MASTERS IN MANAGEMENT EQUITY RESEARCH EDP RENOVÁVEIS COMPANY REPORT. A bright future ahead UTILITIES SECTOR 22 MAY 2016 STUDENT: JOÃO TIAGO CABO

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1 MASTERS IN MANAGEMENT EQUITY RESEARCH EDP RENOVÁVEIS UTILITIES SECTOR 22 MAY 2016 STUDENT: JOÃO TIAGO CABO A bright future ahead Diversification is the key from growing Recommendation: Vs Previous Recommendation Price Target FY16: BUY BUY 7,07 EUR EDP Renováveis (EDPR) produced energy is mostly generated by onshore wind power. However, the company is looking to diversify its energy sources and is focused on creating solar PV power system and offshore wind power. Hydro dams are also in the company s plans if any opportunities arise. The company has entered in the Mexican market through a participation with Industrias Peñoles. This elevates the markets to 12 countries where EDPR is now operating. Vs Previous Price Target 22,4% Price (as of 22-May-16) 6.74 EUR Reuters: EDPR.LS, Bloomberg: EDPR:SW 52-week range (EUR) 5,70-7,38 Market Cap (EUR millions) 5.879,36 Outstanding Shares (millions) 872,31 Free Float 22,5% Source: EDPR Annual Report 2014 The Polish and Romanian market have been presenting with the highest growth rates, leading EDPR to the leader producer of renewable energy in Poland. In Romania, the company has achieved its first solar PV power system. However, the USA and Spanish markets are still the most relevant ones to EDPR. The struggles faced by the company related to the financial crisis, both due to the difficulties from Portugal and Spain to pay their debts as well as the disturbs on the stock market, and due to the regulation changes caused in the previous years, seems to have come to an end and EDPR is now facing with several growth opportunities. The growth the company has achieved combined with the increase in its efficiency are resulting in a decrease on its debt, improving its debt to equity ratio. Company description EDP Renováveis is an energy producer company that uses only renewable sources. Its history started in 2007 when it was created by EDP to manage its assets from wind power. With time, the company grew and today EDPR is present in 12 countries spread around the world. Additionally, it is also expanding its portfolio to other renewable sources such as solar PV plants, offshore wind power and hydropower dams. Source: Euronext Lisbon (Values in EUR millions) 2014A 2015E 2016F Revenues EBITDA EBITDA Margin 68% 67% 70% EBIT Net Income Cash Ratio 11% 6% 1% ROA (%) 1% 1% 1% ROE (%) 2% 3% 3% D/E 1,26 1,42 1,21 P/E EV Multiple 10,98 9,14 9,62 Source: EDPR Reports; Nova Analyst Estimates THIS REPORT WAS PREPARED BY JOÃO TIAGO CABO, A MASTERS IN MANAGEMENT STUDENT OF THE NOVA SCHOOL OF BUSINESS AND ECONOMICS, EXCLUSIVELY FOR ACADEMIC PURPOSES. THIS REPORT WAS SUPERVISED BY SARA ALVES WHO REVIEWED THE VALUATION METHODOLOGY AND THE FINANCIAL MODEL. (SEE DISCLOSURES AND DISCLAIMERS AT END OF DOCUMENT) See more information at Page 1/29

2 Table of Contents EXECUTIVE SUMMARY... 3 COMPANY OVERVIEW... 4 COMPANY DESCRIPTION... 4 SHAREHOLDER STRUCTURE... 5 STRATEGY... 5 MARKET OVERVIEW... 6 COMPETITION... 6 DEMAND FORECAST... 7 REGULAMENTATION... 8 SPAIN... 9 PORTUGAL FRANCE BELGIUM POLAND ROMANIA ITALY UNITED KINGDOM UNITED STATES OF AMERICA CANADA MEXICO BRAZIL MARKET FORECASTING ASSUMPTIONS REVENUE GROWTH EBITDA MARGIN TAX RATE DIVIDEND PAYOUT CAPM INPUTS DATA OTHER ASSUMPTIONS VALUATION RECOMMENDATION RESULT SENSITIVITY ANALYSIS APPENDIX FINANCIAL STATEMENTS ADJUSTED PRESENT VALUE RESEARCH RECOMMENDATIONS PAGE 2/29

3 Executive summary The energy market has been seen from the last decades as the future of utilities sector. However, the huge fixed costs and capital requirements to operate, aligned to an inefficient energy producer have been delaying the boom for this sector. Nowadays, it is possible to understand this market will not have a boom as it was expected, but it will gradually grow and today is sustainable enough to be operated by global companies. Most energy companies had been created spin-off from its renewable departments in order to provide them visibility and consequently, allow them to create value on their own. Maintaining a connection with its mother company has also generated synergies that permitted renewable energy companies to keep growing in this competitive market that it has become today. EDPR was no different from most global renewable energy producer, and it was born from EDP to manage its renewable assets. In 2008, the company went public with a share price of 8,00 EUR. After that, the share price has been decreasing, reaching a minimum of 3,50 EUR per share. Most likely, the main reason for this scenario was due to the financial crisis that struck the global economy in 2008, few months after the company had gone public. Even with the company consistently growing every year, currently producing the triple of energy it produced at that time, the share price has never reach the 8,00 EUR per share. This financial crisis had brought suspicion in the investors to the stock market, and with countries such as Portugal and Spain with debt issues only caused an additional negative impact at EDPR. Moreover, the countries implemented reforms in the sector, since it was highly dependent on governments. The financial crisis made it mandatory to reduce costs and then this sector was deeply penalised. With time, financial situation in global markets, particularly in Portugal and Spain, has improved and also the company has adapted to the regulation changes it has faced, which resulted in an advantage for them (the prices per EUR/MWh increased in most markets). This has resulted in an improvement in its share price. In this analysis, it was used the Discounted Cash Flows (DCF) in order to determinate the company value. The reason to use this approach to the detriment of Adjustment Present Value (APV) holds in the difficulty in calculating the agency and bankruptcy costs. Once this there is no reliable form to calculate this costs, it was used the DCF valuation method due to using more trustful inputs. As a result, it was obtained the company fair value of 7,07 EUR per share, higher than is being currently trade off in the stock market. Nevertheless, although the positive results, the Sensitive Analysis performed (on price per MWh, energy produced and WACC) showing EDPR is a risk security, once its results present a high volatility to the inputs used. PAGE 3/29

4 Company overview Company description Image 1: EDPR markets 1: Diagram 1: EDPR organization EDPR NA USA Canada Mexico Source: EDPR Annual Report EDPR EDPR EU&BR Spain Portugal France Italy Belgium United Kingdom Romania Poland Brazil Source: EDPR Annual Report EDP Renováveis (English: EDP Renewables) is a company operating in the utility sector, which focuses on producing energy through renewable sources. The production of energy comes mostly from its wind farms that are spread around the world, with some solar power plants and hydric dams. Those wind farms mostly are onshore, meaning that they are placed on land. However, the company is considering to diversify its energy sources by producing offshore wind farms (which are placed on the sea) and create more solar power plants. We can perceive this strategy by the investments the company is performing. In 2014, the company concluded 10 projects in different countries where 2 are from solar photovoltaics (solar PV). These projects represent an increase in total production of 471 MW. Nowadays, the total production of energy from EDP Renováveis is about 21,4 TWh, which is nearly the triple of energy produced back in 2008 when the company went public. According to the company estimates, the energy produced by EDPR is avoiding the release of 18,7mt CO 2 into the environment. Its headquarters are based in Madrid, however, it is traded in Euronext Lisbon (PSI-20) with EDPR as stock symbol. Additionally, EDPR has also an office in Oviedo, where it is legally registered. The company was created in 2007 by Energias de Portugal (EDP) to manage the renewable energy sector, although EDP had wind farms since In 2008, EDPR became a public-traded company, with an open price of EUR 8,00. The company is organised in one corporate centre in the holding which manages 2 platforms, EDP Europe & Brazil and EDPR North America. These platforms are organised according to their geographic location. The platform EDPR Europe & Brazil is responsible for the Spanish, Portuguese, French, Belgian, Polish, Romanian, Italian, British and Brazilian markets, while EDPR North America operates in Mexico, United States of America (USA) and Canada. Regarding the company s Executive Committee, this is composed by 5 people. The first one is João Manso Neto, which is the CEO of EDPR. The remaining of the Executive Committee is composed by Miguel Amaro (CFO), João Paulo Costeira (COO of Europe and Brazil), Gabriel Afonso (COO North America) and Nuno Alves (Executive Committee Member). Additionally, the president of the Administrative Council is António Mexia, the CEO of EDP, leading shareholder of EDRP. Besides the Executive Committee, the Administrative Council also contains Audit and Control Committee and Nominations and Remunerations Committee. PAGE 4/29

5 Shareholder structure Graph 1: EDPR shareholders Source: EDPR Annual Report The company holds in the market shares since it became public on As previously mentioned, EDP is the main shareholder and holds about 77,5% shares of EDRP. EDP is also a utility company, being the largest producer, distributor and supplier of electricity in Portugal, also with significant operations in the gas sector and electricity in Spain. It is the fourth largest private company producer of electricity in Brazil through its participation in Energias do Brasil. In the Iberian Peninsula, EDP is the third largest electricity producer and one of the major gas distributors. EDP has also a relevant presence in the energy market in 14 countries, with more than 9.8 million electricity customers, 1.3 million points of gas supply and nearly employees worldwide. In 2014, EDP had an installed capacity of 22.5 GW, generating 60.3 TWh. EDP was recognised as world leader in the Dow Jones Sustainability in the Utilities Sector in 2013, and again in 2014, as a reflection of the performance group on economic, social and environmental aspects. The holding company, Energias de Portugal S.A. is a listed company which common shares are traded Euronext Lisbon (PSI-20), as well as EDPR, since its privatization in In September 2013, MFS Investment Management informed Comisión Nacional del Mercado de Valores (CNMV), the Spanish government agency responsible for financial regulation of the securities markets, that it possesses 3,1% of EDPR shares and consequently, the voting right. The remaining 19,4% of EDPR social capital are spread around small investors. Consequently, these investors are also spread worldwide, with a total of 23 countries. Regarding the type of these investors, the majority are composed by Investment Funds which are followed by social responsible investments, representing 80% and 16%, respectively. Strategy Table 1: EDPR new assets Source: EDPR Annual Report The EDPR s strategy is based on three main pillars: increase profitability; selective growth; and self-funded business model. This strategy is also in accordance to EDP, which manages the group where EDPR is inserted. Hence, to capture new growth opportunities and expand operations, the company aims to successfully select the best projects, manages its performance under standards of excellence and minimises dependence on external sources of funding. These projects are usually selected through acquisitions or partnership with local companies. As a result, in 2014, the company started 2 new projects which will increase EDPR s portfolio, both in markets and in new sources of energy. PAGE 5/29

6 Offshore wind power in France Graph 2: CAPEX distribution EDPR had successfully assigned, in a consortium, 1GW of offshore wind power, through partnership with GDF Suez, Neoen Maritime and AREVA. On this project, which is composed by two wind farms on Tréport and Yeu and Noirmoutier islands, EDPR will hold a minority position of 43%. This project has special importance to EDPR since it not only increases its presence in the French market, but also diversifies the energy portfolio with offshore wind power. Mexican market Source: EDPR data In 2014, EDPR entered in the Mexican market also through a partnership with Industrias Peñoles. This project consists of a wind farm in Coahuila state, on the north of the country. The construction commenced in 2015 and will start to operate in The yearly energy production forecast is 180 MW. This contract has a duration of 25 years and the prices were established in USD. Market overview Competition Graph 3: Companies production Nowadays, the energy market is no longer a monopoly industry as it was several years ago. Companies have developed from national companies to operate globally and as a result, they were faced with something new in the business: Competition. It is hard to point all the competitors EDPR faces on the market since the tremendous local producers on the EDPR markets. Moreover, since the company is present in 12 markets, there are global producers present in a portion of the markets EDPR operates (from the 12 markets, only operates in 1 or 2). Therefore, this analysis took in consideration the companies that present the same financial and operating level as EDPR, as well as operating in the same markets. Companies Headquarters Production (TWh) Assets (in EUR millions) EDPR Markets Source: Companies data Iberdrola Spain Engie France ENEL Green Power Italy Acciona Spain EDPR Spain As we can see, most of EDPR competitors are European companies. This result is due to most of the North American and Chinese companies are operating in PAGE 6/29

7 Graph 4: Companies assets their home country. Additionally, most North American energy companies are not focus on the renewable energy yet, since renewable energy usually is not more than 10% of its total energy produced. To conclude, this shows the importance and focus the European companies are giving to this sector, since half of the competitors identified (ENEL Green Power and Acciona) produces energies only through renewable sources such as EDPR. Demand forecast Source: Companies data Regarding the demand forecast, in order to analyse the tendency for the energy sector, it will be use to variables in this analysis: Population growth and global Gross Domestic Product (GDP) growth. The reason for choosing these variables holds in the main consumers of energy, families and companies. In the following graph it is possible to obverse the population growth forecast WORLD AFRICA ASIA EUROPE LATIN AMERICA AND THE CARIBBEAN NORTHERN AMERICA Source: United Nations Graph 5: GDP growth (%) Source: International Monetary Fund By the graph, we can conclude the demand forecast for energy will grow based on the population growth. However, it is important to highlight the main responsible for the world growth will be Asia and Africa, two continents where EDPR does not hold operations. On the other hand, Europe and North America, the continents where the majority of EDPR energy is produced, will be stable, which indicates demand will be stable regarding the families, unless the company continues to expand to other markets. Regarding the GDP, we can analyse its forecast in the following table Millions (in EUR) % 3,12% 3,83% 5,76% 5,84% Source: International Monetary Fund PAGE 7/29

8 With this, we can conclude the tendency in demand for energy will most likely growth in order to fulfil the needs from both companies and global population. Regarding the renewable energy market, this assumption is based on the favourable regulamentation in place in most markets, showing that governments are investing in this solution in order to become more independent on this vital sector on the economy. Regulamentation Image 2: European Legal scenario Source: EDPR data In this aspect is where lays the most challenge to companies on this sector. The reason is due to the business is still very dependent on governments. The average of operating costs is relative low, but initial investment requires high effort from companies. Consequently, the energy price is not defined by the companies. Instead, there are legislations that define the price under certain conditions. As a result, companies do not have the option to adjust the price under its needs. This leads to an increase in the risk of the sector. Nevertheless, due to the high investment done in this sector, special in the EU, there are advantages for these companies, usually with governments buying all energy produced. Next we present a brief resume of the most common bases that state the price: Feed-in Tariff (FiT): Policy mechanism designed to accelerate investment in renewable energy technologies. It offers long-term contracts to renewable energy producers, typically based on the cost of generation of each technology. Green Certificate (GC): Tradable commodity proving that certain electricity is generated using renewable energy sources. Power Purchase Agreement (PPA): Contract between two parties that defines all commercial terms for the sale of electricity. In the following table, we summarize the regulamentation inforce in the countries EDPR have significate production. PAGE 8/29

9 Country Legislation Factor to determine price EDPR average EUR/MHw Spain RD 413/2014 Return on standard assets 45 Portugal MO 325-A/2012 FiT 95 France Loi n FiT 91 Graph 6: EUR/MWh Belgium Local legislation PPA and GC 109 Poland Order 18/10/2012 PPA and GC 88 Romania Legea 123/2012 PPA and GC 72 Italy DM 06/07/12 GC 118 US State legislation PPA 45 Canada GEA, 2009 FiT 99 Brazil PROINFA PPA 94 Table 2: Directive 2009/28EC goals Source: European Union Moreover, there is the Directive 2009/28EC, published by EU, which aims to promote the renewable energy production. The goal is to 20% of the EU total energy consumption is produced by renewable sources. As a result, and due to the financial crises, governments (mostly European) updated its legislation in order to reduce dependence of this sector but without compromising its 2020 goals. By looking to the legislation, it is possible to see that in Europe, most of the current legislation was after 2010, when the financial crisis began. The UK and Mexico are not present in this analysis since EDPR does not directly produces energy on these markets. Instead, it holds participations in some renewable assets from local companies. In the following paragraph, it is possible to analyse in more detail each market. Spain Spain market holds a tremendous importance to EDPR, which even led the company to install its headquarters in Spanish territory. At the time of its creation, in 2007, Spain was the third country with the most dependency of wind power in the world, followed by the US and Denmark, and since EDP, major shareholder of EDPR, was already on the Spanish market, it was decided to set the headquarters in Madrid to take advantage of the big investments made by the Spanish government on renewable energy sources, particularly on wind farms. PAGE 9/29

10 Prices by MWh are defined in Royal Decree 413/2014 Graph 7: Spanish energy produced 2014 Source: Red Elétrica de España data This led EDPR to the third biggest producer of renewable energy in Spain, with 4.87 GWh, behind Iberdrola and Acciona with GWh and 5.954GWh, respectively. However, this sector was strongly affected by the financial crisis in 2008, since it was highly dependent on government s investment. In 2015, the Spanish government did not invest a single euro on this sector, something that has not happened since the 80 s. Nevertheless, Spain intends to produce more energy by renewable sources and reduce its independence to oil. In 2014, it was approved the Royal Decree 413/2014 (RD 413/2014) which establishes the remuneration system of renewable energy. With this new legislation, Spain intends to increase its energy production and create a sustainable sector that is not government dependent. This Decree ends with the fixed and market tariff by implementing an addition to the market price. This addition is composed by: the remuneration to the investment corresponding to the amount per installed power facility, which covers the investment costs for a standard plant that cannot be recovered from the sale of electrical power; and the remuneration to the operation corresponding to an amount for the operation itself, which covers the difference between operating costs and the revenue obtained from the market by said standard power plant. This specific remuneration that allows companies to produce electricity from renewable energy sources to achieve a reasonable rate of return, which is calculated on the basis of a standard power plant, over the useful regulatory life thereof and based on the business activity that would be carried out by an efficient and well-managed company. Additionally, RD 413/2014 defines the concept of reasonable rate of return by referencing the return on the secondary market average yield on 10-year government bonds for the 24 months prior to May of the previous year as of the beginning of the regulatory period 1, increased by a differential. Notwithstanding, those facilities that benefitted from a feed-in tariff regime as of July 14, 2013 will receive a reasonable rate of return based on the return on the secondary market average yield on the 10-years prior to the entry into force of Royal Decree-Law 9/2013 (RDL 9/2013) government bonds, plus 300 basis points. For new renewable facilities, the specific remuneration will be granted by a competitive tendering process respecting transparency, non-discrimination and objectivity principles. Once power plants producing electricity from renewable energy sources have completed their useful regulatory life, they would not be entitled to receive any specific remuneration and would merely obtain the income associated with the participation in the electricity market. 1 Each regulatory period will last for six years, the first starting in July 14, 2013, and lasting until December 31, PAGE 10/29

11 Portugal Graph 8: EDPR invested capital in existing assets Source: EDPR data Similarly to Spain, Portugal is also a very important market to EDPR since it is where the business has started. Additionally, EDPR was created to manage the assets of EDP related to renewable energy, which is located in Portugal. Here, EDPR comes present as second biggest producer with GWh behind Iberwind with GWh, according to 2014 data. Renewable energy was responsible for 50,4% of total energy produced in the country. Due to the country small size, it is not seen as one of the biggest renewable energy producers, but this figure makes Portugal one of the countries least dependent on fossil energies. Here, like in Spain, Eolic energy is the main responsible for the high production of renewable energy. However, hydro power is just being as the second most used source of renewable energy. The two sources combined represent 83% of renewable energy produced in Portugal. Regarding the remuneration system, the generation of electricity from renewable energy sources are mainly sold through a guaranteed feed-in tariff. Operators of renewable energy plants are contractually entitled against the grid operator to payment for electricity exported to the grid. The grid operator is obliged to enter into a contract on the purchase of electricity at a statutorily set price. The feed-in tariff consists of two elements: a guaranteed payment rate and an amount calculated by a statutorily set formula. Most of the feed-in tariffs were defined in 2007 and are applicable to renewable technologies (except large hydropower plants) for a certain timeframe (i.e., 2, 12, 15, 20, 25 or 35 years) or until an upper limit of production is reached, whichever occurs first. France Although France market does not hold significant impact on EDPR, it is seen as a strategic market, with a very high potential. The reason for this is due to the good conditions the country holds for wind power, both onshore and offshore, and also because renewable energy is far from being the main source of the country, being only 15%. France counts mostly on nuclear energy to face energy demands of the country, which represents around 77%. However, according to Directive 2009/28EC, which intends that 20% of energy used in EU countries is produced by renewable sources, France compromised itself with 23%. The remuneration system in France is simpler than the one in Iberian countries. Here, there is a fixed feed-in tariff for 82,00 EUR, adjusted with inflation, for 10 years. Beyond this period, it is applied a tariff depending on the wind farm s utilisation, to 82,00 EUR at hours until 28,00 EUR to hours. PAGE 11/29

12 Belgium Table 3: Directive 2009/28EC Country % renewable Target energy Belgium 2,2 % 13 % Bulgaria 9,4 % 16 % Czech Republic 6,1 % 13 % Denmark 17,0 % 30 % Germany 5,8 % 18 % Estonia 18,0 % 25 % Ireland 3,1 % 16 % Greece 6,9 % 18 % Spain 8,7 % 20 % France 10,3 % 23 % Italy 5,2 % 17 % Cyprus 2,9 % 13 % Latvia 32,6 % 40 % Lithuania 15,0 % 23 % Luxembourg 0,9 % 11 % Hungary 4,3 % 13 % Malta 0,0 % 10 % Netherlands 2,4 % 14 % Austria 23,3 % 34 % Poland 7,2 % 15 % Portugal 20,5 % 31 % Romania 17,8 % 24 % Slovenia 16,0 % 25 % Slovak Republic 6,7 % 14 % Finland 28,5 % 38 % Sweden 39,8 % 49 % United Kingdom 1,3 % 15 % Source: European Union Similarly to France, the Belgian energy is also highly dependent on nuclear energy, which is responsible for producing 57% of the countries energy supply, while the rest is produced by fossil and renewable sources with 36% and 7%, respectively. Due to the EU directive from European Parliament, which set the goals to achieve a 20% renewable energy production in EU, Belgium compromised with 13% until However, the governments have been pushing up on this goal, and there have been discussions on ending the nuclear plants in Additionally, there are also plans to the country s energy being produced 100% by renewable sources. The onshore wind power does not hold a very significant impact on the total energy produced, due to the relative short area available in the country. Most renewable energy produced is from dams. However, Belgium plans are to invest in wind farms offshore, to take advantage of the strong winds on its exclusive economic zone. Another option that has been talked about is to create an island in order to allocate wind farms onshore. The main producers are by far Electrabel and EDF Luminus, two Belgium companies that are held by French utilities groups. However, unlike EDPR, the energy production from these companies is not exclusively from renewable sources. The remuneration system in Belgium, contrarily to the other markets, prices are regulated by each region. In the three regions, Elia, the Belgium distributor, is forced to buy first energy produced by renewable sources. In both Brussels and Wallonia 2, each renewable-energy generator can sell to the operator of the local transmission system, directly at a guaranteed minimum price. The price of the energy produced by renewable source, which the local transmission system operator is required to buy, is set at EUR 65,00. As for Flanders region, Elia in its capacity of operator of the local power transmission system must apply the Flemish minimum support to generation facilities connected to the local 70-kV to 30-kV transmission system in the Flemish Region. The minimum support that is laid down depends on the energy source and generation technology that are used and the date of commissioning. The date of commissioning also determines how long this support is provided for. Poland This market is also seen as great potential to EDPR. Poland is a relatively new market compared to the previous markets than the other countries since only later had access to the several incentives from EU. The country energy is mainly produced by coal, but Poland intends to change that and until 2020 has the aim 2 Region in the south of Belgium. PAGE 12/29

13 to achieve 15% of its energy production through renewable sources. Here, EDPR presents itself as the main producer, with 12% of market share. However, EDPR sold in the end of 2015 part of its portfolio to Poland and Italy. As far as the remuneration system goes in Poland, electricity price can be established through bilateral contracts or selling to distributor at regulated price at 163,58 PLN 3 /MWh in For wind power, producers receive 1 Green Certificate (GC)/MWh which can be traded in the market. Electric suppliers have a substitution fee for noncompliance with GC obligation. In 2015, the substitution fee was set at PLN300/MWh. Graph 9: Romania renewable energy production (%) Source: IEA Romania Romania market shows some similarities with the Poland market. Both countries only had access to incentives from the EU later than the other markets and most of its energy comes from fossil sources. However, due to the climate differences between these countries, Romania market is considerably more advanced that it would seem. The country has made large investments on renewable energy and currently it represents around 38% of total energy produced in the country. However, this result is accomplished mainly by hydro energy, with 27%. This market is dominated by Romanian Electric Power Corporation, a statecorporation. One aspect that makes Romanian market very important is its good conditions to produce solar energy. This has even led EDPR to plant its first solar power plant in 2013 on this market. Regarding the remuneration system, wind assets receive 2 GC/MWh until 2017 and 1 GC/MWh after 2017 until completing 15 years. 1 out of the 2 GC earned until March 2017 can only be sold from January 2018 and until December Solar assets receive 6 GC/MWh for 15 years. 2 out of the 6 GC earned until March 2017 can only be sold after April 2017 and until December GCs are tradable on market under a range from 29,40 EUR and 59,90 EUR. Italy Italy energy market is at a very mature stage. Although in 2005, at the time of Directive 2009/28/EC, the country was not very developed in this sector compared to other EU s founders, in % of the energy produced was from renewable sources. Regarding the renewable power source, in Italy is the hydro power that contributes the most for the 38%. One particularity of the Italy market, is that wind power comes third on the list of the renewable energy sources used, with solar PV being the second. Additionally, Italy is the biggest solar PV energy producer in the world. Although the potential this market holds, EDPR only holds 3 37,92 EUR at rate of 14 March. PAGE 13/29

14 Image 3: EDPR presence in UK Source: EDPR data 1% of market share, being far away from the market leader Enel Green Power. In Italy, the remuneration system is for plants operating before 2013 receive, until 2015, market price plus GC. GSE, an Italian energy distributer, has the obligation to buy GC 180,00 EUR/MWh minus the average price of the previous year, times 0,78. For 2015, GC price from GSE will be 97,40 EUR. From 2016 onwards, during 15 years, market price plus premium scheme which can be calculated with the previous formula. United Kingdom In the United Kingdom (UK), renewable energy was first implemented in the middle of 1990, with small hydroelectric power plants. In 2005, by the time EU set the goals for 2020 regarding renewable energy, UK had only 1,3% of its energy produced by renewable sources. Nevertheless, the government set out the ambitious goal of UK of 15%. In 2013, its production was already 14,9% from renewable sources, being very close to the goal. Due to this, in 2007, the UK government agreed to overrun EU target of generating 20% of the EU s energy from renewable sources by 2020 and exceed the 15% previous committed, however, it was not established a goal. Most of its energy, produced by renewable sources, is produced by wind farms and hydroelectric plants, due to the UK s climatic characteristics. The position of EDPR in this market is however very low, by owning 49% of Inch Cape farm (with potential power of MW), in partnership with Repsol. United States of America Image 4: EDPR presence in USA Source: EDPR data The USA market is of extremely importance to EDRP. This market is currently the market where EDPR produces most of its energy. USA is the second country which consumes more energy, after China. However, renewable energy are responsible only for 8% of the energy produced. Most of the USA energy is produced by fossil sources, such as coal, petroleum and natural gas. In addition to this, the country also produces energy throughout its nuclear plants. Alhough the country has large reserves of fossil resources, the increase of energy produced by renewable sources has been increasing significantly. Hydroelectric power is by far the most used renewable energy source produced in the USA, but the country also produces energy from wind and solar PV. EDPR entered the US market in 2007 and since then it more than doubled its wind power production making it one of the world s largest producers. Today, it contains a market share of 7%. The remuneration system in the USA is reasonably simple, since sales can be agreed under Power Purchase Agreements (PPA), up to 20 years. The GS however, are subject to each state regulation. Regarding taxes incentives, Production Tax Credits (PTC) are collected for 10 years since operation date, PAGE 14/29

15 which is 23,00 USD/MWh in Additionally, wind farms beginning construction in 2009 and 2010 could opt for 30% cash grant instead of PTC. Canada Canada is one of the largest energy producers in the world. Most of its energy derives from hydroelectric dams. However, wind power importance has been increasing in Canada and today, the country is the 6 th largest producer in the world. Although EDPR has a small participation, with an installed capacity of 30 MW in a country with more than MW, Canada is seen as a very important market on this North American grown strategy. Ontario introduced a remuneration system based on a feed-in tariff (Ontario s FiT) of 64,20 CAD/kWh for applications received after 2 July Applications received prior to that had until 31 May 2011 to install the system to receive the higher rate. Ontario's FiT program also includes a tariff schedule for larger projects up to and including 10MW solar farms at a reduced rate. By April 2012, systems had been installed and the rate decreased to 54,90 CAD/kWh, for applications received after 1 September The prices were updated in 2013 regarding solar prices to a range between 28 to 38 CAD/kWh. Mexico Mexico installed electricity capacity in 2008 was 58 GW. Of the installed capacity, 75,3% is thermal, 19% hydro, 2,4% nuclear and 3,3% renewable other than hydro. The general trend in thermal generation is a decline in petroleum-based fuels and a growth in natural gas and coal. Since Mexico is an importer of natural gas, higher levels of natural gas consumption will likely depend upon higher imports from either the United States or via liquefied natural gas. This might indicate numerous opportunities for renewable energy sector. However, regarding EDPR, it has only entered in the Mexican market in 2014, throughout a partnership with Industrias Peñoles. According to the Mexican Constitution, the electricity sector is federally owned, with the Comisión Federal de Electricidad essentially controlling the whole sector. Private participation and foreign companies are allowed to operate in the country only through specific service contracts. Attempts to reform the sector have been made but they were faced strong political and social resistance in Mexico, where subsidies for residential consumers absorb substantial fiscal resources. Brazil Although Brazil has large oil reserves, it produces most of its energy through renewable sources. According to Energy Research Corporation (EPE), PAGE 15/29

16 renewable energy in Brazil accounted for more than 85,4% of the produced electricity used in Brazil in After the oil shocks of the 1970s, Brazil started focusing on developing alternative sources of energy, mainly ethanol fuel (sugarcane ethanol). Its large sugarcane farms producer and in 1985, 91% of cars produced that year ran on this fuel. The success of flexible-fuel vehicles, introduced in 2003 blend throughout the country, have allowed ethanol fuel consumption in the country to achieve a 50% market share of the gasolinepowered fleet by February However, the most used source of energy in the country is the hydroelectric power, generating more than half of the country energy. In Brazil, unlike the majority of the other markets, wind power does not hold a very significant position on the country s energy production. Yet, the windiest periods in Brazil are from June to December, which coincides with the months with less rain. Due to this, wind power has been seen as an alternative to hydroelectric power in order to end the seasonality. Besides this three sources, the country also invests in solar PV and biomass sources. Here, EDPR also has a small participation, with only 1% of market share. Regarding the regulation, the installed capacity is under the Programme of Incentives for Alternative Electricity Sources program. This program is a Brazilian programme of incentives for electricity generation projects aimed at three specific sources of renewable energy: small-scale hydropower, wind power and biomass. Additionally, the producers have the change to perform PPA under competitive auctions with duration until 20 years. Market forecasting Graph 10: Global renewable energy produced Source: IEA data According to International Energy Agency (IEA) renewable energy will represent the largest single source of electricity growth in the next five years, driven by falling costs and expansion in emerging economies. Pointing to the great promise renewables hold for affordably mitigating climate change and enhancing energy security, governments were faced to reduce policy uncertainties that are acting as brakes on deployment. Renewable electricity additions over the next five years will reach 700 GW (twice Japan s current installed power capacity). They will account for almost two-thirds of net additions to global power. Non-hydro sources will represent nearly half of the total global power capacity increase. The share of renewable energy in power generation will rise to over 26% by 2020, from 22% in To simplify, IEA states that by 2020, the amount of global electricity generation coming from renewable energy will be higher than today s combined electricity demand of China, India and Brazil. Emerging countries will increasingly shift to emerging economies and developing countries, which will make up two-thirds of the renewable electricity expansion in China alone will account for nearly 40% of total renewable power capacity growth and PAGE 16/29

17 Graph 11: Global renewable energy production forecast Source: IEA data requires almost one-third of new investment in Renewable generation costs have declined in many parts of the world due to technology progress, improved financing conditions and expansion of deployment to newer markets with better resources. Announced prices for long-term generation contracts reduced levels are emerging in diverse areas. Some regions now have the potential to a development paradigm mainly based on increasingly affordable renewable power. This is especially true in Sub-Saharan Africa. Financing remains key to achieving sustained investment. Regulatory barriers, grid constraints, and macroeconomic conditions pose challenges in many emerging economies. In industrialised countries, the deployment of renewables requires scaling down fossil-fired power plants, putting incumbent utilities under pressure. An improving picture for renewables can have positive ramifications for global climate change negotiations. But the accelerated case requires more coherent and committed policy action. Assumptions Revenue growth Graph 12: Market growth Source: IEA data According to the IEA, and as aforementioned, the renewable energy market is foreseen to increase in the long term, where the generation of energy through renewable sources will increase from 22% obtained in 2013 to 26% in However, regarding the mid-term growth, IEA forecasts a slow down on its growth. Based on their last report Renewable Energy Medium-term Market Report 2015, the forecasts are -1,42%, 2,16% and 5,63% for 2016, 2017 and 2018, respectively. The reduction in 2016 is based on the deceleration of emerging markets like China and Brazil, which are two of the leading renewable energy producers. These markets are facing challenges on their economics which is leading to a deceleration on investment. Additionally, the EU is also responsible for the reduction in 2016 due to the recent regulation on pricing implemented in most countries. IEA believes this will have a negative impact on the renewable energy producers since they will need time to adapt to the new regulations and implement the necessary restructuring to operate. However, according to the same organization, this situations will be overtaken and renewable energy market will recover after As for EDPR, the company presents a revenue growth of 6% in 2013, -3% in 2014 and 21% in 2015, which shows revenues are extremely volatile. The company, however, does not have activity in the Chinese market, which is the main renewable energy producer and therefore, the main responsible to influence the growth in the market. Due to this, the revenue growth was adjusted to -2% in 2016, 1% in 2017 and 4% in PAGE 17/29

18 EBITDA Margin Image 5: Paris agreement Regarding the EBITDA margin, it was assumed as 70% of the revenues based on the EDPR business plan for In their strategy for this period, they expected EBITDA to present 9% as CAGR. However, due to the decrease in the market in 2014 and foreseen in 2016, in order to maintain the 9% CAGR, EBITDA margin would have to be 90%, which would be a too optimist scenario. Consequently, since EBITDA margin was around 67% and 68%, it was assumed an increase in efficiency (which is also one of EDPR goals) and EBITDA margin for 2016 and 2018 was assumed as 70%. Source: EDPR annual report Tax rate For the tax rate, in our forecast it was used only the Corporate Tax Rate. The reason for this is due to the analysis of the Effective Tax Rate, we noticed volatility from 8% to 25%. Also, penalties and other fines that influence the Effective Tax Rate are unpredictable and therefore it was assumed EDPR will only pay its Corporate Tax. Here, by analysing its Annual Report , it was possible to verify the Corporate Tax Rate EDPR is subject to. The document states the Corporate Tax Rate was gradual reduced from 30% in 2013 to 25% in 2015, and that it would remain 25% from the periods beyond. Concluding, due to a very recent change in taxes, we assume it will remain 25% during the periods in this forecast. Dividend Payout For the Dividend Payout ratio, as in EBITDA margin, we used the EDPR business plan Here, they estimate to have a Dividend Payout ratio from 25% to 35%. Due to this, our estimations would be also within this range. However, in order to reduce and obtain a more accurate Dividend Payout, it was analysed the previous years to obtain a historical data from this ratio. The analysis reveals a ratio of 35%, 44% and 47% in 2013, 2014 and 2015 respectively. So, we assumed a Dividend Payout ratio of 35% in order to be consistent with the company strategy and with its historical data PAGE 18/29

19 CAPM inputs data Graph 13: Asset av. Age & useful life Graph 14: CAPEX growth 25% 20% 15% 10% 5% 0% Historial data Forecast Source: EDPR data 2014A 2015E 2016F 2017F 2018F Source: IEA data In this analysis, it was necessary to estimate EDPR s cost of equity. One way to obtain this valuation is by using the CAPM formula 6. However, it was necessary to obtain additional inputs. The inputs necessary to obtain EDPR s cost of equity are the risk free rate (r f ), the beta (β) and the expected market return (r m ) which were obtained in the Professor Aswath Damodaran website 7. This Professor is known as author of several widely used academic and practitioner texts on Valuation, Corporate Finance and Investment Management. Addtitionally, Professor Damodaran is widely quoted on the subject of valuation, with a great reputation as a teacher and in valuating companies and sectors. Since most volume of EDPR business is placed in the USA, we use US bond for 10 years, as it is used in the market. Though Bloomberg, it was obtained a value of 1,81%. Following the same logic, the expected return on market was based on S&P 500 which according the professor is 7%. For the beta, since EDPR is operating on a global market, competing also with global companies, we used the average beta for the industry also given by the Professor Damodaran. However, to adjust the beta as closer as possible to EDPR reality, it was used the unlevered beta adjusted from cash, which is 0,84. This beta is the most pure beta of the sector since assumes company only financed by equity and since cash is part of the assets on the balance sheet but its risk is null, it was excluded from beta. The next step will be calculating the unlevered beta 8 for EDPR. The reason to calculate from unlevered beta adjusted from cash rather from used the sector is that EDPR cash and equivalents can be used instead of the market average. To finalize, we calculate the levered beta 9 by using the unlevered one, due to the same reason as for the unlevered beta with the unlevered beta adjusted from cash. Other assumptions Other assumptions that were not mentioned on the previous paragraphs, such as CAPEX growth, cost of debt as examples, were calculated taking in consideration its historical data, by calculating the average from the last three years. In the Appendix is possible to consult all the assumptions taken on this analysis. 6 r e = r f + β (r m r f ) β U = β U cash adjusted (1 ( Cash Assets )) 9 β L = β U (1 + (1 t) D E ) PAGE 19/29

20 Valuation Table 4: Investing valuation ratios To estimate the company value it was used the Discounted Cash Flows (DCF). This approach consists in determining the future cash flows released from the company to its shareholders and discounted to the present value. The reason for performing the valuation by the DCF approach is based on it is currently the most used in the financial markets. Moreover, even with the disadvantages of this valuation method, it is still the one that provides more safety to investors. Additionally, we provide on the Appendix the valuation by the Adjusted Present Value (APV) approach in order to compare the results. This last method, consists in determine the Net Present Value (NPV) by using the cost of the unlevered company to discount the future cash flows, adding the possible benefits generated by Tax shields. However, the agency and bankruptcy costs are not easily calculated and thus, the assumption needed to this variable would not be viable. To perform the DCF valuation method, first it was estimated the Free Cash Flows to Firm (FCFF) from EDPR. FCFF represents the cash that a company is able to generate after laying out the money required to maintain or expand its asset base and thus, it was used this result as future cash flow from the company that will be discounted. The following table presents the FCFF statement and the results gathered. EDP Renováveis Consolidated Free Cash flow to Firm Fiscal Year Ending - December 31 millions 2016F 2017F 2018F EBIT Income Taxes NOPLAT Depreciation Gross Free Cash Flow Net Capex Change in Net Working Capital Operating Free Cash Flow Change in Securities (in cash) Non-Operating Free Cash Flow Total Free Cash Flow Available to Investors To discount the FCFF when performing the DCF approach, it is commonly used the Weight Average Cost of Capital (WACC). This rate basically indicates the risk of a firm by estimating an average between its cost of debt and cost of equity. The formula to calculate WACC is presented below: WACC = ( E D + E r D e) + ( D + E r d (1 t)) PAGE 20/29

21 Where: E Equity Graph 15: US bond 10y growth D Debt r e Cost of equity r d Cost of debt t Taxes As a result, we obtained a WACC of 7,74%, 7,56% and 7,42% for 2016, 2017 Source: Bloomberg and The last necessary variable needed to calculate is the Terminal Value. This variable is important since it represents most of the value calculated in the DCF. The Terminal value corresponds to the cash flows generated by the company in the future years from the forecast. Without the Terminal Value, the analysis would be assuming the company would close in 2018 (in this analysis). The formula to estimate the Terminal Value is given by: Graph 16: S&P 500 growth Terminal Value = Cash flow t+1 WACC t g t As far as the discount rate for the period beyond 2018 (i.e. g), we used the Sustainable Growth Rate (SGR) by multiplying ROE with one minus Dividend Payout ratio. The result was a SGR of 1,69%. With these three components (FCFF, WACC and Terminal Value) it was determined the company Enterprise Value (EV). By removing its liabilities, we obtain EDPR s equity fair value. The Source: Yahoo Finance following table presents the result obtained in this analysis. EDP Renováveis Valuation Fiscal Year Ending Dec. 31 millions 2015A 2016F 2017F 2018F Value of Operations Securities Total Enterprise Value Liabilities Equity Outstanding Shares Current Share Price 6,98 Expected Share Price (Price Target) 7,07 7,65 7,72 7,85 Recommendation Result After performing our valuation through DCF approach, detailed explained in the previous chapter, we conclude EDPR s equity fair value is higher than its booked value. Subsequently we analysed the difference between the share prices in order to obtain the potential capital gain from the undervalue share. Moreover, PAGE 21/29

22 we analysed the potential gains generated from changes in Net Equity forecast in this analysis. The following board present the result obtained in this analysis. EDP Renováveis Valuation Fiscal Year Ending Dec. 31 millions 2015A 2016F 2017F 2018F Value of Operations Securities Total Enterprise Value Liabilities Equity Outstanding Shares Current Share Price 6,98 Expected Share Price (Price Target) Expected Capital Gain 9,6% Shareholders' Cash In / Out (per share) Expected "Cash" Gain 12,8% 7,07 7,65 7,72 7,85 0,11 0,90 1,03 1,36 Total Shareholders Expected Return "True" Recommendation Recommendation (research notes) 22,4% BUY BUY Based on this analysis, it was obtained a recommendation of BUY. As perceptible in the previous table, the total potential return on EDPR is 22,4% which means is higher of its current value. The reason for this is due to its Graph 17: Portuguese debt to GDP undervalue share price, which offers a potential capital gain of 9,6%. The remaining 12,8% are from potential cash generated from net change in equity (in cash). The reason for this undervalue price share might be related to the recent financial crisis that brought a colossal impact on the stock market, making shares reduce its value from several years. However, EDPR has invested in several Source: Banco de Portugal projects all around the world which are bringing results, whatever is by creating net profit or selling its assets to other companies (special Chinese companies who have been investing in Europe). Another possible cause for its undervalue share price might result from the regulation changes the sector has been facing across the globe. To finalise, EDPR stock situation was affected by the struggle faced from countries such as Portugal and Spain, who had to request for financial assistance in order to pay their respective debts. Nevertheless, after some impasse, both reason are reducing its impacts, since confidence is reaching the stock markets, both Portugal and Spain are now in better control of its debt compared to previous years in this analysis, and even the regulation changes seems to be creating more value to EDPR, since it managed to increase the price by EUR/MWh. Furthermore, EDPR operates in a sector that has been the PAGE 22/29

23 Energy Produced EDP RENOVÁVEIS focus of organizations such as EU and G-20 as a solution of climate changes and sustainable economics, and everything points out to remain as a priority. Sensitivity Analysis Graph 18: Spanish debt to GDP Source: Eurostat With the aim to provide a more confidence analysis, we conducted a Sensitive Analysis to see how fragile this valuation is. The variables chosen are the energy produced and the average price by MWh. The reason for choosing these variables holds on the fact that EDPR does not control these variables. Energy production is dependent on climatic environment and with changes on the regulamentation, the company is dependent on legislation scenarios. The Sensitive Analysis was calculating a change in these variables forecast. Basically, it was tested the impact until 3% change in these variables growth. The following table presents the results from the Sensitive Analysis. EDP Renováveis Sensitivity Analysis Price 3% 2% 1% 0% -1% -2% -3% 3,00% 116,85% 102,49% 87,77% 72,63% 57,02% 40,86% 24,06% 2,00% 102,49% 87,61% 72,31% 56,52% 40,17% 23,17% 5,39% 1,00% 87,77% 72,31% 56,36% 39,83% 22,63% 4,63% -14,30% 0,00% 72,63% 56,52% 39,83% 22,45% 4,26% -14,90% -35,22% -1,00% 57,02% 40,17% 22,63% 4,26% -15,10% -35,65% -57,66% -2,00% 40,86% 23,17% 4,63% -14,90% -35,65% -57,89% -82,00% -3,00% 24,06% 5,39% -14,30% -35,22% -57,66% -82,00% -108,77% As conclusion from the Sensitive Analysis, it is possible to see that company is still very dependent on macro environment situations. Although the results from our valuation were very positive, future revenues are very hard to forecast since this sector is dependent on the weather. Moreover, the prices are regulated by governments which take the company control to adjust the price at its will. Concluding, our analysis shows EDPR is a risk security, since small changes on the variables cause high impact on the company value. Additionally, it was also analysed the impact in a variation on WACC. Here, it was tested impact of 1,5% on WACC. The following table presents the results obtained: Expected Return 1,5% 1,0% 0,5% 0,0% -0,5% -1,0% -1,5% -27,96% -13,65% 2,95% 22,45% 45,67% 73,80% 108,57% Once again, it is possible to conclude the risk of EDPR by its volatility in WACC due to the impact on the company value from small changes on WACC. PAGE 23/29