.

As a consequence of the liberalization process, we had to consider in our

valuation model the move of clients to liberalized market, or to other competitors.

This shift was made at a slower pace, but with the objective of the fully

liberalization in 2014, since it will be difficult to shift all clients until 2013, according

to EDP and ERSE.

Supply of electricity and gas is facing another issue that can shiver expected

revenues for this area. Recently, the Portuguese Government decided to increase

VAT (Value Added Tax) from 6%, the rate applied to essential goods, to 23%, the

rate that is applied to general products. This means that if a consumer maintains

his/her electricity consumption, the value that he/she will pay in the end will be

higher. However, this increase is not reflected in an increase of EDP’s revenue.

We know that EDP’s client portfolio assembles two types of consumers: private

ones (families and particular houses) or, in other words, normal low-voltage

clients, and industrial ones, which gathers medium/high-voltage and very high-

voltage. This increase in taxes only will affect private consumers, since companies

can recover it. Accounting with this fact, we can analyse this effect, only taking

into account consumption from private clients, through the price-demand elasticity,

bearing in mind that electricity is a good that cannot be easily replaced. In the very

short term the effect of this tax increase on revenues will be zero, since

consumers will not feel this change in the moment of its implementation, meaning

that demand is practically inelastic. However, throughout time this elasticity is

expected to increase. In the short-medium term elasticity may assume values

between 0 and 0.5, since consumers will see that the amount they are paying is

higher. Thus, they will cut their expenses in other goods that can be easily

replaced by others very similar instead of cutting in the electricity consumption. In

the long run elasticity will be close to 1 as people will opt to change their

equipments for ones that use greener sources of energy8. However, this effect is

much more complicated to include in our valuation model than it seems, because

8 Source: Mark A. Bernstein, James Griffin in “ Regional Differences in the Price-Elasticity of Demand for Energy”

Graph 14 - Clients by voltage in Portugal

Source: EDP

VAT increase will have some implications on final

consumers...

0

10.000

20.000

30.000

Very high High/Medium Low

9M11 2010




PAGE 19/33

it will have effect in many variables. This decrease in consumption will affect

energy supplied and may affect also load factors; if consumers decreased their

utilization, power plants will not need to produce so much electricity, and so

electricity production will be adjusted to demand. Still, it will not affect the sale

price directly, since it is settled by the market, i.e. by the Iberian pool (OMIP).

Instead, the cost related with the overall system (present in the client receipt) will

increase. This new situation may also bring other issues. If clients’ bill will increase

it may happen that some people will not be able to pay it in the end of the month,

which will impact accounts receivable of the company (it will increase), and, who

knows, perhaps Provisions. Given these accumulated effects, the Government

may act, saying that the tariff charged to costumers will decrease, resulting in an

increase of the Portuguese tariff deficit. For EDP, this may penalize its liquidity,

which could lead to a debt increase. Besides all these possible effects, we

considered the decrease in demand in our valuation model, but in a very simple

way so that the model remained feasible and easily understandable.

In this business segment, the major risks associated are the market risk and

economic risk. Since this activity is majorly liberalized and works under market

conditions, it is subject to market fluctuations and volatility, which turns gross profit

quite unstable and uncertain. Also, it has inherent economic risk because the

market responds quite directly to economic conditions. For instance, during this

period of crisis, prices went down and so the gross margins obtained by EDP.

EDP Renováveis

EDP Renováveis (EDPR) is a company that is responsible for the design,

development, management and operation of power plants that produce electricity

from renewable sources. The company appeared in 2007 as an EDP holding

consequent from the participations that the company had in NEO Energia and

Horizon Wind Energy. In June, 2008 EDP listed 22.5% of EDPR in an IPO on

Euronext Lisbon, and since then it has been a listed company in Lisbon Stock

Exchange market, as a member of the benchmark PSI-20 index being the fifth

largest company by market capitalization. Nowadays, EDPR is the third largest

player in the world wind energy (based on installed capacity) and is seen as a top

three company that as the major growth potential in the sector.

EDPR is present in three main geographic areas, North and South America, and

Europe. At the moment the company operates more than 180 wind farms in these

markets and has other plants under construction in Italy, Canada and the UK. In

Graph 15 - Cumulative returns EDPR vs. PSI20

Source: Bloomberg

EDPR represents 22% of the Group’s EBITDA

55%

65%

75%

85%

95%

105%

Jan-1

0

Mar-

10

Mai-10

Jul-10

Set-

10

Nov-1

0

Jan-1

1

Mar-

11

Mai-11

Jul-11

Set-

11

Nov-1

1

PSI20 EDPR




PAGE 20/33

Europe the company is present in countries like Portugal, Spain, France, Belgium,

Poland and Romania But is the Spanish market that represents the biggest

European player in terms of installed capacity, as we can see in the Graph 16,

mainly because it is in Spain the company has the major pipeline in Europe. At the

moment, EDPR has an installed capacity of 7,280 MW, with 490 MW still under

construction. The load factors the company presents are higher than the market

average, which contributes positively to the strong performance of the company.

The average load factor of the current portfolio is about 29% while for the new

projects is around 30%9. This fact is very important, since it reveals EDPR’s ability

to choose projects that are able to generate more revenues than the previous

ones, contributing positively for the company to become a reference in wind

generation.

EDPR, as EDP, is a highly regulated company, with more than 90% of its portfolio

being subject to regulated frameworks of long-term contracts. However, the

regulation varies according to the

market that we focusing our

attention. Regarding the European

and Brazilian markets it is expected a

price stability granted by regulation

and long-term contracts. The UE

mandatory targets for 2020 indicate a

strong growth in wind market. The

20% quota of renewable energy sources for electricity generation remains

unchangeable, with wind onshore being the major contributor for the renewable

capacity growth10

. In USA there is a huge incentive to invest in green sources of

energy, since utilities acquire these sources in the form of long-term PPA. Plus,

wind farms receive tax incentives that can be in a cash format, representing a

percentage of the initial investment, or in the form of a production credit updated

to inflation in the first 10 years of the investment.

Analysis

EDPR represents a company that has a huge growth potential, mainly driven by

the growing environmental concerns. We believe that the company will continue to

receive some Governmental support, from both USA and Europe, as they have

9 Source: EDP Renováveis

10 Source: EDP Renováveis

Graph 16 - Installed capacity of EDPR (MW)

Source: EDPR

The environmental concern is a major source of growth for EDPR

0

500

1.000

1.500

2.000

2.500

3.000

3.500

2009 2010 9M2011

Spain

Portugal

Rest EU

US




PAGE 21/33

committed with the change in uses and sources of energy, and also have some

targets they compromise themselves to reach.

Regarding the contribute of EDPR as a company inserted in the EDP Group, we

believe that EDPR represents a great alliance, since it will help EDP to achieve

environmental targets, and also will contribute for a cost reduction related with

CO2 emissions. EDPR is the major investment area in the group, representing

around 40% of its total Capex.

Energias do Brasil

Energias do Brasil (EdB) is the EDP Brazilian holding that detains investments in

the energy sector, operating in the generation, distribution and supply of electric

energy. It is present in the generation business in 6 Brazilian states (Espírito

Santo, Mato Grosso do Sul, Tocantins, Ceará, Santa Catarina and Rio Grande do

Sul) and in the distribution segment in 2 states (São Paulo and Espírito Santo),

through 2 distribution concessions, EDP Bandeirante and EDP Escelsa

(respectively). At the moment, EdB has an installed capacity of 1,827.9 MW, in

which 37.8 MW are renewable sources. Also the company has some plants under

construction and repowering, in Amapá, Ceará and Espírito Santo, that amounts

808 MW. As showed in Table 5, EdB expects to have an installed capacity of

2,570 MW in 2015. This holding is listed in the São Paulo Stock Exchange market

since 2005, in Bovespa index. During this year EDP launched an IPO in which it

sold 14% of its stake in the Brazilian company. At the moment, EDP holds a stake

of 51%.

The businesses of generation and distribution in Brazil are highly regulated, being

the majority of the electricity supplied under PPA contracts. EdB generates electric

energy based on coal and hydro power plants (except renewable), both with a

PPA average maturity equal to 15 years, with prices updated at Brazilian inflation.

Hydro PPA contracts lasts until 2024 and Coal PPA matures in 2026. Regarding

the electricity distribution of both Bandeirante and Escelsa, it is fully regulated and

their remuneration is defined by Agência Nacional de Energia (ANEEL), the

Brazilian regulator of the energy sector. As in Portugal, their revenues are

calculated based on a RAB and a RORA (after taxes). There are regulatory

periods in which these values are discussed, but they differ among both

distributors, as showed in Table 6. In July, 2010 and in September, 2011 was

settled a RORA for both Escelsa and Bandeirante (respectively) equal to 9.95%

after taxes.

Table 5 - Installed capacity evolution for EdB (MW)

Start operating

MW

UTE Pecém 2012 360

UHE Mascarenhas 2013 9

UHE St Antônio Jari 2015 373

Installed Capacity 2011 1.828

Installed Capacity 2015E 2.570

Source: EdB

Graph 17 - Cumulative returns EdB vs. Bovespa

Source: Bloomberg

Energias do Brazil’s EBITDA represents 21% of Group’s EBITDA

65%

85%

105%

125%

Jan-1

0

Mar-

10

Mai-10

Jul-10

Set-

10

Nov-1

0

Jan-1

1

Mar-

11

Mai-11

Jul-11

Set-

11

Nov-1

1

IBOV ENBR3




PAGE 22/33

Analysis

As said before, the fact that this business is greatly regulated enables EDP to

have a stable gross profit from this part of the business, which makes us conclude

that EDP’s presence in Brazil is fairly strategic and consistent with the company’s

goals of having a low-risk profile regarding its operational side. The power plants

named in Table 5 will be under PPA contracts and will be active for 15 years after

their starting point in operations.

The Brazilian market is also experiencing a huge growth. Brazil has passed

through a quite short and soft recession (2008-2009) from which the country

recovered quite well and faster than predicted by the local Government. Due to

this fact, agents have been concerned with the Brazilian economy, since it is

expanding too rapidly and it is

possible that in the near future the

speedy growth in demand will not be

met by increases in output, leading

to higher prices and elevated

inflation. In fact, the Central Bank of

Brazil was the first to increase

interest rates in order to slow the

pace of economic growth. However,

this favorable economic growth is also led by domestic and foreign investment, as

well as domestic consumption. According to EIA, electricity demand will increase

around 4%-5% in the next 3 years (the prospects for inflation and GDP are

showed in Graph 18), which is consistent with the fast-paced growth.

Nevertheless, this situation may boost future investments in installed capacity

since there is a need for supply-side to trail the increase in demand.

Graph 18 - Inflation and GDP previsions for Brazil

Source: IMF and EIA

Table 6 - Regulatory Periods for EdB

Reg.

Period Next Reg.

Period

Bandeirante 4 years Sep-15

Escelsa 3 years Jul-13

Source: EdB

EdB included in a fast-pace

growing economy 0,0%

1,0%

2,0%

3,0%

4,0%

5,0%

6,0%

7,0%

2011 2012 2013 2014 2015

Inflation BRA*

PIB BRA*




PAGE 23/33

Valuation

In order to evaluate EDP Group in a proper way we used the Sum of Parts (SoP)

method. Basically, we have evaluated each business area individually so that we

could consider all risks inherent to every single business. For each area we have

constructed provisional maps, as the Income Statement, Balance Sheet and

Statement of Cash-Flows. Our evaluation is based on the Discounted Cash-Flow

method (DCF). We used a provisional interval of 5 years (2011-2016). In the final

stage of the evaluation we discounted FCF and the Continuing Value at the

Weighted Average Cost of Capital (WACC) that differs among areas, reflecting all

treats and benefits of each area. Because there is a significant level of uncertainty

about the future of the economy that, in our opinion, affects EDP as well, we

decided to make a scenario analysis and consider it to calculate our price target.

For that, we built a basic scenario that is described in the “Methodology”, and a

bad scenario in which we assumed that the Portuguese economic environment

continues to deteriorate over time, near default level.

Methodology

Given the business complexity, some assumptions were made regarding the

several business areas so that the evaluation model could be feasible and easily

understandable. They are explained in the following points. Regarding EDPR we

considered the market value, which consists in summing up the market

capitalization of the company with the most recent information about the

company’s net debt (9M2011).

Gross Profit

The calculation of Gross Profit with respect to each area accounted with the fact

that some business areas are present in both regulated and liberalized markets.

Regarding Generation in Iberia we took into account both Sales and Costs related

with Sales for CMEC in Portugal, Special Regime and the Liberalized market. The

gross margin of CMEC was known in advance, however some adjustments were

made, namely the passage of some power plants to the liberalized market. About

the Special Regime generation, we assume the gross margins to grow at

expected inflation rates.

Calculating the gross profit coming from the liberalized market involved more

calculations. We estimated the evolution of installed capacity of power plants

Graph 19 - Liberalized Inst. Capacity (MW)


Different WACCs were used to account with different

sources of risks

The main focus was on separating regulated from

liberalized business

6.000

6.500

7.000

7.500

8.000

8.500




PAGE 24/33

working under market conditions, as coal, CCGT, nuclear and hydro, in both

Portugal and Spain. For hydro we considered the information present in Table 3;

for the other 3 sources of energy we assumed expectations from EDP and EIA

report. We calculated the electricity that would be generated with the available

installed capacity, and for that we used the load factors11

. We used historical

information and previsions from EIA to set future load factors (see Table 7). To

obtain Turnover we analyzed the trend of future prices of electricity that are traded

in The Iberian Energy Derivatives Exchange (OMIP)12

. However in this market are

only traded energy futures until 2013, thus for this year onwards we updated

prices at expected inflation. Regarding costs associated with production we used

historical prices and also considered that they will grow at inflation.

For the remaining regulated areas we applied expectations from the market

regulators, while for the other liberalized business areas we considered gross

margins calculated with historical data, however accounting with some future

changes in the business, like the increase of VAT that will impact mainly the

Portuguese supply business.

Operational Costs

Operational costs were calculated based on each area’s activity, i.e. the areas that

have more activity are the ones that will have higher operational costs.

Historically, operational costs evolved in a fairly stable way with gross profit

evolution, thus this assumption was taken to estimate future operational costs.

Capex

According to EDP, since the group has an ambitious investment plan, they

predicted an annual Capex of €2.1 billion until 2016. However, due to the current

situation of the global economy and also due to the high level of debt the company

has, we believe that EDP will not be able to support such target. Therefore, we

assumed Capex levels that are shown in Graph 18. The 2011 Capex reflects the

postponement of the construction of Alvito plant that has a value of €360 million.

Yearly Capex was used to calculate PP&E13

.

11

12

OMIP was a result of MIBEL creation 13

We calculated PP&E based on the following expression:

Table 7 - Average Load Factors

Hydro 23%

Coal 32%

CCGT 32%

Nuclear 90%

Small-Hydro 27%

Cogeneration+Waste 70%

Biomass 54%

Source: EIA and Analyst estimates

Graph 20 – Capex projections (€ million)

Source: Analyst estimates

Historical data played an important role on forecasts…

1.700

1.900

2.100

2.300

2.500




PAGE 25/33

Weighted Average Cost of Capital (WACC)

The WACC used to calculate the value of all business areas was constructed in a

way that it could reflect the major risks of each area; still it only reflects systematic

risks. As we have been saying along this report, the major risks associated to EDP

business are related with regulation. WACCs used in the valuation model are

presented in Table 8.

Table 8 - WACC calculation

Regulated Liberalized PT ES PT ES BRA

rd 6.1% 6.1% 6.1% 6.1% 11.4%

rm-rf 6.0% 6.0% 6.0% 6.0% 6.0%

β 0.81 0.81 1.38 1.38 1.95

rf 2.5% 2.5% 2.5% 2.5% 2.5%

β CR 1.6 1.72 1.6 1.72 1.95

re 10.3% 10.9% 15.8% 16.7% 13.6%

E/EV 38.5% 38.5% 38.5% 38.5% 65.0%

D/EV 61.5% 61.5% 61.5% 61.5% 35.0%

t 26.5% 27.5% 26.5% 27.5% 34.0%

WACC 6.71% 6.89% 8.80% 9.15% 11.49%

Source: Bloomberg and Analyst estimates

To compute the cost of debt we decided to use the current yield to maturity (YTM)

of EDP’s debt emissions (8.92%), since it reflects the opportunity costs of

investing in EDP. We could have used YTM as a proxy for EDP’s cost of debt, but

only if the expected return was equal to the promised return, which is not quite

true in this case. Therefore we needed to account with other two factors to

achieve an accurate cost of debt, and they are: the probability of default and the

recovery rate14

. A probability of default equal to 6.52% was obtained through a 10-

year average cumulative default rates correspondent to EDP’s current rating; the

recovery rate used is according to Moody’s loss given default (LGD) assessment,

which was approximately 65% for EDP15

. Running the calculations we got a Cost

of Debt for EDP equal to 6.1%. Moreover, we assume it to be equal across all

business areas because it is EDP (and not each business area individually) that

goes to the market and finances itself.

For the market risk premium we assumed it to be equal to 6%, since it is usually

between 4% and 6% during crisis periods16

. Since the economy is still quite

unstable and feeling the consequences of the previous financial crisis, we

14

15

Moody’s Investors Service in “Corporate Default and Recovery Rates, 1920-2008”, February, 2009 16

Mehra, R., Prescott, E.C. in “The Equity Premium in retrospect”

WACC was calculated so that EDP’s major risks could be considered




PAGE 26/33

consider that in the near future market risk premium will be higher than in the past,

therefore we use a 6% value.

Industry betas (β), i.e. betas of comparable firms, were used to calculate EDP’s

beta. We ran regressions using 4 years of monthly data against the Euronext 100

(N100) index17

. The results obtained are presented in Table 9. In order to make it

usable for EDP we had to unlevered all betas considering the market capital

structure of each company. To obtain a beta for EDP in both regulated and

liberalized markets we separated the companies according to its business

structure (% Liberalized business), average the betas and re-levered them at

EDP’s expected market capital structure.

For the risk free (rf) rate we used the 10-year average (3-year period) German

Government bond yield, even for the Brazilian WACC since revenues are

denominated in Euros.

Since WACC has to include all systematic risks, we decided to consider in its

calculation the country risk (CR). When we computed EDP’s beta we used

companies from different countries, just accounting with the risk inherent to their

business. In our opinion the fact that EDP is inserted in various countries, such as

Portugal, Spain or Brazil, confers to it a stake of risk we consider to be systematic,

and that is not reflected in the company’s beta. Therefore, we considered the

country risk through a beta that basically reflects the country’s exposure to world

events. It was calculated by dividing the volatility of the local index (PSI 20, IBEX

35 and Bovespa for Portugal, Spain and Brazil respectively) by the volatility of a

global index (S&P Global 1,200)18

. However, according with the formula, we have

to consider a , which is the correlation between the indexes. In this case

we assume it to be equal to 1, meaning that the crisis is systemic and

there is a contagion effect. The way that we reflected this country risk in

WACC was through the cost of equity (re)19.

In order to include in the most accurate way the liberalization process that EDP is

facing we decided to weight WACC along the projection period according to

variation in all businesses’ regulation. In other works, as a business is becoming

17

The regression was the following: , where R stands for excess return 18

19 Cost of Equity:

Table 9 - Comparable's betas

Levered Unlevered

EDF 0.99 0.54

RWE 0.89 0.46

Iberdrola 1.02 0.50

REE 0.71 0.71

REN 0.43 0.17

Endesa 0.81 0.51

E.ON 0.98 0.62

Terna 0.41 0.26

Enagás 0.69 0.33

Source: Analyst estimates

The country risk was also considered in the

WACC through a β




PAGE 27/33

more and more liberalized, the WACC related with the liberalized business will

become more significant when discounting FCF.

Scenario Analysis

As we know, the world is facing a very difficult situation related with the debt

sovereign crisis. Since 2009 that an increasing fear appeared among investors

from all over the world related with the rising government debt in all economies

together with the successive downgrades from some European economies. In

2010 this fear assumed a position so strong in the market that some Euro

countries, as Greece, Portugal and Ireland, start to face several issues regarding

the re-financing of their debts.

Greece was a strong economy in the early-mid 2000s, and so the government

took advantage of this by

increasing largely its debt.

However, when the

economy struggled in latest

2000s, Greece’s main

industries (tourism and

shipping) were hardly

affected because they are

very sensitive to business

cycles. As a consequence,

Greece’s debt starts to be rapidly accumulated.

In Ireland the situation was quite different, since its sovereign debt crisis was not

related with government over-spending, but related with guarantees given by the

government to Irish banks for the financing of a property bubble. In 2007, with the

burst of the property bubble, banks faced a €100 billion loss, as property

developers and homeowners defaulted on their huge loans.

The Portuguese crisis development was quite similar to Greece’s one, as during

more than 30 years government encouraged over-expenditure and incurred in

several high investments, considered to be unnecessary and inefficient.

As we can see, the way that countries involved themselves in this crisis was

different, however, due to the interconnection in the global financial system, all of

them ended by facing losses. As a consequence, there is an increasing fear

Graph 21 - Public debt (in $ billion) as a % of GDP of several countries (2010)

Source: Bloomberg

83%; 2.752

83%; 2.144

76%; 1.708

60%; 821 93%; 214 95%; 194

119%; 2.445

143%; 436

0

1.000

2.000

3.000

55% 75% 95% 115% 135%

German

France

UK

Spain

Portugal

Ireland

Italy

Greece

The sovereign debt crisis showed that the world was more globalized that it was

thought…

Countries were affected by the crisis in different ways; however the final result was the same…




PAGE 28/33

related with the spread over other European countries, and so some measures

were presented. Euro countries and IMF agreed to start a bail-out to these

countries. They borrow € 110 billion to Greece (May, 2010), €85 billion to Ireland

(November, 2010) and €78 billion to Portugal (May, 2011) together with ruthless

austerity measures. As a result of these efforts and some others assumed by the

Portuguese government, as the transfer of pension funds and the tax increase, in

December, 2011 was reported that Portugal would be able to get a 4.5% budget

deficit in 2011, substantially lower than previously estimated.

Due to the uncertainty that surrounds the all economy, specially these countries’

success in surpassing this tough situation, we decided to study what would be the

effect on EDP’s price target in the case in which Portugal is not able to meet

previsions from IMF regarding budget deficit. However it is important to highlight

that we will only work this scenario in terms of variables that are related with

EDP’s business (i.e. diversifiable risks), and not with, for instance, changes in

WACC because we stated that it already incorporate all risks that are systematic

and, therefore, all possible future scenarios.

Worst case scenario

In order to construct this scenario we took into account several details, some

related with the Portuguese economy, and others related with EDP’s situation in

case that Portuguese economy goes to a worst situation than today’s one. We

started to think what would happen if Portugal’s situation get worst.

Firstly, if Portugal continues to show signs of contraction and inability of achieving

targets settled by IMF, the risk associated with the country would increase. This

may lead to a decrease in inflation and GDP expectations. Consequently, EDP

may also be affected since it is in Portugal that the company has its core

business; if the country risk increases its business that are in Portugal will be

affected. At this point we can also consider two different cases. We can assume

this situation will only affect Portugal and the business areas in Spain and Brazil

will not be affected. However, this does not make much sense, since previously

we said that the market is characterized by a high level of contagion; therefore,

the other point is assuming that the Portuguese situation will affect other

countries, thus EDP’s business in Spain might also be negatively influenced.

Regarding Brazil, we may assume that it will be not affected since its economy is

quite different from both Portuguese and Spanish ones. It represents an economy

that has a high growth potential and already shown to be immune to what

Through scenario analysis we can have an idea of how future changes will affect EDP’s price target

The Portuguese situation worsening may have no impact on the Brazilian economy

GDP and inflation expectations may be negatively affected if Portuguese condition gets

worst…




PAGE 29/33

happens in the world (as said before, Brazil did not strongly feel the negative

impacts of the debt crisis).

Having some idea about the Portuguese economic outlook and its consequences,

we will analyze its impacts in each EDP’s business area separately. Beginning by

the generation area, we know that EDP has an investment plan that covers the

increase of the company’s installed capacity (see Table 3). If the Portuguese

economic situation gets worst EDP will not be able to sustain its investment plan,

and therefore some projects will be postponed or even canceled. Also, the supply

business will experience a downturn since demand for electricity will decrease (the

elasticity will be higher than in the basic scenario). If it is expected a decrease in

demand, we may also expect that available plants will produce below average,

therefore load-factors might suffer a decrease as well. Regarding the distribution,

it is dependent on regulation, not varying so much with economic cycle. Perhaps

we may suppose that regulation will change, however this effect is quite

complicated to quantify.

Running these expectations in our model we achieved a price target for 2012

equal to €2.18. Basically, we changed our expectations regarding the evolution of

EDP’s installed capacity, demand for electricity, and both inflation and GDP

growth rates. We consider this scenario to be quite relevant given the current

Portuguese situation. Nevertheless we attributed to this scenario a low probability

of happening due to the entry of the new shareholder, since the main objective of

this partnership is to help EDP in its liquidity problems, which decrease the

probability of EDP to face a default. Moreover, the fact that EDP is more and more

diversified in terms of sources of operational revenues (operations in Portugal

have a lower weight in EDP’s operational portfolio), it decreases the company’s

exposure to the Portuguese economic situation.

Sum of Parts

By accounting with both basic and bad scenario we achieved a price target of

€3.16. We considered that basic scenario has a 90% probability of happening and

the remaining 10% were attributed for the bad one. The Sum of Parts map is

presented below, where we have the enterprise values for each individual

business area for both scenarios.

EDP business areas may be

severely influenced…

A price target of €2.18 was reached through this bad scenario!




PAGE 30/33

Table 10 - SoP Analysis (in € thousand)

Basic Scenario (90%) Bad Scenario (10%) Expected

EDP Group € Thousand €/share € Thousand €/share € Thousand €/share

Generation PT 9,041,012 2.47 6,430,458 1.76 8,779,957 2.40

Generation ES 1,222,575 0.33 867,605 0.24 1,187,078 0.32

Distribution PT 8,415,896 2.30 7,908,256 2.16 8,365,132 2.29

Distribution ES 1,206,582 0.33 1,178,606 0.32 1,203,784 0.33

Supply PT 125,927 0.03 117,661 0.03 125,100 0.03

Supply ES 596,483 0.16 602,707 0.16 597,105 0.16

Gas PT 92,203 0.03 80,038 0.02 90,987 0.02

Gas ES 2,709,701 0.74 2,740,855 0.75 2,712,817 0.74

EDP Brazil 4,323,200 1.18 4,481,525 1.23 4,339,033 1.19

EDP Renováveis 7,546,848 2.06 6,792,164 1.86 7,471,380 2.04

Sum of Parts 35,280,429 9.65 31,199,875 8.53 34,872,373 9.54

REN 38,707 0.01 36,632 0.01 38,500 0.01

BCP 21,268 0.01 18,311 0.01 20,973 0.01

Others 197,520 0.05 197,520 0.05 197,520 0.05 Spanish Tariff Deficit 549,100 0.15 549,100 0.15 549,100 0.15

Financial Assets 806,595 0.22 801,563 0.22 806,092 0.22

Net Debt (2011E) 18,680,945 18,678,056 18,680,656

Minorities (2011E) 4,019,582 3,916,990 4,009,323

Pensions 1,417,000 1,417,000 1,417,000

Equity Value 11,969,497 7,989,392 11,571,486

# Shares Outstanding 3,656,538 3,656,538 3,656,538

PRICE TARGET 2012 3.27 2.18 3.16

Source - EDP and Analyst estimates

As we can see by looking to Table 8, the major stake of the enterprise value

comes from its traditional activities, as generation and distribution of both gas and

electricity. EDP Renováveis contributes as well with a relevant share of value

€2.06. The positions in REN and BCP correspond to market capitalization. The

rubrics “Others” and “Pensions” are both at book values.

Financials

In this section we will present our forecasts regarding the maps that were the

basis of our analysis: Income Statement, Balance Sheet and Statement of Cash-

Flows. They will be presented in a consolidated basis.

EDPR represents the major source of value for

EDP share price




PAGE 31/33

Income Statement

Table 11 - Consolidated Income Statement

2010 2011E 2012E 2013E 2014E 2015E 2016E

Gross Profit 5,404,331 5,521,486 5,803,453 5,872,787 6,108,070 6,332,713 6,547,328

Other operating income/(expenses)

-1,791,521 -1,891,257 -1,962,001 -2,005,203 -2,076,459 -2,142,622 -2,200,654

EBITDA 3,612,810 3,630,229 3,841,452 3,867,584 4,031,612 4,190,091 4,346,674

Depreciation and amortization

-1,469,327 -1,484,765 -1,512,177 -1,537,366 -1,560,443 -1,581,515 -1,617,292

Other -80,974 -14,712 -14,712 -14,712 -14,712 -14,712 -14,712

EBIT 2,062,509 2,130,752 2,314,563 2,315,506 2,456,457 2,593,864 2,714,670

Financial Costs -400,676 -561,697 -544,178 -544,956 -537,976 -525,965 -684,646

EBT 1,661,833 1,569,055 1,770,385 1,770,550 1,918,481 2,067,899 2,030,024

Taxes -427,232 -443,625 -500,548 -500,594 -542,420 -584,665 -558,257

Net Income 1,234,601 1,125,430 1,269,837 1,269,956 1,376,062 1,483,234 1,471,768


Balance Sheet

Table 12 - Consolidated Balance Sheet

2010 2011E 2012E 2013E 2014E 2015E 2016E

PP&E 20,323,583 20,537,125 20,916,285 21,264,688 21,583,887 21,875,360 22,370,218

Other 12,883,645 13,037,301 13,261,045 13,462,530 13,652,007 13,825,768 14,088,754

Non-Current Assets 33,207,228 33,574,426 34,177,330 34,727,218 35,235,893 35,701,127 36,458,973

Current Assets 7,281,625 7,644,864 7,211,120 7,253,999 7,563,691 7,731,569 7,091,721

TOTAL ASSETS 40,488,853 41,219,290 41,388,450 41,981,217 42,799,584 43,432,697 43,550,694

TOTAL EQUITY 10,784,959 11,416,549 12,236,214 12,998,235 13,866,314 14,799,123 14,957,257

MLT Debt 14,887,195 15,637,956 15,189,334 15,071,578 14,997,928 14,764,334 15,036,456

Other 7,087,060 7,123,402 7,106,595 7,102,348 7,162,291 7,189,999 6,764,852

Non-Current Liabilities 21,974,255 22,761,358 22,295,930 22,173,926 22,160,219 21,954,333 21,801,307

ST Debt 3,004,451 2,759,639 2,680,471 2,659,690 2,646,693 2,605,471 2,653,492

Other 4,725,188 4,281,744 4,175,835 4,149,366 4,126,358 4,073,770 4,138,637

Current Liabilities 7,729,639 7,041,383 6,856,306 6,809,056 6,773,051 6,679,240 6,792,129

TOTAL LIABILITIES 29,703,894 29,802,741 29,152,236 28,982,982 28,933,270 28,633,574 28,593,437

TOTAL LIAB+TOTAL EQUITY

40,488,853 41,219,290 41,388,450 41,981,217 42,799,584 43,432,697 43,550,694


Statement of Cash-Flows

Table 13 - Consolidated Cash-Flow Statement (in € thousand)

2010 2011E 2012E 2013E 2014E 2015E 2016E

EBIT 1,867,595 1,776,725 1,822,110 1,773,763 1,871,710 1,964,950 2,103,462

Depreciation 961,753 1,045,717 1,065,023 1,082,763 1,099,016 1,113,858 1,139,055

Provisions 105,356 14,712 14,712 14,712 14,712 14,712 14,712

Other 542,050 1,018,115 359,480 533,218 697,153 674,960 195,559

Net Operating CF 3,476,754 3,855,270 3,261,325 3,404,456 3,682,591 3,768,479 3,452,789

Capex 990,128 1,804,000 2,079,000 2,058,210 2,037,628 2,017,252 2,357,079

Other Investments -9,166 30,134 47,095 39,165 18,123 37,659 31,914

Other financial Income/expenses 81,279 0 0 0 0 0 0

Net Investing CF 1,062,241 1,834,134 2,126,095 2,097,375 2,055,751 2,054,911 2,388,993

FCF to the Firm 2,414,513 2,021,136 1,135,230 1,307,081 1,626,840 1,713,569 1,063,795





PAGE 32/33

Summary

Throughout this report we stated that EDP was a highly levered company with an

ambitious investment plan that requires a Capex of €2.1 billion until 2016. The

major stake of this Capex will be used to pursue the company’s objective of

becoming a greener company, and thus it will be used to finance projects in the

renewable sources of energy field. EDP intends to have around 65% of its

installed capacity powered by hydro and wind sources in the end of 2012. The

regulated source of operational cash-flows, that are known ex-ante, allowed the

company to support such levels of debt, and even so delivering the promised

results year after year and meet its financial obligations. However, the company

is not able to support such levels of debt thus according to our estimates net debt

will start decreasing 2012 onwards. Moreover, EDP is trying to achieve business

stability, and high levels of debt would go against this premise.

The entry of a new shareholder in the company, Three Gorges Corporation

(CTG), will also bring several financial and operational benefits. Through this

partnership EDP will receive a credit facility

amounting €2 billion for 20 years, with the

objective of decreasing the ratio Net

Debt/EBITDA to 3.0x in 2015, well below our

estimations (see Graph 23). Furthermore, EDP

and CTG will combine efforts to become

worldwide leaders in renewable energy, and for

that CTG will invest €2 billion equity stakes in operational and ready-to-build

projects representing 1.5 GW20

. Basically, the Chinese company will enable EDP

to improve is position in the market and also may help it to surpass current

economic issues.

All in all, we consider EDP a solid company that is in the right path regarding

innovation in greener sources of energy. Also we believe that the company will

be able to surpass the present challenges regarding the changes in its business

(liberalization process and VAT increase) and the overall economic situation, and

still meet its targets for 2015/2016.

20

Source: EDP

Graph 22– Net Debt (in € billion)


Graph 23 – Net Debt/EBITDA


17.000

17.500

18.000

18.500

3

4

5 EDP’s situation will improve thanks to the new shareholder




PAGE 33/33

Disclosures and Disclaimer

Research Recommendations

Buy Expected total return (including dividends) of more than 15% over a 12-month period.

Hold Expected total return (including dividends) between 0% and 15% over a 12-month period.

Sell Expected negative total return (including dividends) over a 12-month period.

This report was prepared by a Masters of Finance student, following the Equity Research – Field Lab Work Project, exclusively for academic purposes. Thus, the author, which is a Masters in Finance student, is the sole responsible for the information and estimates contained herein and for the opinions expressed, which reflect exclusively his/her own personal judgement. All opinions and estimates are subject to change without notice. NOVA SBE or its faculty accepts no responsibility whatsoever for the content of this report nor for any consequences of its use. The information contained herein has been compiled by students from public sources believed to be reliable, but NOVA SBE or the students make no representation that it is accurate or complete, and accept no liability whatsoever for any direct or indirect loss resulting from the use of this report or its content. The author hereby certifies that the views expressed in this report accurately reflect his/her personal opinion about the subject company and its securities. He/she has not received or been promised any direct or indirect compensation for expressing the opinions or recommendation included in this report. The author of this report may have a position, or otherwise be interested, in transactions in securities which are directly or indirectly the subject of this report. NOVA SBE may have received compensation from the subject company during the last 12 months related to its fund raising program. Nevertheless, no compensation eventually received by NOVA SBE is in any way related to or dependent on the opinions expressed in this report. The NOVA School of Business and Economics does not deal for or otherwise offers any investment or intermediation services to market counterparties, private or intermediate customers. This report is not an investment recommendation as defined by Article 12.º-A of the Código do Mercado de Valores Mobiliários. The students of NOVA School of Business and Economics are not registered with Comissão do Mercado de Valores Mobiliários as financial analysts, financial intermediaries or entities or persons offering any services of financial intermediation, to which Regulamento 3.º/2010 of CMVM would be applicable. This report may not be reproduced, distributed or published without the explicit previous consent of its author, unless when used by NOVA SBE for academic purposes only. At any time, NOVA SBE may decide to suspend this report reproduction or distribution without further notice.

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