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Southern Energy’sInvestment in CEMIG

Matt MichaudJudd Murphy

Tory NotoMatt 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%)– Southern Energy (25%)– Opportunity Fund (10%)

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 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

Brazil

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

Brazil

Brazilian Inflation, 1993 - 1996(% Change in One Year)

1993 1994 1995 Sept. 1996

General Prices (domestic) 2,708.55 1,093.84 14.78 9.82Wholesale Prices (domestic) 2,639.27 1,029.36 6.39 7.07Consumer Prices 2,489.11 929.32 21.98 12.98

Source: The Economic Intelligence Unit. "Country Profile - Brazil," The Economic Intelligence Unit Limited , 1997.

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

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

BrazilLatin America Installed Capacity - 1997

(in Megawatts, MW) Hydroelectric Thermoelectric Geothermal Nuclear Total

Argentina 8,687 11,686 1 1,018 21,392 Belize 23 43 - 66 Bolivia 313 497 - - 810 Brazil 54,134 7,490 - 657 62,281 Colombia 8,140 6,474 - - 14,614 Costa Rica 981 292 65 - 1,338 Chile 3,882 3,976 - - 7,858 Ecuador 1,500 1,414 - - 2,914 El Salvador 404 450 105 - 959 Guatemala 507 466 - - 973 Guyana - 157 - - 157 Honduras 434 305 - - 739 Mexico 10,125 30,076 744 1,309 42,254 Nicaragua 103 238 70 - 411 Panama 621 434 - - 1,055 Paraguay 7,491 38 - - 7,529 Peru 2,499 2,499 - - 4,998 Suriname 189 200 - - 389 Uruguay 1,521 716 - - 2,237 Venezuela 14,003 8,525 - - 22,528

TOTAL 115,557 75,976 985 2,984 195,502

Source: Evans, Andrew. "Opportunities for Power Generation in Latin America," Reuters Business Insight - Energy , 1998.

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

CEMIGInstalled Power Plant Capacity - 1995(MW)

CompaniesHydroelectric

CapacityThermal Capacity Total Capacity

Electronorte 4,718 783 5,501Chesf 8,617 290 8,907Furnas 7,212 1,297 8,509Eletrosul 2,602 620 3,222Total Electrobras 23,149 2,990 26,139

Itaipu 6,300 6,300Cesp (SP) 9,461 9,461Cemig (MG) 4,928 125 5,053Copel (PR) 3,324 20 3,344CEEE (RS) 896 511 1,407Light (Private) 768 768Celg 675 3 678Eletropaulo 820 470 1,290Sub-Total 27,172 1,129 28,301Other 514 558 1,072TOTAL CAPACITY 50,835 4,677 55,512

Project Overview

• Southern’s share would cost $276 million– $126M in cash– $150M in dollar-denominated debt

• Thus exposing SEI to currency risk

Project Overview

Pre-Transaction OwnershipVoting Shares Preferred Shares Total

Owners Number Percentage Number Percentage Number PercentageMinas Gerias government 47,658 83.99% 6,957 9.52% 54,615 42.07% Electrobras 831 1.46% 1,270 1.74% 2,101 1.62% Others 8,253 14.54% 64,852 88.74% 73,105 56.31% Total 56,742 100.00% 73,079 100.00% 129,821 100.00%

Post-Transaction OwnershipVoting Shares Non-Voting Shares Non-Voting Shares

Owners Number Percentage Number Percentage Number PercentageMinas Gerias government 28,933 50.99% 6,957 9.52% 35,890 27.65% Others 831 1.46% 1,270 1.74% 2,101 1.62% Electrobras 8,253 14.54% 64,852 88.74% 73,105 56.31% AES 12,171 21.45% 0 0.00% 12,171 9.38% Southern Energy 4,681 8.25% 0 0.00% 4,681 3.61% Opportunity Fund 1,872 3.30% 0 0.00% 1,872 1.44% Total 56,742 100.00% 73,079 100.00% 129,821 100.00%

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

• 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

• 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 AnalysisFree 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

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?

• 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 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.