Brazilian Utilities. Transmission Sector: Ready to Grow. 25 October 2016 Americas/Brazil Equity Research Electric Utilities

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1 Americas/Brazil Equity Research Electric Utilities The Ideas Engine series showcases Credit Suisse s unique insights and investment ideas. Research Analysts Vinicius Canheu, CFA vinicius.canheu@credit-suisse.com Arlindo Carvalho arlindo.carvalho@credit-suisse.com Brazilian Utilities INITIATION Transmission Sector: Ready to Grow In this report, we take a deep dive in the transmission sector and provide our views regarding its promising outlook, on the back of the strong pipeline of greenfield auctions (R$30bn-50bn) to be held in Brazil over the next 3 years. In our view, the transmission segment has the best outlook for greenfield projects in the country, given the government's significant willingness to solve the relevant bottlenecks existent in the transmission grid. The upcoming October 28 auction, which will offer roughly R$13bn worth of projects, has the potential to mark a new period of profitable expansion in the sector, after many years with a predominance of (1) low allowed returns; (2) aggressive bidders; and (3) strong subsidies in the segment's financing. We now expect a strong interest from local and foreign players of the electricity sector, and also from financial players, given the high returns that can be achieved in these projects under good execution (up to ~11% IRR, real, unleveraged). Over the 34 pages of this note, we first analyze the recent history of transmission auctions and identify the reasons for the lack of investment that led to the current issues in the grid, which drove the need of offering higher returns and lower execution risks under the new auction guidelines. Then, we present an analysis of the expansion opportunities brought about by the upcoming auctions, with a detailed breakdown of the profile and value-creation potential of each one of the 24 lots to be offered on October 28. One of our main conclusions in this section is that competition for this auction (in terms of discounts to RAP) may not be as high as before, since (1) there must be a predominance of players with capital discipline, like private utilities and financial players; and (2) there will be at least two other auctions of similar size and profitability in the short-term, meaning that interested bidders do not have to unleash all their firepower this October. Finally, we go over the investment case of two listed players focused on the transmission business: Alupar (OUTPERFORM, TP of R$20/ALUP11, previously R$15.85) and CTEEP (initiating coverage in this note, NEUTRAL, TP of R$77/TRPL4). (We are restricted on TAEE.) We see these stocks as good vehicles to play the greenfield growth story, as they have all shown adequate skills and similar investment appetite for the upcoming bids. We note that Alupar is the company with the highest potential for value accretion, since its smaller market cap provides greater room for equity upside in this story. We value both companies at their status quo and add a growth component given our expectations for the upcoming auctions. Re CTEEP, we highlight the main risks to our valuation involve negative decisions in its many regulatory disputes (Eletrobras, SEFAZ, Contract 059, DITs). DISCLOSURE APPENDIX AT THE BACK OF THIS REPORT CONTAINS IMPORTANT DISCLOSURES, ANALYST CERTIFICATIONS, LEGAL ENTITY DISCLOSURE AND THE STATUS OF NON-US ANALYSTS. US Disclosure: Credit Suisse does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the Firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision.

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3 Table of contents Transmission Sector: Ready to Grow 1 The October 28 Transmission Auction 4 Weaker Participation Rates 4 Changing Bidder Profiles 4 A Structural Bottleneck 7 Improving Conditions 7 What's at Stake? 8 Main Lots 10 Re-Auctioned Lots 11 A New Competitive Game 12 The Key Determinants for the Auction 13 Considerable Value Accretion 15 Expectations for the Upcoming Auctions 17 Alupar (ALUP11) 19 CTEEP (TRPL4) 23 Brazilian Utilities 3

4 Low returns and high construction risks led to weaker participation rates in recent years The October 28 Transmission Auction Weaker Participation Rates The success rates of transmission auctions in Brazil, measured as the percentage of lots that received bids, presented a major decline over the past five years after being very close to 100% between 2011 and That was followed by a period of revenues pressed downwards by the federal government, in which the regulatory WACC was also very low reaching a trough of 4.6% (in real terms) in Then, with rising interest rates and companies with balance sheet issues under a much tougher credit market, success rates dropped considerably, especially as the macro situation went downhill. Figure 1: Brazil's Macroeconomic Evolution GDP Growth 7.5% 2.7% 0.9% 2.5% 0.1% -3.8% IPCA 5.9% 6.5% 5.8% 5.9% 6.4% 10.7% Selic at YE, Nominal 10.8% 11.0% 7.3% 10.0% 11.7% 14.3% Source: Credit Suisse estimates 2013 presented weaker auction results, with ~75% success rates (% of lots with bids in a given auction) and slightly higher in terms of capex offered. In 2014, such numbers were lower than 50%, deteriorating further in 2015 (excluding one-lot auctions), since return rates were not high enough for most players and the short deadlines made licensing and potential capex overruns even bigger issues. At the same time, the aggressiveness of bidders, measured as level of discounts to the maximum RAP (annual allowed revenues) decreased significantly, as there was a much lower competition for the assets. Then, the Federal Government and ANEEL started to improve conditions in 2016, as we will later detail in the report. The result was a better, but still weak auction last April. Figure 2: History of Success Rates per Year, in terms of Lots Available Source: ANEEL, Credit Suisse estimates Changing Bidder Profiles There was a sharp change in the profile of bidders in recent years. Mostly due to (1) weaker cash-flow availability (after the change in concession terms in 2012); (2) execution issues in ongoing projects; and (3) a tougher access to credit, that led the large state owned companies to gradually leave the transmission auctions. Chesf (Eletrobras), which was a very active bidder in 2011 and early 2012, has not won any lots ever since. In fact, the company was blocked by ANEEL to participate in the upcoming auction given the magnitude of its delays in the execution of projects. Furnas (Eletrobras) won several lots until 2013 and hasn't been a major player since then. We note the only two state-owned firms to win lots since 2014 were Eletrosul (Eletrobras) and Copel, with the Parana Stateowned company winning a lot with estimated capex of R$581mn in Brazilian Utilities 4

5 Brazilian Utilities 5 Figure 3: History of Transmission Auctions since 2011 Auction 001/ / / / / / / / / / / / / / / / / / / General Information Date 10-Jun-11 2-Sep Dec-11 8-Feb Apr-12 6-Jun-12 1-Nov May Jul Oct Dec-13 7-Nov May Nov-14 9-Jan-15 6-Oct Nov Jul Apr-16 Regulatory Wacc 5.6% 5.6% 5.6% 5.6% 5.0% 5.0% 5.0% 5.0% 4.6% 4.6% 6.6% 4.6% 5.5% 5.6% 5.6% 7.7% 7.7% 8.1% 9.5% Success Analysis Lots Offered Lots Sold Success Rate 100% 100% 89% 100% 75% 83% 88% 60% 71% 77% 100% 75% 69% 44% 50% 36% 33% 100% 58% Total Capex Offered 750 2,828 1,642 2, ,329 5,304 1,281 3,535 2, ,362 3,308 1,728 7,843 7,545 7,000 12,133 Total Capex Sold 750 2,828 1,625 2, ,094 4, ,378 2, , ,383 1,455 3,449 7,000 6,873 Success Rate 100% 100% 99% 100% 85% 91% 95% 77% 68% 96% 100% 95% 85% 19% 80% 19% 46% 100% 57% Total Km of Lines Offered 460 2,227 1,412 1, ,932 4,603 1,580 2,604 2, ,217 4, ,776 4,093 2,518 6,098 Total Km of Lines Sold 460 2,227 1,382 1, ,275 3, ,604 2, ,533 2, ,828 2,518 3,307 Success Rate 100% 100% 98% 100% 79% 89% 87% 80% 46% 100% 100% 100% 79% 56% 100% 19% 45% 100% 54% Average discount 53% 23% 25% 38% 23% 1% 22% 12% 13% 7% 38% 6% 13% 13% 5% 2% 1% 19% 3% Breakdown of Winners, By Lots Number of Different Winners Main Listed Transmission-Focused Taesa CTEEP Alupar Main State-Owned Copel Furnas Eletronorte Eletrosul Chesf Main Foreign Players State Grid Abengoa Isolux Source: ANEEL 25 October 2016

6 Transmission focused companies were not major players between 2012 and Meanwhile, transmission focused companies were no longer major players between Taesa won only ~R$140mn of capex in that time span, while Alupar stayed at R$262mn. CTEEP did not win anything since 2011, as the cut in revenues brought about by MP579 and the delay in the reimbursement of RBSE (indemnification for old transmission assets) sparked a significant regulatory uncertainty for the firm. Figure 2: Participation of Transmission-Focused Companies in Auctions Taesa Km of Lines # Substations Total Capex (R$mn) Alupar Km of Lines # Substations Total Capex (R$mn) CTEEP Km of Lines # Substations Total Capex (R$mn) 1, Source: ANEEL Large projects became fit for those with lower cost of capital, namely foreigners who were eager to consolidate their positions in the Brazilian market. Some, like State Grid from China, participated in consortiums with local players in order to get used to the market, before bidding for very large lines. Others, like Abengoa (Spanish construction group), pursued more aggressive strategies, bidding with high discounts and very low return rates. This allowed the firm to develop a deep pipeline of projects between 2012 and 2014, but made the execution of such pipeline financially unfeasible. Now, the company is facing the consequences of this strategy, having filed for Chapter 11 both in Brazil and in Spain. As regulatory conditions for auctions started to improve in 2016, we saw the emergence of other players, namely smaller EPC and financial firms, which were interested in the high return rates offered by infrastructure assets that, when built, present very little operational risk. Finally, this last auction also saw the return of Taesa and Alupar to the competition. Figure 4: Examples of the Evolution of Main Types of Bidders Since 2011 Source: Credit Suisse Research Brazilian Utilities 6

7 A Structural Bottleneck The Federal Government has a very large pipeline of transmission projects to be implemented in order to address the connection issues of a large country like Brazil, who is seeing the incremental generation capacity being built in areas very far (hydro plants in the North and wind farms in the Northeast) from the main consumption centers in the Southeast. In this backdrop, the challenging and unattractive conditions from the previous transmission auctions led to many important projects not being implemented. This is creating a structural bottleneck, since a potential recovery of the Brazilian economy over the next few years could lead to higher electricity consumption growth rates that could not be met by the existing capacity. Figure 5: Projected Growth of Brazilian Total Installed Capacity (GW) CAGR: 4.7% Source: ONS Improving Conditions Auction conditions started to improve in 2015, but received the major boost after the recent change in government. ANEEL had already improved conditions for April's first tranche of the auction. It allowed for longer construction period for the projects, so they could better accommodate the licensing and preparation phase. It was the first time ANEEL allowed a 5-year construction time for some lots, although that was the case for only 8 out of the 25 available. It also increased the regulatory WACC (real terms, unlevered), from 8.5% to 9.5%. This was the first time it was above regulatory WACC for distribution, a riskier business. Moreover, BNDES agreed to increase its participation in the funding of the projects to up to 70% of financeable items (equivalent to 50-60% of total capex). The result was a better, but still weak transmission auction (more details in our April report, here). Figure 6: Evolution of Regulatory WACC for Transmission and Distribution 11% 10% 9% 8% 7% 6% 5% 4% WACC Transmission (Auction) WACC Distribution Source: ANEEL, Credit Suisse Research Brazilian Utilities 7

8 There were several changes for this second tranche of the auction. First, there was an increase in the maximum RAPs and regulatory WACC, as ANEEL was eager to attract new bidders. It also allowed for 5-year construction periods for most lots, in order to soften the burden of the pre-construction time and provide additional cushion for potential investors to solve any licensing issues. Then, the regulator published a second version of the invitation to bid on August 2, with a different WACC and with three more lots that failed to receive bids in April. However, BNDES reduced its maximum financing to ~50% of the financeable items, before finally opting for no subsidized TJLP-based debt and offering only market rates for potential bidders. This, added to some backlash from companies such as Alupar, who publicly criticized ANEEL's decisions on its 2Q16 conference call of results, led the agency to publish a third edition of the invitation to bid on September 28, with revised, more favorable conditions. The average regulatory WACC increased to ~10%, as ANEEL altered some of its components. Namely, it changed inflation expectations, increased the cost of debt (considering no TJLP financing), and altered the spread S1 it includes in the calculation. Individual lots saw changes in their cost and proportional amount of equity (both increased for the WACC calculation). The agency also removed one of the lots inserted in version 2, a 10km line with capex of R$98mn and maximum RAP of R$19mn. A comparison between the three versions can be seen below. We note that, after the final version was published, BNDES agreed to finance some of the capex at TJLP-based rates (more details below). Figure 7: Evolution of the Conditions in the Invitation to Bid for Auction 013/ Version 1 (July 7) Version 2 (August 3) Final Version (September 28) Original Scheduled Date September 2 September 2 October 28 Number of Lots 22 (Total Capex of R$11.8bn, Total Max. RAP of R$2.1bn) 25 (Total Capex of R$12.6bn, Total Max. RAP of R$2.3bn) 24 (Total Capex of R$12.6bn, Total Max. RAP of R$2.62bn) Regulatory WACC, Real Terms Average WACC: 8.38% Average Implicit ke: 11.4% Average Implicit kd: 5.8% Average WACC: 8.9% Average Implicit ke: 10.68% Average Implicit kd: 6.7% Average WACC: 9.7% Average Implicit ke: 11.1% Average Implicit kd: 8.9% RAP/Capex Expected BNDES Participation 70% of financeable items, TJLP-based, up until 80% via market rates 50% of financeable items at TJLP, up until 70% via market rates 50% of financeable machinery TJLP-based, remainder up until 80% of financeable items at IPCA + spread Source: ANEEL, BNDES, Credit Suisse estimates What's at Stake? There are 24 lots being auctioned on October 28 th. This represents over 6,614km of lines and a total capex of R$12.6bn. Revenues at the cap add up to R$2.6bn, establishing a RAP/Capex ratio of 0.21 (the main metric ANEEL looks at). This marks a considerable improvement from the R$2.3bn RAP from the previous version of the invitation to bid and its corresponding 0.18 RAP/Capex ratio. A summary of the lots and their main features can be seen below. Brazilian Utilities 8

9 Brazilian Utilities 9 Figure 8: Summary of Lots Available for 013/ Auction Lot State Date Due # lines Total Km # Sub-St Capex (R$mn) Max RAP (R$mn) RAP/Capex Unlev IRR NPV Unlev 1 BA Feb % 94 23% 2 BA, MG Feb , % % 3 BA, MG Conditioned to Lot 2 Feb % % 4 MG Conditioned to Lot 2 Feb % 79 23% 5 MG Conditioned to Lot 2 Feb % 27 27% 6 MG, ES Conditioned to Lot 2 Feb % % 7 MG Conditioned to Lots 2 and 6 Feb % 62 23% 8 BA, GO Feb % % 9 BA Feb % % 10 PI, BA Conditioned to Lot 9 Feb % % 11 PI, PE, CE Conditioned to Lots 9 and 10 Feb % % 12 BA, PI Conditioned to Lots 9 and 10 Feb % % 13 RN, PB, CE Feb % % 14 MG, BA Feb , % % 15 MG, BA Conditioned to Lot 14 Feb % % 16 MG Conditioned to Lot 14 Feb % % 17 MG, BA Feb % % 18 MG Conditioned to Lot 14 or Lot 17 Feb % 62 29% 19 MG Feb % 63 23% 20 GO, MG, BA Feb % % 21 ES Feb % 72 24% 22 MG, ES Conditioned to Lot 21 Feb % % 23 PA Feb % % 24 ES Aug % 26 22% Total 30 6, ,584 2, % 2,876 23% Source: Credit Suisse estimates, ANEEL NPV/Capex (Unlev) 25 October 2016

10 Main Lots We note that 50% of the auction (12 lots) is conditioned to a successful bid (by anyone) for a few specific lots. This means that up to 43% of the total capex (or R$5.4bn) may not even be auctioned if 6 lots do not receive bids. We highlight the five lots centered on the Minas Gerais state (total estimated capex of R$1.9bn, maximum RAP of R$402mn) conditioned to a successful bid for Lot 2 (capex of R$1.3bn, maximum RAP of R$265mn). Lot 9, in Bahia State, is a conditional for Lot 10 (capex of R$820mn, RAP of R$171mn), which is, in turn, a conditional for two additional lots in the Northeast region (total capex of R$1bn, RAP of R$206mn). We also highlight that Lot 18 is conditioned to either Lot 14 or Lot 17. A summary of all conditionals/conditioned can be seen below. Figure 9: Lots Conditioned to Lot 2 Figure 10: Lots Conditioned to Lot 9 Lot 3 Lot 11 Lot 2 Lot 4 Lot 5 Lot 9 Lot 10 Lot 12 Lot 6 Lot 7 Source: ANEEL Source: ANEEL Figure 11: Lots Conditioned to Lot 14, 17 Figure 12: Lot conditioned to Lot 21 Lot 15 Lot 14 Lot 16 Lot 18 Lot 17 Source: ANEEL Source: ANEEL By speaking with industry players, we understand that there are some synergies between lots that could help the winner of the conditional to win the smaller ones. However, they are reportedly only for a few specific cases, with a strong possibility that other players are more competitive for smaller ones even without winning the conditioning one. Brazilian Utilities 10

11 Figure 13: Approximate Location of Lots to be Auctioned on October / Auction Source: Taesa, Credit Suisse Research Re-Auctioned Lots We also note that there are three lots that are currently being re-auctioned, since they received no bids in previous auctions and were deemed of considerable importance by ANEEL. They are namely Lot 21 (estimated capex of R$298mn, maximum RAP of R$63mn), Lot 23 (estimated capex of R$427mn, maximum RAP of R$90), and Lot 24 (estimated capex of R$116mn, maximum RAP of R$22mn). We note that Lot 21 is a conditional for Lot 22 (estimated capex of R$486mn, maximum RAP of R$101mn), increasing its significance even further. Figure 14: Lots to Be Re-Auctioned Lot 21 Auction 013/ Auction 005/2015 TL 345 kv Viana 2 - João Neiva 2-79 km; - Lot D SS 345/138 kv João Neiva 2, (9+1Res) x 133 MVA - Lot D Static Compensator 345 kv (-150/+150) Mvar. - Lot D Lot 23 Auction 013/ Auction 005/2015 TL 500 kv Vila do Conde - Marituba - 56,1 km Lot J Lot I TL 230kV Marituba - Castanhal - 68,6 km; Lot J Lot I SS 500/230 kv Marituba - (3+1R)x300 MVA Lot J Lot I SS 230/69 kv Marituba - 2X200 MVA Lot J Lot I Lot 24 Auction 013/ Auction 005/2015 SS 230/138 kv São Mateus 2 (ew) - (3+1R)x50 MVA Lot U Lot D TL 230 kv Linhares 2 - São Mateus km Lot U Lot D Source: ANEEL Brazilian Utilities 11

12 A New Competitive Game The auction conditions have undoubtedly improved and we understand it has generated a considerable appetite from potential bidders. This happens at a time of expected declining interest rates in the local market and zero to negative rates in the developed world, making the solid cash flows of these projects even more interesting, especially considering how these attractive conditions for the projects should not remain for the longer-term. We expect transmission-focused firms like ALUP, TAEE and TRPL to be key players in the upcoming auctions. The participation of State Grid remains the biggest question mark; Eletrobras should remain on the sidelines. We think the lots with lower construction risks should see the highest competition, since all transmission projects offer very little operational complexity and low opex levels. In our view, the bulk of the value creation for these projects comes from a construction done in a cost effective and timely manner, as well as the financing schemes used to fund them. We note that transmission-focused companies such as Taesa, Alupar and CTEEP have already stated their solid interest in participating. First, on Taesa, we note that management has called the market attention for the potential synergies of the lots in Minas Gerais with their existing asset base and claimed to be analyzing 18 out of the 24 lots. Looking at where the auction's lots are located, we see that several lines are in the same region as those operated by Taesa and Alupar. We note that the companies could bid via TBE, a company in which they own 49% and 51% stakes, respectively. TBE is relatively unlevered, at 1.3x net debt/ebitda, which could provide additional room for projects. We highlight that whereas Taesa does not consolidate TBE, Alupar, who is considerably more levered, does so, thus limiting the amount of debt it can raise. While actual synergies between different lines and substations are usually limited, we believe that the specific know-how for each state and/or region may be a source of considerable advantage in the planning of the pre-operational phase (mostly licensing and rights of way), thus giving an edge to companies that better understand their environment and are able to provide more competitive bids. On Alupar, we note that the company was unhappy with the previous versions of the auction's rules, as they complained in their 2Q16's conference call of results that the regulatory WACC dropped in comparison to April's auction, despite the lower financing from BNDES. The latest changes, however, took the WACC in real terms back to double digits and Alupar may be able to attain the IPCA+10% hurdle rate that they mentioned on the call. The company has already disclosed its solid intent to participate in the auction. CTEEP is the other transmission-focused listed firm we expect to be a key player in the auction. The company expects much larger competition given the improved conditions, but mentioned that the timing is very good for them to make investments with better returns than those they had in the past, as they see several good projects in the auction. The company mentioned by the time of the RBSE decision in April that it now had the financial security to enter new auctions and leverage itself. As for foreign players, we highlight the cases of Brookfield and State Grid. Both are being really aggressive with M&As and greenfield projects and have the deepest pockets in the sector, given their lower costs of capital at home and better access to financing. We expect both to be relevant players in the auction and the only two relevant foreign players, since the Spanish companies that dominated the auctions are now in dire financial conditions. While Brookfield seems more like a lock for the auction, State Grid's participation is less certain, given their problematic track record in greenfield execution of recent auctions (mostly in partnership with Copel and Eletrobras) and, to a lesser extent, their recent deal to acquire CPFL's control and their reported interest in the Abengoa assets currently for sale. We also see other power sector companies that were not participants in the transmission segment as potential bidders. These are namely Equatorial and Energias do Brasil, who have already stated their interest in the segment and the high returns seen in these auctions. We note that construction-based infrastructure groups like WTorre and Zopone, Brazilian Utilities 12

13 We expect a diverse array of bidders, including financial players, small EPC firms and power sector companies traditionally not focused on transmission. who won some lots in April, may return, especially as they might be able to cut capex costs and margins in exchange for a higher long-term return and vice-versa. Finally, we note that financial players should also play a role in the bidding process. Private equity firm Patria Investimentos, who already participated in a consortium that won a ~R$2bn project in April, is an example of that type of potential bidder. We note, however, that there are some higher restrictions for joining the auction, such as higher thresholds on the size of the interested companies imposed by ANEEL, which could limit the participation of smaller and less experienced players. In order to avoid "adventurers" that might not be ideal concessionaires and pose greater risk to the system, the agency determined that a firm will only be eligible to bid if its book value is at least 10% of the total estimated capex of the lot. Furthermore, this rule is cumulative, meaning that if a company wants to bid for three assets, its special purpose entities' book value must be at least 10% of the sum of the three capex estimates. This could limit the participation of some financial players and some smaller EPC firms to just a few lots, opening the path for the specialized companies. The Key Determinants for the Auction EPC, licensing and funding will be critical for the auction and associated returns. From our conversations with companies and investors, we see three issues that were always at the center of discussions related to the upcoming auction: (1) the availability of EPC firms and proper labor force for the construction phase; (2) licensing; and (3) access to funding. While the availability of EPC firms and proper labor escalated into a major concern in recent months, we understand that the situation has seen worse perspectives. Taesa, specifically, mentioned on its conference call of results that the situation improved considerably, as EPC firms are working to supply the proper service when needed, in 2 years' time. Alupar, on the other hand, seems more skeptical, citing its ability to do its own capex as a key differential for the auction. Another question that companies raised in the beginning of the year was the absence of qualified labor. Alupar repeatedly stated that the workers that build transmission lines require specific skills and that it was still seeing a shortage in this market. When asked in a meeting with investors, Taesa mentioned that Abengoa has recently let go ~6,000 workers due to its Chapter 11 request. Thus, the company believes that there is indeed a good supply of qualified labor available today. Moreover, the company believes that, as construction only starts in around two years after the auction, the EPC firms have plenty of time to get themselves ready. Figure 15: Approximate Timeline of New Projects with a 5-year Deadline Source: Credit Suisse estimates Still in the pre-construction phase, we believe that licensing will be the key individual issue for the lots. In the past, some lines have struggled considerably to obtain the proper environmental licenses, which led to many delays and even projects on which the companies gave up. A critical example was TNE, a concession held by Alupar (51%) and Eletronorte (49%). The concession, with 715km of lines and 3 sub-stations, was auctioned in However, Alupar notified ANEEL of its intentions to return the concession in September 2015, citing that it was unable to get the required licenses, mostly on the grounds of issues with indigenous populations and environmental permits. Shortly thereafter, some of the regulatory bodies that could issue the licenses did so, but Alupar Brazilian Utilities 13

14 Longer preconstruction phase allows for plenty of cushion for licensing and EPC planning. 20-year price amortization schedule balances the lower subsided amount of BNDES financing. claimed that it was a very different reality (different macro conditions, access to capital markets, etc.), which required a completely different return/rap. The holding comprised by Alupar and Eletronorte claims it spent over R$300mn in the project, mostly related to building one specific substation, buying 2/3 of the required cables and securing expensive bridge loans in the pre-construction phase. The company is now seeking an indemnification for the expenses it incurred. We note that there may be issues in very small parts of the planned lines which can harm the entire projects' returns considerably. A thorough due diligence is necessary, with special attention to indigenous reservations and environmental preservation areas. We note that Taesa mentioned that all lots were designated as "relevant" by the government. This means that even lots that are restricted to one state will not be analyzed at state level, but will also have their licenses given by IBAMA instead. This helps avoid potential conflicts of interest and provides for a unified framework, helping mitigate potential issues. Finally, we note that the conditions for responsibility and costs improved considerably, with companies not being liable for any licensing delays for which they were not responsible. Meanwhile, funding is the big overarching issue for the segment. Companies still face high debt costs, as the Brazilian credit market still struggles. BNDES has greatly reduced its loans, following several complications on the macro side. In April 2016's first tranche of the auction, BNDES was financing up to 70% of financeable items, which amounted to ~50% of the total capex. Then, BNDES reduced its maximum participation back to 50% of financeable items (as it was before), covering the difference to the level of 80% of the financeable capex at market rates. However, after the publication of the final version of the notice, BNDES determined that it would limit the use of subsidized TJLP-based loans even further. Instead, it will cover up to 80% of the financeable capex, splitting it according to their final usage. 50% of the purchased equipment and machinery may be financed with a TJLP-based rate in a 14- year term. The remainder may be financed at market rates, in a 20-year price amortization schedule. While the new WACC already supposedly accounted for more expensive costs of debt, with no TJLP loans, this could somewhat change the competitive landscape for the auction as the higher final rates may reduce the attractiveness of the auction vs. what was expected by the time of the notice. We note, however, that the 20-year loans with price amortizations were already seen as a major positive by the firms, as it mitigates the issues of less TJLP-based financing. The change in BNDES participation could impact bids in the sense that interested players, in an attempt to keep their minimum required rate of return, may reduce the discount they are willing to bid or give up on bidding on specific lots. However, we note that the extended term (20 years) and the price amortization schedule allow for conditions better that those offered by commercial banks, even if final interest rates are slightly higher than those originally expected (we expect rates at around IPCA+10%). Therefore, we do not believe this could drastically reduce interest in the auction, as unlevered returns are still high and lower discounts (even with competition) can help maintain solid leveraged IRRs. Brazilian Utilities 14

15 Figure 16: Changes in BNDES Participation from April's Auction April s Auction (013/2015 A) October s Auction (013/2015 B) Participation and Rates 70% of financeable items at TJLP + spread Additional 10% at IPCA + spread Total of 80% of financeable items. 50% of equipment and machinery at TJLP + spread; rest at IPCA + spread Spread Basic BNDES remuneration: from 1.5%/year Additional credit spread: up to 2.97% Basic BNDES remuneration: from 1.5%/year Additional credit spread: up to 3.37% Term 14 years 14 years for TJLP items 20 years for other items Amortization Schedule SAC constant amortization Price constant PMT (interest + amortization) if infrastructure debentures are issued at a later stage Price constant PMT (interest + amortization) Source: BNDES, Credit Suisse estimates Considerable Value Accretion While conditions indeed seem favorable, we note that the actual value creation is highly dependent on variations to ANEEL's estimated capex and discounts to the maximum RAP. In our calculations, if companies deliver projects on budget and on time, a bid with no discount to the maximum RAP could yield an unlevered NPV of ~23% of the project's capex, if cash flows are discounted at an 8% Ke in real terms, which is a level we assumed reasonable for greenfield transmission projects. This means that the auction could have a value accretion of ~R$2.9bn (NPV), when we consider all its lots. For this analysis, after talking to several potential bidders, we determined a specific capex curve for the projects with the February 2022 deadline, which we illustrate below. For the sake of consistency, we keep this same curve throughout all our calculations. Figure 17: CS Projected Capex Curve for 5-Year Projects 25% 25% 30% 15% 5% Source: Credit Suisse estimates We highlight that leverage may increase returns even further, as seen on the sensitivity analysis below. For this analysis, we considered different levels of total financing, included only the BNDES debt, and split the total amount it funds between 25% TJLP + spread and Brazilian Utilities 15

16 75% IPCA + spread, in order to reflect the portion of equipment and machinery more accurately. In our calculations, we used a 5.4% annual spread for the TJLP portion of the debt and a 10% spread for the IPCA. While the 25/75 proportion may vary specially according to the number of sub-stations (which demands more machinery), we used this average for all lots, after discussing it with companies and potential bidders. Figure 18: Sensitivity Analysis of Leverage at Max. RAP Unlevered and BNDES debt Leverage Structure Unlev 50% 60% 70% Average IRR 11% 13% 14% 16% 8% Real (R$mn) 2,876 3,575 3,784 3,941 NPV/Capex 23% 28% 30% 31% Source: Credit Suisse estimates With the impact of leverage clear, we will now dive deeper into the effects of bid discounts and variations of capex. Considering its importance as a conditioning lot, we picked Lot 2 as our example for the sensitivities. Lot 2 is comprised of 541km of lines and 2 substations and has a max. RAP of R$265mn and a total estimated capex of R$1.3bn. Whereas there might be small deviations across different lots, we believe that Lot 2 is a good proxy, given its mixed composition and relevance. We note that large discounts may be justified by potential synergies in operations with existing asset bases, re-leveraging structures over the project life and different capex performances in relation to ANEEL's estimates. We now assess how different discounts to the maximum RAP and capex estimates affect the IRR of an unlevered project. Figure 19: IRR (Real) Sensitivity Analysis for Lot 2, RAP vs. Capex - Unlevered Case Variation vs. Aneel's Capex Source: Credit Suisse estimates Discount to Max. RAP 0% 5% 10% 15% 20% -15% 12.8% 12.2% 11.6% 10.9% 10.3% -10% 12.1% 11.5% 10.9% 10.3% 9.6% -5% 11.5% 10.9% 10.3% 9.7% 9.1% 0% 10.9% 10.4% 9.8% 9.2% 8.6% 5% 10.4% 9.8% 9.3% 8.7% 8.1% 10% 9.9% 9.3% 8.8% 8.2% 7.7% We then analyze the same variation for Lot 2, but considering a 60% financing scenario, which we deem as our base case. For this sensitivity, we use the same TJLP/IPCA split we mentioned above, considering no re-leveraging and only this BNDES debt. Figure 20: IRR (Real) Sensitivity Analysis for Lot 2, RAP vs. Capex 60% Leverage Variation vs. Aneel's Capex Source: Credit Suisse estimates Discount to Max. RAP 0% 5% 10% 15% 20% -15% 17.1% 16.2% 15.2% 14.3% 13.2% -10% 16.1% 15.2% 14.3% 13.3% 12.3% -5% 15.1% 14.3% 13.3% 12.4% 11.4% 0% 14.3% 13.4% 12.5% 11.6% 10.6% 5% 13.4% 12.6% 11.7% 10.8% 9.8% 10% 12.6% 11.8% 10.9% 10.1% 9.1% Brazilian Utilities 16

17 These variations also affect the value creation of the projects. Assuming the 8% cost of equity in real terms, the impact of such discounts can be seen in the exhibit below, where we look at the same BNDES debt structure for Lot 2. Figure 21: NPV (R$mn) Sensitivity Analysis for Lot 2, RAP vs. Capex 60% Leverage Variation vs. Aneel's Capex Source: Credit Suisse estimates Discount to Max. RAP 0% 5% 10% 15% 20% -15% % % % % % The deviations in the discount to the maximum RAP and the actual capex also affect the NPV/Capex ratio. We recall that our base case of ANEEL's capex + no discount bid in a 60% leverage structure leads to a 30% ratio. We present this sensitivity analysis below. Figure 22: NPV/Capex Sensitivity Analysis for Lot 2, RAP vs. Capex 60% Leverage Variation vs. Aneel's Capex Discount to Max. RAP 0% 5% 10% 15% 20% -15% 46% 41% 36% 30% 25% -10% 40% 35% 30% 25% 20% -5% 35% 30% 25% 20% 16% 0% 30% 25% 21% 16% 12% 5% 26% 21% 17% 13% 8% 10% 22% 18% 13% 9% 5% Source: Company data, Credit Suisse estimates Expectations for the Upcoming Auctions We expect a much better success rate for the October 28 auction, but there could still be empty lots. As seen above, return rates and value accretion are indeed very strong. Only a very large discount, with virtually no leverage and with a significant capex overrun could potentially be very harmful for bidders. We believe that these improved conditions should indeed attract players from several segments, as the search for yield and value creation continues. There should be substantial competition and we could see some lots coming out at a discount to the maximum RAP. However, there could also be lots with no bidders, as a deeper analysis of the capex, licensing procedures and other specific details of each asset may present projected estimates that differ from those presented by ANEEL. Meanwhile, the solid returns and value creation provided should support a continued interested for future auctions, since ANEEL has already made clear its intention to hold another auction of greenfield transmission lines early in 2017 at similar profitability conditions. This auction, originally planned for the end of 2016 as the third tranche of the , had to be postponed due to delays in the execution of previous auctions. For this one, we believe that ANEEL will most likely keep the same main features in terms of deadlines, financing and return rates and will attempt to re-auction some of the lines that haven't received bids in the series. Brazilian Utilities 17

18 On its revised Transmission Expansion Plan, which goes all the way to 2021, the Ministry of Mines and Energy (MME) and its Energy Planning Company (EPE) projected an additional capex of R$43bn over the course of the next five years. A breakdown of such capex can be seen below. Figure 23: New Transmission Capex Planned Until 2021 Region Km of Lines (000s) # of Substations Capex Lines (R$mn) Capex Substations (R$mn) Total Capex (R$mn) North Northeast Southeast /Center-West South Total Source: EPE In order for such aggressive amount to be attained, we highlight the importance of bringing the various types of bidders previously discussed to the table. This means that return rates should be kept elevated and financing favored, in order to attract the non-transmissionfocused players that have more of a portfolio management approach. ANEEL's Director Tiago de Barros Correa, in a meeting with investors held in São Paulo on September 29, agreed with such perspective and added that such high rates should be kept for around two to three years, so that these other agents are attracted and help solve the bottleneck situation. We recall that most of the projects currently being auctioned have deadlines of five years, which would make Mr. Correa's assertion imply a potential solution to the structural problem by If conditions remain attractive for the next few years, we expect participation rates to remain elevated and even increase in case of an actual macroeconomic recovery which could improve the companies' access to credit at lower rates. The Transmission-Focused Companies With transmission in the spotlight of the power sector and within the scope of the upcoming auction, we initiate our coverage of CTEEP and revise our estimates for Alupar. We have updated our cost of capital and macroeconomic assumptions, and adjusted our figures to recent results. While we will dive into the specifics for each company over the next pages, a summary of our new CAPM assumptions can be seen in the table below. Please note that all CS target prices are set with a 12-month horizon. Figure 24: CAPM Assumptions US Risk Free Unlevered ß Equity Risk premium Country Risk Premium 2.50% % 3.50% Source: Credit Suisse estimates Brazilian Utilities 18

19 Alupar (ALUP11) We maintain our OUTPERFORM rating for Alupar while raising our TP to R$20/unit (vs. R$15.85 previously). In our numbers, we value Alupar's business "as-is" at R$19/share (Dec-2017), after updating for recent results and new cost of capital and macro assumptions. However, we note that Alupar, given its smaller market cap and similar fire power to other players, may be the best vehicle to play the several auctions of transmission lines planned for the next year. We note that if the company wins ~R$1bn worth of projects in the upcoming auctions (which we deem feasible), the NPV creation may amount to ~R$1/share. Hence, including this growth perspective as we expect the company to be a major bidder, we set our target price at R$20/ALUP11. We expect Alupar to deliver improving results in generation, as it completes its ramp-up phase in the segment. Meanwhile, the company should continue to see a major deleveraging process over the next two years, before it has to take any debt for new capex. While this status-quo seems already priced in, the ability to add growth at high return rates lead us to still see some upside for the firm. Updated Estimates In our financial forecasts, we do not account for any incremental growth. Additionally, as discussed below, we give no value to the TNE and ELTE concessions going forward. We also updated our figures for the sale of Transchile and the recent capital increase. Then, adjusting for recent results and applying the basic cost of capital and macro assumptions changes mentioned above, we present the main changes to our estimates below. Figure 25: Changes to Our Estimates for ALUP, BRGAAP 2016E 2017E 2018E 2019E Net Revenues Old 1,538 1,630 1,718 1,631 New 1,596 1,631 1,704 1,662 EBITDA Old 1,372 1,507 1,276 1,344 New 1,434 1,509 1,246 1,319 Net Income Old New Source: Credit Suisse estimates Generation Update The segment is still making the jump towards concluding its ramp-up. We note that the Morro Azul/Risaralda small hydro plant in Colombia (20MW installed capacity) just became operational, being the second relevant project to do so in Meanwhile, the company is struggling to conclude the La Virgen plant in Peru (84MW), which should become operational in 1H17, due to delays caused by the geological formation of the region. The company expects a capex overrun between 10-15%, designating one-third (~R$50mn) of the proceeds of the Transchile deal for it. Recent Deals Alupar won two lots in April's transmission auction (013/2015-1), with a total estimated capex of R$436mn and RAP of R$77mn. Lot I, for which ALUP bid with 11% discount to the maximum RAP, had a total estimated capex of R$285mn. Meanwhile, Lot T, a Brazilian Utilities 19

20 substation that was won at the revenue cap, presented a capex of R$151mn and RAP of R$28mn. A summary of the winning bids can be seen below. Figure 26: Alupar's Winning Bids in April 2016's Auction Lot States Km of # Sub- Due Est. Capex Final RAP Discount of Final RAP/ Lines Stations Date (R$mn) (R$mn) Bid (%) Capex Lot I RN 20 1 Dec % 17% Lot T ES - 1 Jun % 19% Total % 18% Source: ANEEL Alupar has recently announced the sale of its 51% stake on Transchile to Ferrovial S.A. for US$59mn (US$52mn after tax, according to the company). Using a BRL/USD rate of 3.25, this represents ~5% of Alupar's current market cap. Transchile's RAP accounted for less than 1% of Alupar's net revenues. Yet, the deal was made at 16x RAP and was able to reduce the company's net debt/ebitda ratio by 0.16x. We note that Alupar did not consolidate Transchile and that the concession was basically irrelevant in our numbers. Licensing Alupar has two major issues with licensing in its recent history, ELTE and TNE. The ELTE concession (2 substations and 38km of lines near the shore of São Paulo state, RAP of R$34mn) was delayed indefinitely due to various licensing problems. Licenses were expected since October 2015, but are still pending. The lot was auctioned on 2014, with an estimated capex of R$ 262mn. The company has spent only ~R$5mn in the project, as it learned from its past mistakes with TNE and opted to wait for all licenses before incurring larger expenses. Alupar expects a solution for the concession early in 2017, but, given the uncertainty, we opted to not include anything in our numbers. As for TNE, Alupar filed a formal request to ANEEL to forfeit the project, given the issues with licensing. The project had an estimated capex of R$1.1bn on its inception and has not obtained the required licenses since Alupar claims that a new RAP is required, given the significant macro changes since then. We do not include anything from TNE in our forecasts. Additionally, we note that the consortium that was responsible for the project (Alupar has a 51% stake) has asked for an indemnification of R$534mn for it. We do not believe that is likely at this moment and did not incorporate it into our numbers. Leverage Alupar presented a 2Q16 leverage ratio of 3.2x, after reaching 3.5x in the beginning of the year. Then, the company concluded a R$350mn capital increase in July and the aforementioned sale of its stake in Transchile. These measures reduced these figures to 2.79x. This reduced leverage allows for the company to focus even more on core growth, with the upcoming auction already in plain sight. Expectation for Upcoming Auction We expect Alupar to be a major player in the upcoming auction. The company has the expertise and know-how, is able to internalize some of the EPC, thus being less reliant on a limited amount of suppliers, and has the required balance sheet for a solid participation. We note that Alupar may participate directly within the holding's umbrella, via TBE (its partnership with Taesa), or via other partnerships with financial players. Unlike Taesa, however, Alupar consolidates TBE, which means that its leverage must be accounted for. Brazilian Utilities 20

21 Figure 27: Alupar's Factsheet BASICS COMPANY DESCRIPTION Sector Utilities/Generation Ticker ALUP11 Price (R$) 17.8 Target (R$) 20.0 Recommendation OUTPERFORM Mkt. cap. (R$mn) 4,455 POSITIVES Free Float (R$mn) 1,109 SHAREHOLDING STRUCTURE Guarupart FI-FGTS Free Float TOTAL Alupar operates in transmission and generation segments, focusing on development and investing in infrastructure projects in the power sector, mainly in Brazil. It is controlled by the Godoy Pereira family. Established track record Strong and visible cash Flows Potential for solid growth in transmission over the next few years TOTAL (EQUIVALENT UNITS) % 35 14% NEGATIVES 62 25% Execution risks of portfolio under construction % Uncontracted capacity in generation EBITDA BREAKDOWN OWNERSHIP STRUCTURE 1,500 1,300 1, , , A 2016E 2017E 2018E 2019E 2020E Genco Transco Other Guarupart FI-FGTS Free-Float 61% 14% 25% ALUPAR FINANCIAL METRICS (R$MN) 2015A 2016E 2017E 2018E 2019E 2020E OPERATING METRICS 2015A 2016E 2017E 2018E 2019E 2020E Net Revenues 1,494 1,596 1,631 1,704 1,662 1,722 Generation production (GWh) 2,309 2,825 3,146 3,414 3,414 3,424 Manageable Expenses (204) (178) (222) (225) (230) (235) Generation price (R$/MWh) Non Manageable Expenses (154) (175) (157) (181) (178) (180) Installed capacity - MW EBIT 1,136 1,242 1,251 1,298 1,254 1,306 Assured energy -MW avg EBIT margin 76.0% 77.8% 76.7% 76.2% 75.5% 75.9% Total Lines (km) 4,750 4,750 4,750 4,750 4,770 4,770 EBITDA - IFRS 1,129 1,327 1,370 1,427 1,377 1,429 RAP (R$mn) 1,180 1,254 1, ,047 EBITDA margin 76% 83% 84% 84% 83% 83% RAP/km EBITDA - Proportional (BR GAAP) 1,208 1,434 1,509 1,246 1,319 1,483 Net financial expenses (428) (387) (327) (293) (269) (242) LEVERAGE 2015A 2016E 2017E 2018E 2019E 2020E Taxes (78) (136) (171) (229) (203) (213) Net Debt/EBITDA Equity income/minorities (345) (350) (322) (148) (157) (182) Net debt/equity Net income - IFRS Foreign Debt/Total Debt 11% 3% 1% 0% 0% 0% Net income - Regulatory (BRGAAP Avg. Cost of Debt 3% 4% 4% 4% 4% 4% # shares ('000) Capex/Operat.Cash Flow EPS (R$) EBITDA/Net Interest Exp NOPAT Depreciation Capex RETURN / YIELD 2015A 2016E 2017E 2018E 2019E 2020E FCFF ROIC 19% 22% 23% 24% 24% 26% FCFE 807 (44) ROE 11% 12% 13% 18% 16% 17% Dividends/ IOE ROA 3% 4% 4% 6% 6% 6% Total assets 10,012 10,225 10,280 10,537 10,681 10,614 FCF Yield 20% -1% 1% 7% 9% 13% Cash Div. Yield 4% 4% 5% 7% 13% 8% Net debt 4,037 3,169 2,737 2,787 2,295 1,876 Book value 2,510 3,158 3,414 3,574 3,885 3,961 VALUATION 2015A 2016E 2017E 2018E 2019E 2020E Net PP&E 3,593 3,572 3,865 4,045 4,066 3,979 EV/Adj. EBITDA 6.6x 5.3x 4.8x 5.8x 5.1x 4.3x Market cap. 3,949 4,455 4,455 4,455 4,455 4,455 EV/IC 1.2x 1.2x 1.2x 1.1x 1.1x 1.1x EV 7,985 7,624 7,192 7,243 6,751 6,332 P/E (Regulatory) 20.7x 14.0x 10.7x 12.7x 10.6x 7.9x Invested capital 6,547 6,327 6,151 6,362 6,181 5,837 P/B 1.6x 1.4x 1.3x 1.2x 1.1x 1.1x Source: Company data, Credit Suisse estimates Brazilian Utilities 21

22 Alupar (ALUP11) Price (24 Oct 2016): R$17.81; Rating: OUTPERFORM; Target Price: (from R$15.85) R$20.00; Analyst: Vinicius Canheu Income Statement 12/15A 12/16E 12/17E 12/18E Revenue (R$ m) 1, , , ,703.6 EBITDA 1,204 1,355 1,370 1,427 Depr. & amort. (69) (112) (119) (129) EBIT (R$) 1,136 1,242 1,251 1,298 Net interest exp (428) (387) (327) (293) Associates Other adj PBT (R$) ,005 Income taxes (78) (136) (171) (229) Profit after tax Minorities (345) (350) (322) (148) Preferred dividends Associates & other (76) (28) 0 0 Net profit (R$) Other NPAT adjustments Reported net income Cash Flow 12/15A 12/16E 12/17E 12/18E EBIT 1,136 1,242 1,251 1,298 Net interest (428) (387) (327) (293) Cash taxes paid Change in working capital Other cash & non-cash items Cash flow from operations 1,211 1,317 1,326 1,373 CAPEX (708) (528) (418) (321) Free cashflow to the firm ,052 Aquisitions Divestments Other investment/(outflows) Cash flow from investments (708) (528) (418) (321) Net share issue(/repurchase) Dividends paid (175) (175) (215) (314) Issuance (retirement) of debt Other (4,364) 253 (261) (788) Cashflow from financing activities (4,539) 78 (476) (1,102) Effect of exchange rates Changes in Net Cash/Debt (4,037) (51) Net debt at start - 4,037 3,169 2,737 Change in net debt 4,037 (867) (432) 51 Net debt at end 4,037 3,169 2,737 2,787 Balance Sheet (R$) 12/15A 12/16E 12/17E 12/18E Assets Cash & cash equivalents Account receivables Inventory Other current assets 1,545 1,685 1,685 1,685 Total current assets 2,320 2,705 2,589 2,456 Total fixed assets 3,662 3,684 3,983 4,175 Intangible assets and goodwill Investment securities Other assets 3,880 3,663 3,535 3,734 Total assets 10,012 10,225 10,280 10,537 Liabilities Accounts payables Short-term debt 1, Other short term liabilities Total current liabilities 1, Long-term debt 3,515 3,985 3,437 3,354 Other liabilities Total liabilities 5,945 5,234 4,686 4,603 Shareholder equity 2,510 3,158 3,414 3,574 Minority interests 1,557 1,833 2,180 2,359 Total liabilities and equity 10,012 10,225 10,280 10,537 Net debt 4,037 3,169 2,737 2,787 Source: Company data, Thomson Reuters, Credit Suisse estimates Per share 12/15A 12/16E 12/17E 12/18E No. of shares (wtd avg) CS adj. EPS Prev. EPS (R$) Dividend (R$) Dividend payout ratio Free cash flow per share Earnings 12/15A 12/16E 12/17E 12/18E Sales growth (%) EBIT growth (%) Net profit growth (%) EPS growth (%) EBITDA margin (%) EBIT margin (%) Pretax margin (%) Net margin (%) Valuation 12/15A 12/16E 12/17E 12/18E EV/Sales (x) EV/EBITDA (x) EV/EBIT (x) P/E (x) Price to book (x) Asset turnover Returns 12/15A 12/16E 12/17E 12/18E ROE stated-return on (%) ROIC (%) Interest burden (%) Tax rate (%) Financial leverage (%) Gearing 12/15A 12/16E 12/17E 12/18E Net debt/equity (%) Net Debt to EBITDA (x) Interest coverage ratio (X) Quarterly EPS Q1 Q2 Q3 Q4 2015A E E A LU P1 1.SA Share price performance Ja n A p r Ju l O c t SA O PA U LO SE BO V ESPA IN D EX On 24-Oct-2016 the SAO PAULO SE BOVESPA INDEX closed at Daily Oct26, Oct24, 2016, 10/26/15 = R$ Brazilian Utilities 22

23 Initiating coverage with a NEUTRAL rating and TP of R$77/TRPL4 CTEEP (TRPL4) We take the opportunity to initiate coverage of TRPL4 with a NEUTRAL rating and a TP of R$77/TRPL4. In our view, the stock's investment case is still suitable for investors looking for a defensive name with a huge potential for dividend distribution, but we do not see much room for another significant re-rating of the stock. The monetization of CTEEP's RBSE receivables, which should take place over the next 8 years starting in mid-2017, is the main reason behind the potential for such high cash returns. In our financial estimates, we value CTEEP's current business situation at R$75/share (Dec-2017). We add to this number an additional R$2/TRPL4, which reflects a scenario in which the company wins ~R$1bn worth of projects in the upcoming auctions. Hence, including this growth perspective, we set our target price at R$77/TRPL4. Besides the reinvestment opportunities presented by the series of greenfield auctions that we already discussed extensively over the previous sections, further upside potential depends on the outcome of a series of binary events that should take place in the upcoming years and could translate into a more favorable "carry" for TRPL4. Under our base case scenario for these upcoming events, there is little upside left that would justify a more favorable investment opinion. We will introduce a brief discussion on these main points (page 26) and summarize in an exhibit what's the potential impact from them and their respective impact on the share price later in this report (page 28). Company Description CTEEP is a pure transmission player, with the bulk of its assets concentrated in the São Paulo state. The company was acquired in a privatization auction in 2006 by ISA, a Colombian state-owned group. The company is currently run by CEO Reynaldo Passanezi Filho, who took office on November 2013, together with current CFO Rinaldo Pecchio Jr. Both executives have their mandates until February Mr. Passanezzi held numerous positions at the bank BBVA, before joining CTEEP as CFO in 2012 and making the jump to CEO in the following year. Meanwhile, Mr. Pecchio held finance positions at AES before joining CTEEP as CFO and IR Officer. As a pure transmission company, CTEEP businesses are very simple, as they depend only on the lines and sub-stations availability and do not depend on volumes From 2006 to 2012, CTEEP had a strong policy of returning cash to shareholders and was relatively active in greenfield auctions in the country. The company expanded its operations outside of the São Paulo state, both through direct investments in new lines and by establishing partnerships in consortiums with other groups. So far, its largest investment was the project that connects the big power plants Jirau and Santo Antonio in the north of Brazil to the Southeastern grids, through a subsidiary called IE Madeira, where CTEEP has a 50/50 structure with Eletrobras. In 2012, with the changes in the remuneration of "Type 1" transmission assets (all the transmission assets that were not part of greenfield auctions) brought about by the Law (former MP579), the company lost a significant part of its recurring revenues in exchange for a 30 year extension of the concessions plus a reimbursement of the residual values of such assets. The reimbursement of the "Type 1" assets was split in two parts (1) one associated with the assets that were built after 2001 and had revenues with periodic reviews (RBNI assets); and (2) another one linked to the assets built before 2001 that did not have revenues exposed to reviews, being only adjusted by inflation (RBSE assets). Brazilian Utilities 23

24 Figure 28: CTEEP's Shareholder Structure (% of total capital) ISA Capital Eletrobras Vinci Remaining Free Float 37% 35% 4% 23% CTEEP 51% 51% 25% 50% 100% 100% 100% 100% Serra Madeira Garanhuns IENNE IE Sul Pinheiros do Japi Source: Credit Suisse estimates IEMG Evrecy Three main sources of revenue: (1) assets renewed through law ; (2) assets from greenfield auctions; and (3) RBSE reimbursement. Growth for CTEEP may come from greenfield auctions and reinforcement capex. The RBNI residual values were paid out by the government without major controversies, with the companies cashing them in completely until the end of 2015 (CTEEP was granted R$2.9bn for the RBNI, 2013 currency, paid 50% in January 2013 and 50% split in monthly installments from January 2013 until the end of 2015). The reimbursement of RBSE residual values had a much more controversial follow-up, as a decision on a final solution has not yet been made. However, that final resolution is now around the corner, as the government defined some directions regarding payment methods and the value to be reimbursed. For CTEEP, the amount of "reimbursable assets" was set at R$3.9bn (2012 values), while the precise details of how the cash in of such value will take place are yet to be defined by ANEEL (they should be subject to a public hearing until the end of 2016). However, ANEEL has already outlined the main concepts behind such, which we used in our financial forecasts and valuation of the stock, discussed later in this report. As a result, the company now has 3 main sources of revenues, namely (1) the concession contract renewed as a result of the law of 2013 (the so called "Contract 059"); (2) its wholly and partially owned subsidiaries (assets developed through greenfield auctions); and (3) the RBSE reimbursement (a financial asset), which will start in mid Any growth should come mainly from two fronts: (1) participation in new greenfield auctions, as previously discussed in this report; and (2) reinforcement capex, comprising upgrades in its existing network, mostly related to the Contract 059 that involved all the legacy transmission network of the company. This reinforcement represents a continuous opportunity for regulated investments in its grid, since their remuneration is set by ANEEL regulation. Currently, we believe such investments are not generating meaningful value for the company, given the regulatory WACC of 6.64% linked to them, but this could change in the future depending on the revised WACC for the future RAP reviews. Expectations for Upcoming Auction After years without participating in greenfield auctions, we expect CTEEP to be a major player over the next year. The company has mentioned numerous times that the indications and preliminary definitions regarding the RBSE indemnifications allow for the financial security it needed in order to bid for new assets. Hence we included the growth component in our analysis, but note that, in relative terms, the impact of a similar bid is much lower to CTEEP's share price vs. those of its peers, given TRPL's larger market cap. Brazilian Utilities 24

25 Brazilian Utilities 25 Figure 29: SWOT Analysis of CTEEP Strengths One of the largest and oldest base of legacy transmission assets in Brazil (second only to Eletrobras), supporting a very strong growth potential through reinforcement capex on its own network; Very strong balance sheet and cash generation, especially after the startup of the process of the RBSE monetization; Decent track record of capital discipline. Threats Competition is getting stronger by the day, with more and more players looking to enter the sector. The appetite of State Grid, from China, is the main example on this front; There is no visibility on the terms of the RAP review of its main contract (059) which is likely to take place by Meanwhile, the terms for the RBSE monetization, CTEEP's main source of value, are not yet fully defined; The potential elimination of interest on equity payments (a tax deductible way of returning cash to investors in Brazil) could mean the removal of one important source of value for the company. Source: Credit Suisse Research Weaknesses Fully regulated business with the largest contracts being subject to periodic reviews by ANEEL (only its auctioned assets, 37% of proportional RAP, have very little exposure to changes in regulation); CTEEP controlling shareholder, ISA, is a state-owned company in Colombia, while the shares that have the best trading liquidity (TRPL4) are not associated with the highest levels of corporate governance in the Bovespa (do not have any tag-along rights); There are relevant litigations involving the company in the Brazilian courts (SEFAZ issue and dispute with Eletrobras/Eletropaulo), which could be relevant for its valuation. Opportunities Greenfield transmission auctions are currently in a sweet spot, with lower execution risks and high potential returns, allowing for a strong pipeline of value creation; Lower interest rates and higher credit availability in the local market could allow for the utilization of higher levels of financial leverage in the existing business, potentially boosting ROEs; A higher level of cash return to shareholders on the back of the RBSE inflow would put TRPL4 among the highest dividend yields in the local market, likely calling the attention of new investors to the stock. 25 October 2016

26 Main Issues Involving the Investment Case RBSE monetization We value the RBSE indemnification at R$40/TRPL4 (TP Dec- 2017). Details of the process are not fully defined, with the main questions revolving around a potential tax gross-up. After a long and stressful period of discussions regarding the amounts and the methods for the payment of the indemnification of all the transmission assets built before 2001 (RBSE), the Federal Government finally released the basic conditions for this process in April this year. More specific details should be defined by ANEEL in a process expected to end in early So far, of all the companies involved in this discussion, only Copel has not had its asset size defined. For CTEEP, the residual values based on their 2012 evaluation were ratified by ANEEL at R$3.9bn. CTEEP has challenged such value, requesting an additional R$400mn in the evaluation of such assets. Its appeal is yet to be judged by ANEEL. In our earnings forecasts and valuation for the company, we calculated the cash in of the RBSE cash flow following the guidelines published by ANEEL in the technical note released on October 13. In a nutshell, we consider that the RBSE reimbursement will be a function of the sum of two RAPs: (1) the remuneration of the accumulated RAP that it should have received from the end of 2012 to mid-2017, adjusting by the regulatory cost of equity of 10.45% and inflation to the end of the first half of 2017, creating a financial asset, which we consider a base for a new RAP calculation from mid-2017 to mid of 2025); and (2) a proxy for the RAP that CTEEP would have received from those assets using a pretax WACC of 10.04% (based on the regulatory WACC of 6.64% in real terms) from the end of 2012 to 2020, considering 8 years of the remaining life of those assets. Once we have both RAPs adjusted to the calendar year and our inflation forecasts, we sum up these two RAPs and reach what should be the financial flow for the company from the period of mid-2017 to mid We considered that there are no costs associated with this cash-flow since the regulation that created this possibility considers that the regulatory costs associated with that will be fully grossed up to the RAP flow. For the calculation of taxes, we assumed that CTEEP will depreciate the book value of its RBSE (~R$1.5bn) over 8 years, creating a tax-shield for the payment of the 34% income tax rate in Brazil. Such math leads to an NPV of R$ 40/TRPL4 (Dec-2017) in our target price calculation. We understand that the full details of the RBSE cash-in are not yet fully defined by ANEEL and could have changes to the approach we used here, since the current process of the public audience being held by ANEEL could lead to changes in the final version. One of the main question marks is whether the transcos would have the right to receive the RBSE flow fully grossed up of taxes, which could represent a major financial gain for them, given the huge difference in the accounting values of those assets (based on how much they were depreciated for accounting purposes before) versus the asset values calculated for the RBSE flow. In our model, if we were to consider a fully grossed up value of the RBSE, we would have to increase the NPV of our RBSE flow by ~R$7/TRPL4, but we understand from the technical note released by ANEEL that there are very low chances of this claim being approved. Another item that has been subject to discussion is whether the Ke used to update the financial assets in the period from the end of 2012 to mid-2017 would have to be grossed up as well. If we were to consider this feature, it would increase further the NPV of our RBSE flow by ~R$2.5/TRPL, but given the details provided on the technical notes of ANEEL, we also see a very low chance of this claim being accepted. Finally, if we were to consider that the appeals that CTEEP has made in order to increase the asset value of its RBSE by the end of 2012 were accepted (R$400mn by the end of 2012), this could increase our RBSE flow by ~R$4/TRPL4 under our valuation approach. The RBSE valuation is the most relevant item for CTEEP s investment case and should be monitored in detail as its public hearing process progresses at ANEEL, since there could Brazilian Utilities 26

27 be some changes to the final version of the technical notes relative to what has been already released by the regulator. We assume no real adjustment to the RAP of Contract 059 by its 2018 tariff review. We assume that the SEFAZ payments will continue until 2018, with no reimbursement for previous expenditures. We do not consider any potential loss related to the Eletrobras/ Eletropaulo case Contract Review As we commented earlier in the report, the contract regulating the remuneration of the largest asset base of CTEEP (Contract 059) had its terms defined in 2012, at the time of the enactment of the law , which allowed a 30 year extension of its concession contract. At that time, it was defined that the conditions of the contract would be reviewed every 5 years, leaving its first review to According to the remuneration conditions of that time, the transmission companies would be allowed to enjoy a 10% profit margin on top of the opex. For the next review cycle, we have no visibility whether such conditions will be maintained or not. In our view, there is a chance that such metrics are kept and all incremental investment made to those assets start having a clear remuneration based on a RAB basis (defined on top of the reinforcement capex made since 2013). If this is the case, we could see a potential RAP cut being made to the core of the Contract 059, since the major cost cutting done by CTEEP since then is likely to have place it above the 20% opex outperformance. In our base case scenario, we have no real adjustment to the RAP of the Contract 059, but if we were to assume a 10% cut that would remain for the rest of the concession, our TP could drop by ~R$ 4/share. SEFAZ Issue This issue relates to a legal discussion with the Finance Secretary of the Sao Paulo State regarding the payment of incremental benefits to the participants of CTEEP s pension funds. TRPL understands that such incremental benefits were never an obligation of the company; they would be the State of Sao Paulo's instead. CTEEP has been making such payments, which amount to roughly R$160mn/year, though it has two legal challenges in courts running for quite some time in order to (1) stop such disbursements; and (2) recover what has already been paid in the past (~R$1.5bn). Such payments are not part of the company s income statement and have been booked under a receivable account on the asset side of its balance sheet, though the receivable does not show the totality of the past disbursements since the company has already made a partial write-off (~R$500mn). In our model, we consider the current SEFAZ payments continuing until the end of 2018 and then stopping, since we believe that this dispute could be fully concluded by then with a favorable decision to the company. If we were to consider that CTEEP would stop making the payments by the end of 2016, we would increase our TP by R$2/share. We do not include any value in our model from the potential recovery of the past payments and leave this as a full upside to the model (potential +R$9/share). In our view, a favorable decision for the company with regards the recovery of the past payments, though possible, would take many years to materialize and could happen with the state paying in instruments that do not allow for a full recovery of those values. Therefore we believe that the market is unlikely to price in the recovery feature in a meaningful way. Eletrobras/Eletropaulo/CTEEP case This is a very long and complex case that dates back to 1989 and has been subject to great scrutiny by investors, given its huge relevance to the investment case of Eletropaulo. CTEEP estimates the potential loss value of this case in ~R$2bn (pre-tax, equivalent to R$12.1/TRPL), which is the total that could be due to Eletrobras a result of a financing granted back in 1989 that was never paid back. CTEEP does not officially recognize any potential loss related to this case. In our model and TP, we do not have any consideration for this potential loss either. Brazilian Utilities 27

28 We do not consider any negative impact from a potential change in the remuneration of DITs. We assume IE Madeira's RAP cut will be removed by 2H17. DITs DIT is an acronym for other transmission installations and basically comprises assets that operate closely with the distribution network. In 2015, ANEEL planned to transfer some of those assets to the distribution companies in a way that the transmission operators would lose those associated revenues in exchange for a residual value payment. CTEEP would be one of the most impacted companies by this proposal, which generated very strong complaints from sector players, since it would further impact the remuneration of transmission assets that had already been strongly cut by the law of After such reaction by the sector, ANEEL retreated from its original plans and suggested that any change would result in a very low impact to the company. We note that CTEEP has roughly R$300mn in RAP from DITs. In our numbers we do not consider any negative impact coming from a future change in the remuneration of DITs. Adjustment in the IE Madeira RAP The IE Madeira is the largest investment that CTEEP has made after its privatization in The RAP of this company has been cut by ANEEL in 10% as a result of operational issues in the network. We assume that such reduction in RAP will be completely removed by mid-2017 as a result of the company s efforts to address this issue. If we were to assume that such cut in RAP would remain for the rest of the concession, an extremely unlikely scenario in our view, the net impact to our TP would be -R$1.5/share. Figure 30: Summary of Potential Future Impacts to TRPL4 vs. CS Base Case (to Dec-2017's TP) Source: Credit Suisse estimates Brazilian Utilities 28

29 Figure 31: CTEEP's Factsheet Source: Company data, Credit Suisse estimates Brazilian Utilities 29