Initiation: powering through

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1 Manila Electric Utilities / Philippines Utilities / Philippines Manila Electric Target (PHP): Upside: 19.9% 26 Mar price (PHP): Initiation: powering through New power-generation investment underappreciated by the market, overshadowed by worries of a lower distribution tariff However, we factor this into our forecasts; we expect 12% YoY declines in electricity distribution rates for 2016/17E Initiating coverage with a Buy (1) rating and DCF-based 12- month target price of PHP Buy (initiation) Outperform Hold Underperform Sell How do we justify our view? Bianca Solema (63) bianca.solema@dbpdaiwacm.com.ph Investment case We initiate coverage on Manila Electric Co (Meralco), the Philippines largest electricitydistribution utility company, with a Buy (1) rating. Power-generation assets not fully valued. In 2013, Meralco reentered the power-generating business. It now has an attributable capacity of 379MW, with several projects due to come on line in 2017/18. However, we believe the market does not yet appreciate the potential value of the powergenerating business. Despite Meralco s new ventures in power generation, the stock has traded sideways since 2013, likely due to an anticipated reduction in the electricity tariffs under its 4th regulatory period, which we assume to start in June High yield. Meralco s strong cashflow generation enables it to pay out healthy cash dividends and supports its expansion projects. We estimate it has a 2015E dividend yield of 4.9%, one of the highest among PSEi index constituents. Catalysts Progress on tariff reset. This could be a welcome development for investors, as we believe the market has already priced in a lower tariff scenario relative to the current tariff. In addition, our forecasts factor in lower distribution rates and a 1-year delay in the implementation of a tariff change. We forecast Meralco s average distribution rate to fall by 12% each for 2016 and New power plant. The 500MW San Buenaventura coal plant is Meralco s first power-generation project in which it has a majority interest. Construction will start when it receives regulatory approval for its power supply agreement. The company expects the regulator s decision within 1Q15 or early 2Q15. Valuation We have a DCF-based 12-month target price of PHP324, within which our PHP293/share valuation for electricity distribution already exceeds the current share price. Although the stock s 2015E PER of 16.7x exceeds the 15.1x average of its regional peers (Bloomberg forecasts), we believe its valuations will increase as distribution recovers and new power projects become operational. Risks The main risks to our call would be an adverse decision by the regulator on the tariff and delays/issues in the execution of generation projects. Share price performance (PHP) (%) Mar-14 Jun-14 Sep-14 Dec-14 Mar-15 Source: FactSet, Daiwa forecasts Manila Ele (LHS) Relative to PCOMP Index (RHS) 12-month range Market cap (USDbn) m avg daily turnover (USDm) 2.37 Shares outstanding (m) 1,127 Major shareholder Beacon Electric Asset Hldgs (45.0%) Financial summary (PHP) Year to 31 Dec 14E 15E 16E Revenue (m) 266, , ,003 Operating profit (m) 26,146 25,554 22,943 Net profit (m) 18,053 18,198 16,637 Core EPS (fully-diluted) EPS change (%) (8.6) Daiwa vs Cons. EPS (%) (8.8) PER (x) Dividend yield (%) DPS PBR (x) EV/EBITDA (x) ROE (%) See important disclosures, including any required research certifications, beginning on page 38

2 Contents Investment thesis... 6 Powering through... 6 Key near-term catalysts... 7 Distribution business: unparalleled power... 9 Poised to benefit directly from economic growth... 9 Regulatory headwinds factored in... 9 Forecasts: distribution business Generation: new source of power Need for new capacity Re-entry into power generation Partnering with established generation players Growing contribution from power generation Valuation: power-generation assets ascribed zero value SOTP-based TP of PHP Earnings multiples at the high end in the near term Steady and healthy dividends Key risks Regulatory and political risks Operational and execution risks Market risk Appendix I: company profile Largest electricity distributor Ownership history World-class operations Other projects leveraging the strength of the distribution platform Appendix II: performance-based regulation (PBR) Appendix III: positive macroeconomic drivers Appendix IV: power supply-demand scenario

3 Buy (initiation) Outperform Hold Underperform Sell How do we justify our view? Growth outlook Valuation Earnings revisions Growth outlook Meralco posted a 6% YoY rise in its core net income for Growth should be more modest for 2015, as distribution is likely to be dragged down by the full-year impact of the lower distribution rate implemented in 2H14. For 2016 and 2017, we see earnings declining by 9% YoY and 11% YoY, respectively, due to our lower tariff estimates for the fourth regulatory period (assumed to begin July 2016). We should start to see a recovery in 2018, with 2019 being the banner year, driven by improvements in distribution, coupled with rising contributions from its new generation projects. We forecast earnings to reach PHP16.91bn (+14% YoY) for 2018 and PHP19.42bn for 2019 (+15% YoY). Valuation We value each of Meralco s distribution and generation businesses using a DCF methodology to arrive at our SOTP target price of PHP324. Our target price implies potential upside of 20% and is equivalent to a 2015E PER of 20.2x. We apply varying WACCs, ranging from 6.08% to 9.66%, and a terminal growth rate of 3% for the domestic units and 2% for the company s Singaporebased affiliate. In our valuation of the generation business, we include the company s 3 ventures: PacificLight (28% stake), Global Business Power (22% stake) and San Buenaventura Power (51% stake). Meralco: breakdown of Daiwa s net income forecasts (PHPm) 18,053 18,198 18,070 17,660 Source: Daiwa forecasts Note Meralco: 12-month forward PER bands Source: Daiwa 16,637 15,858 14,793 16,914 13,862 15,031 19,417 20,581 16,451 17, E 2015E 2016E 2017E 2018E 2019E 2020E MER parent (distribution) and others Pacific Light San Buenaventura Power GBP (PHP/sh) 0 Dec-05 Dec-06 Dec-07 Dec-08 Dec-09 Dec-10 Dec-11 Dec-12 Dec-13 Dec x 23.0x 17.1x 11.3x 5.4x Earnings revisions The Bloomberg consensus cut its 2014 EPS forecast for Meralco in May last year with the announcement of the lower approved tariff, or maximum average price (MAP), for Meralco s distribution business (effective 1 July 2014 to 30 June 2015). This started a series of downward revisions to 2015 forecasts as analysts most likely began to recognise the high probability of a further rate reduction for the fourth regulatory period. Our 2015 EPS forecast of PHP16.15 is in line with the consensus figure. Meralco: Bloomberg consensus 2015 EPS forecast (PHP/sh) (PHP/sh) Jan-14 Apr-14 Jul-14 Oct-14 Jan-15 Price (RHS) 2014 EPS (LHS) Source: Bloomberg - 3 -

4 Financial summary Key assumptions Year to 31 Dec E 2015E 2016E Ave distribution rate (PHP/kWh) Distribution electricity sales growth (YoY %) System losses (%) Inflation (%) Profit and loss (PHPm) Year to 31 Dec E 2015E 2016E Sale of electricity 178, , , , , , , ,295 Sale of other services 2,072 1,856 2,819 2,279 3,787 4,596 5,285 5,708 Other Revenue Total Revenue 180, , , , , , , ,003 Other income COGS (150,928) (200,916) (205,674) (232,068) (238,198) (203,242) (244,400) (256,513) SG&A (12,327) (12,873) (14,596) (14,710) (15,469) (16,102) (16,366) (16,637) Other op.expenses (9,870) (14,851) (18,699) (19,384) (20,819) (20,846) (20,072) (17,910) Operating profit 7,633 12,293 17,839 19,108 24,150 26,146 25,554 22,943 Net-interest inc./(exp.) (499) 1, ,041 (307) (726) (717) (675) Assoc/forex/extraord./others 921 (19) 88 1, ,064 1,248 1,584 Pre-tax profit 8,055 13,318 18,746 22,022 24,327 26,484 26,085 23,852 Tax (2,331) (4,023) (5,953) (5,741) (7,054) (8,353) (7,872) (7,211) Min. int./pref. div./others (62) (78) (15) (4) Net profit (reported) 6,005 9,685 13,260 17,117 17,211 18,053 18,198 16,637 Net profit (adjusted) 7,003 12,155 14,887 16,265 17,023 18,053 18,198 16,637 EPS (reported)(php) EPS (adjusted)(php) EPS (adjusted fully-diluted)(php) DPS (PHP) EBIT 7,633 12,293 17,839 19,108 24,150 26,146 25,554 22,943 EBITDA 12,464 18,204 23,343 24,684 30,268 32,239 31,911 29,551 Cash flow (PHPm) Year to 31 Dec E 2015E 2016E Profit before tax 8,055 13,318 18,746 22,022 24,327 26,484 26,085 23,852 Depreciation and amortisation 5,064 6,219 5,637 5,731 6,118 6,093 6,357 6,608 Tax paid (3,797) (4,953) (5,309) (7,228) (7,205) (8,006) (8,001) (7,387) Change in working capital 15,835 (321) 1,177 6,518 2,421 (13,500) 212 (2,887) Other operational CF items 4,558 6,191 11,703 9,234 11,894 11,681 9,967 7,278 Cash flow from operations 29,715 20,454 31,954 36,277 37,555 22,752 34,621 27,463 Capex (8,228) (8,810) (8,552) (9,668) (10,187) (9,929) (20,535) (35,747) Net (acquisitions)/disposals (662) 0 (387) (13) (21,006) Other investing CF items (1,657) 1, (2,075) (716) 14,463 (650) (168) Cash flow from investing (10,547) (7,446) (8,286) (11,756) (31,909) 4,534 (21,186) (35,915) Change in debt (5,212) (584) 6, ,917 (3,878) 35,116 (286) Net share issues/(repurchases) (0) 0 0 Dividends paid (2,820) (6,187) (9,866) (8,890) (12,553) (13,931) (15,029) (14,090) Other financing CF items (2,801) (1,201) 1,449 1,977 Cash flow from financing (7,502) (5,706) (3,128) (8,162) (6,295) (19,011) 21,536 (12,399) Forex effect/others Change in cash 11,666 7,302 20,540 16,359 (649) 8,276 34,972 (20,852) Free cash flow 18,899 9,301 17,660 24,598 26,616 9,546 16,681 2,232 Source: FactSet, Daiwa forecasts - 4 -

5 Financial summary continued Balance sheet (PHPm) As at 31 Dec E 2015E 2016E Cash & short-term investment 17,068 24,370 44,141 60,500 59,851 68, ,098 82,246 Inventory 1,857 2,043 1,675 1,371 2,750 4,980 5,058 5,138 Accounts receivable 21,600 25,609 29,108 28,077 32,718 28,626 32,931 33,749 Other current assets 4,160 7,981 20,849 2,295 12,167 12,167 12,167 12,167 Total current assets 44,685 60,003 95,773 92, , , , ,300 Fixed assets 102, , , , , , , ,473 Goodwill & intangibles Other non-current assets 25,332 15,715 9,805 15,336 43,932 29,271 30,427 31,173 Total assets 172, , , , , , , ,946 Short-term debt 4,582 5,723 4,627 4,147 12,835 1,923 2,212 2,298 Accounts payable 28,261 31,138 40,011 47,576 73,892 60,351 62,292 64,477 Other current liabilities 9,280 8,285 17,517 7,795 7,899 8,246 8,118 3,130 Total current liabilities 42,123 45,146 62,155 59,518 94,626 70,521 72,621 69,906 Long-term debt 17,234 15,498 19,816 20,466 20,756 27,790 62,618 62,245 Other non-current liabilities 51,626 55,128 62,248 68,757 73,287 80,658 93, ,625 Total liabilities 110, , , , , , , ,776 Share capital 14,425 14,646 14,863 15,173 15,315 15,315 15,315 15,315 Reserves/R.E./others 42,944 44,323 47,293 52,729 59,847 63,969 67,139 69,686 Shareholders' equity 57,369 58,969 62,156 67,902 75,162 79,284 82,453 85,000 Minority interests 3,777 4,227 4, ,231 2,716 5,170 Total equity & liabilities 172, , , , , , , ,946 EV 311, , , , , , , ,968 Net debt/(cash) 4,748 (3,149) (19,698) (35,887) (26,260) (38,414) (38,269) (17,703) BVPS (PHP) Key ratios (%) Year to 31 Dec E 2015E 2016E Sales (YoY) (5.7) (10.8) EBITDA (YoY) (1.0) (7.4) Operating profit (YoY) (2.3) (10.2) Net profit (YoY) (8.6) Core EPS (fully-diluted) (YoY) (8.6) Gross-profit margin EBITDA margin Operating-profit margin Net profit margin ROAE ROAA ROCE ROIC Net debt to equity 7.8 net cash net cash net cash net cash net cash net cash net cash Effective tax rate Accounts receivable (days) Current ratio (x) Net interest cover (x) Net dividend payout Free cash flow yield Source: FactSet, Daiwa forecasts Company profile Manila Electric Co (MER) is the largest and oldest electricity distribution utility in the Philippines. Its franchise area spans 9,337 sq km and covers Metro Manila and nearby provinces. It services around 25m people, equivalent to about a quarter of the country's population. Through its subsidiaries and affiliates, it is also into power generation and other related businesses. It currently has an attributable power generation capacity of 379MW

6 interest rates today versus 4 years ago (the time of the last tariff reset). Investment thesis Powering through We initiate coverage on Meralco with a Buy (1) rating and DCF-based 12-month target price of PHP324. Unparalleled scale and experience in power distribution Meralco holds a monopoly in terms of power distribution in the Philippines capital, Metro Manila, and nearby provinces. It is also the country s oldest distribution utility, established in The company s scale and experience have equipped it with strong technical expertise that enables it to outperform all regulatory performance standards and run its operations efficiently. One of the highest dividend yields Although Meralco s current franchise area is arguably mature, it generates strong and steady cash flows that support payment of dividends and expansion projects. Based on its current share price, we estimate Meralco s dividend yield in 2015 at 4.9%, one of the highest among the constituents of the PSEi. Meralco: dividend yield estimates for index stocks 2015 (%) TEL MER GLO AP DMC AEV SCC EDC EMP BPI BDO URC RLC AGI FGEN SM SMC JFC SMP H ALI MPI MBT ICT PCOR MEG AC LTG JGS GTCAP BLOOM Source: Bloomberg, Daiwa for Meralco Factored in decline in distribution tariff We recognise that the investors main concern at this point is the likely downward adjustment in distribution rates during the upcoming tariff reset for Meralco (originally scheduled for July 2015). The reduction should mainly arise from lower allowed returns (lower regulatory WACC), due to a decline in applicable Our forecasts take into account the scenario of lower tariffs. We estimate the company s average distribution rates to fall by 12% YoY for both 2016 and We factor in a regulatory WACC of 11% (previously 14.97% for the third regulatory period), arrived at using the same rules for setting distribution wheeling rates but updating the inputs for current values of risk-free rates, asset beta, country risk premium and inflation. In addition, we factor in a 1-year delay in the implementation of the new rates under the fourth regulatory period, which was originally scheduled for July Meralco: distribution revenue and average distribution rate ,606 50,892 Source: Company, Daiwa forecasts ,105 56,382 56,706 51,781 47,319 50,946 New power-generation investments appear underappreciated We believe, however, that Meralco s new powergeneration investments are being overshadowed by the concerns in the market about the distribution business impending tariff reset. Meralco re-entered the power generation business in 2013 through the acquisition of a 22% interest in Global Business Power (GBP) and a 28% effective interest in an LNG power plant in Singapore (PacificLight). Today, Meralco has an attributable capacity of 379MW and is preparing for several new projects to come on line. The most advanced of these new projects in terms of development is the 500MW San Buenaventura Power, for which the company targets to begin construction this year. Although still accounting for a very small proportion of earnings today, we expect the power-generation business to be a significant earnings driver once the company s new projects become operational. For 2018 and 2019, we estimate the combined contribution from E 2016E 2017E 2018E Distribution revenues (PHPm) Ave distribution rate (PHP/kWh) - 6 -

7 the 3 units to reach PHP1.88bn and PHP2.97bn, or 11% and 15% of the consolidated net profit, respectively. Meralco: breakdown of Daiwa s net income forecasts (PHPm) 18,053 18,198 18,070 17,660 MER parent (distribution) and others San Buenaventura Power Source: Daiwa forecasts Also overlooked by the market, in our view, is the competitive advantage that Meralco gains from the scale of its distribution business for its generation projects. Although the regulator must sign off any contract between Meralco s distribution unit and a power supplier, Meralco s generation projects, at least those in Luzon, have the advantage of being prioritised by Meralco s distribution unit in terms of signing power supply agreements. Getting power-generation assets for free Our target price of PHP324 offers potential upside of 19.9% against the stock s closing share price of PHP on 26 March Based on our SOTP valuation, we value the distribution business at PHP293.07/share and the company s 3 powergeneration units combined at PHP31.09/share. Against our estimated value for the distribution business alone, the stock is trading at a discount of 7.8%. Meralco: SOTP valuation Total equity Meralco s Attributable Value per % of value stake equity value share total (PHPm) (PHPm) (PHP/sh) Parent (distribution) and others 330, % 330, % PacificLight 26,357 28% 7, % San Buenaventura Power (SBP) 27,722 51% 14, % Global Business Power (GBP) 61,142 22% 13, % Total % Target price (TP) No of outstanding shares 1, Source: Daiwa estimates 16,637 15,858 14,793 16,914 13,862 15,031 Key near-term catalysts 19,417 20,581 16,451 17, E 2015E 2016E 2017E 2018E 2019E 2020E Pacific Light GBP We believe that the expected tariff reduction and, consequently, the lower near-term earnings prospects of Meralco have been priced into to the current share price. Meralco was one of the laggards in 2014, underperforming the PSEi by 20.77pp. In addition, we have barely seen sustained positive movement in MER s share price, even after its re-entry into the power generation business in The stock has been trading in a range of PHP range since 2H13. Meralco: Share price (PHP) Dec-08 Dec-09 Dec-10 Dec-11 Dec-12 Dec-13 Dec-14 Source: Bloomberg We see 2 main positive catalysts for the stock that could materialise in the near term. Resolution or clearer picture on tariff reset With the negative scenario about the direction of tariffs likely priced into Meralco s share price, we think progress on the tariff reset could be a welcome development for investors at this point, as it would lessen the overhang resulting from this issue. Moreover, our forecasts also factor in a decline in tariffs for the next rate rebasing period, as we assume a 12% YoY reduction in average distribution rates for both 2016 and We expect to see a resolution on the tariffs soon as the rate reset was originally scheduled to begin on 1 July 2015, upon the start of the fourth regulatory period for Meralco. In case the process is delayed, we should at least see the applicable rules and guidelines for the fourth regulatory period being announced, as well as a much clearer stance from the regulator on this matter, within the year. Commencement of the construction of a major power-generation project Once the Energy Regulatory Commission (ERC) approves Meralco s power supply agreement (PSA) with San Buenaventura Power, Meralco says it will immediately finalise the financing agreement for the project. Thereafter, Meralco should begin construction of the project. All hearings with the regulator for the petition to approve the PSA have been concluded and a decision on the PSA is expected by 1Q15/early 2Q15.

8 As San Buenaventura coal will be Meralco s first power-generation project wherein it has a majority interest, we see the execution of this project as a critical first step by the company, which would allow it to be recognised as a legitimate player in the powergeneration industry. In addition, there has been a positive development in Meralco s other project, the 600MW Subic coal. This was on hold due to legal issues presented by environmental groups. But on 3 February 2015, the Supreme Court ruled, with finality, in favour of the project. Meralco has already expressed its intention to proceed and commence construction within We have chosen to wait for more details before factoring this into our forecasts, but this could be another catalyst once developments on the project become more visible

9 Distribution business: unparalleled power Poised to benefit directly from economic growth Growing Philippines economy should continue to drive demand for electricity The Philippines has been one of the best-performing economies in the region, registering real GDP growth of 6.1% YoY in Although the performance in 2014 was lower than the 7.2% YoY growth posted in 2013, the country was the fastest-growing economy in Southeast Asia and the second-fastest in Asia (next to China) for a third consecutive year. Heightened economic activity should result in increased demand for electricity. There is a high correlation between electricity demand and real GDP growth, with an average elasticity of 0.97x computed since Philippines: historical electricity demand and GDP per capita 16% % 12% % 8% 2.0 6% 1.5 4% 2% 1.0 0% (2%) 0.5 (4%) Source: CEIC, Daiwa Real GDP growth (LHS) Growth in electricity consumption (LHS) Ave elasticity (since 1990) (RHS) Meralco should benefit directly from the economic growth of the country, as around 55% of the country s energy sales and 50% of GDP are consumed and generated in Meralco s franchise area. We believe electricity demand from its 4 customer groups residential, commercial, industrial and streetlights will continue to grow with the population, private consumption and a resurgence of the manufacturing sector in the country. Meralco: energy sales vs. total Philippines electricity demand (GWh) 70,000 61,566 59,211 60,000 55,266 56,098 50,868 50,000 40,000 30,000 20,000 10,000 73% 54% 55% 55% 55% 55% MER Energy Sales Luzon Energy Sales PH Energy Sales Source: Company, CEIC The company s consolidated volume sales have grown steadily at an 11-year CAGR of 3.6%, from 23,834GWh in 2003 to 35,160GWh in Similarly, we factor in a 3.6% annual growth rate for our forecast period. Meralco: electricity sales ('000 GWh) Source: CEIC, Daiwa forecasts 73% 73% 74% 74% Regulatory headwinds factored in The tariff reset process Under the performance base regulation (PBR), base tariffs for Meralco s distribution business are approved at the start of every regulatory period, and the applicable annual average rate, called the Maximum Average Price (MAP), is approved at the beginning of each of the 4 regulatory years (RY) in a regulatory period. Meralco is currently in the fourth RY of its third regulatory period, and was originally scheduled for a reset on 1 July 2015, once the fourth regulatory period starts. To describe the PBR computations in simple terms, the base tariffs are based on an annual revenue requirement (ARR) and projected energy consumption of the distribution utility (DU). The building blocks of the ARR ensure a reasonable return on capital and return of capital (see Appendix II), support for E 2016E Residential Commercial Industrial Streetlights 2017E 2018E - 9 -

10 necessary operating and maintenance expenses, and applicable recoverable taxes. The PBR uses a forwardlooking approach and it defines capital as the rolledforward optimised regulatory asset base (RAB), which is composed of the initial opening value and future capex. The approved MAP will then be translated into a rate table, which indicates respective rates per customer class. Lower interest rates to drive down regulatory WACC One of the key components of return on capital is the regulatory weighted average cost of capital (WACC), which serves as the rate of return on the regulatory asset base. For the third regulatory period, the approved regulatory WACC has been 14.97%. This was computed using economic variables during the final rate determination in the third regulatory period (around February 2011). Interest rates have drastically come down since then, which should reduce the regulatory WACC for the fourth regulatory period. For example, using the same indirect method (using USD treasury bonds and applying a country risk premium), the yield for 20-year USD treasury bonds (averaged for 60 days) was 2.93% as at 9 January 2015, against 4.32% as at 28 February Using the same formula but updating the variables such as the risk-free rate, asset beta, country risk premium and inflation rates, we arrive at a regulatory WACC of 11.02% as at 31 December 2014 and 10.82% as at 5 February In our forecasts, we factor in a regulatory WACC of 11%. Our sensitivity analysis shows that for every 10bps increase/decrease in the regulatory WACC, our target price would go down/up by about PHP2/sh. Factoring in a 1-year delay The fourth regulatory period, together with a new tariff base, was originally scheduled to begin in July We believe, however, that the process will be delayed based on the regulator s progress to date. According to Meralco, there is a high possibility of the new tariff being delayed as the regulators have not yet issued the rules that will apply to the fourth regulatory period and the tariff reset. As such, we have factored in a 1-year delay in the implementation of the new rates. For RY2016 (1 July 2015 to 30 June 2016), we have maintained the status quo and the current MAP of PHP1.5562/kWh in our forecasts. When the rates for the fourth regulatory period are determined, we assume that any difference between the should-be rate for RY2016 and the statusquo rate of PHP1.5562/kWh will be recovered over the remaining regulatory period. Regulatory WACC calculation previous and Daiwa forecasts 3 rd Regulatory Period 4 th Regulatory Period 4 th Regulatory Period (actual) As at 31 December 2014 As at 4 February 2015 Parameters Low Mid High Low Mid High Low Mid High Gearing (debt) ratio D/(D+E) 45% 40% 35% 45% 40% 35% 45% 40% 35% Equity ratio E/(D+E) 55% 60% 65% 55% 60% 65% 55% 60% 65% Debt to equity D/E Asset beta Ba Risk-free rate (nominal 20-yr USD bond yields in USA) % 4.32% 4.57% 2.18% 2.43% 2.68% 2.44% 2.69% 2.94% Country risk premium for equity (excluding FX risk) CRPe 1.21% 1.46% 1.71% 1.12% 1.37% 1.62% 1.06% 1.31% 1.56% Risk-free rate used in WACC Rf 8.80% 9.80% 10.79% 4.59% 5.56% 6.53% 4.79% 5.76% 6.73% Debt margin DM 2% 2.50% 3.00% 2.00% 2.50% 3.00% 2.00% 2.50% 3.00% Cost of debt (pre-tax nominal peso term) Kd 10.80% 12.30% 13.79% 6.59% 8.06% 9.53% 6.79% 8.26% 9.73% Market risk premium (developed country) MRP Rm-Rf 6.00% 6.00% 6% 6.00% 6.00% 6.00% 6.00% 6.00% 6.00% Corporate tax rate tc Inflation rate (PH) iphil 4.54% 5.39% 6.24% 2.56% 3.41% 4.26% 2.56% 3.41% 4.26% Inflation rate (US) iusa 1.19% 1.59% 1.99% 1.32% 1.72% 2.12% 1.32% 1.72% 2.12% Income tax rate on interest income ti 20% 20% 20% 20% 20% 20% 20% 20% 20% Income tax rate on dividend income td 10% 10% 10% 10% 10% 10% 10% 10% 10% Calculated equity (re-geared) betas Equity beta (1) = Asset beta x (1+ D/E) Other parameters Cost of equity (post-tax nominal) = Rf + Equity beta 1 x MRP 11.81% 14.78% 17.45% 7.40% 10.60% 13.46% 7.59% 10.80% 13.66% Vanilla WACC (nominal) 11.36% 13.79% 16.17% 7.03% 9.59% 12.09% 7.23% 9.78% 12.28% WACC set at 75th percentile of the suggested range 14.97% 10.82% 11.02% Source: Energy Regulatory Commission, Daiwa estimates

11 Forecasts: distribution business We forecast lower distribution rate By factoring in a lower regulatory WACC of 11% (compared with 14.97% used for the third regulatory period) and adjusting for a 1-year delay in the implementation of the lower rate, we forecast a MAP of PHP1.1857/kWh for RY2017, down 24% vs. the PHP1.5562/kWh for RY2016. Thereafter, we expect an inflationary increase in tariffs up to PHP1.2783/kWh for RY2019. Meralco: maximum average price (PHP/kWh) with 1-year delay 3rd regulatory period (1 July June 2015) th regulatory period (1 July June 2019) Our forecast of a tariff reduction beginning in 2H16 outweighs our electricity volume growth assumption for the same period. We forecast distribution revenue to fall by 9% YoY to PHP51.78bn for And a further 9% YoY decline in distribution revenue is expected for 2017 with the first full-year of implementation of new tariffs. Recovery with continued improvement in margins Significant gains in operating efficiency have boosted Meralco s margins. Its EBIT margin based on revenues excluding pass-through items showed a marked improvement from 24% in 2009 to 46% in Meralco: EBIT and EBIT margin on revenue (excluding passthrough items) 24% 28% 37% 38% 17,839 19,108 43% 24,150 46% 45% 45% 26,166 25,754 23,143 43% 43% 20,339 22,141 7,633 12,293 RY12 RY13 RY14 RY15 RY16E RY17E RY18E RY19E Source: Energy Regulatory Commission, Daiwa forecasts Note: Rates for the 3 rd RP are all actual based on the ERC; 4 th RP are Daiwa forecasts With the full-year implementation of a PHP1.5562/kWh MAP in 2015, we expect the average distribution rate to fall by 3%. Meanwhile, we forecast a further decline in the distribution rate as we factor in the new tariffs for the 4 th regulatory period beginning RY2017. As RY2017 begins in 1 July 2016 and ends on 30 June 2017, the 24% decline in the MAP will be distributed over 2016 and We estimate the average distribution rate to fall by 12% YoY for both 2015 and 2016, and begin to see an improvement in Meralco: distribution revenue and average distribution rate ,606 50,892 Source: Company, Daiwa forecasts ,105 56,382 56, , ,319 50, E 2016E 2017E 2018E Distribution revenues (PHPm) Ave distribution rate (PHP/kWh) E 2016E 2017E 2018E EBIT (PHPm) Source: Company, Daiwa forecasts EBIT margins on revenues (ex-pass through items) We expect Meralco to sustain the operating efficiencies that have led to the improvement in its margins. In addition, we factor in a gradual decline in provisions for probable charges (considered as operating expenses), as we expect the company is in the tail end of its provisioning for pending legal cases involving possible refunds to consumers. Between 2011 and 2013, Meralco made provisions for a total of PHP28.04bn or an average of PHP9.35bn a year. This compares with its 2009 and 2010 provisioning of PHP2.17bn and PHP4.12bn, respectively. As a result, we expect the company s EBIT margin to hold up above 43% for the period E, despite our lower distribution revenue estimates for the same period. Overall earnings prospects We forecast a 2% YoY decline in the distribution business s core income, at PHP17.66bn, for 2015, due to the full-year implementation of the lower MAP beginning in 2H14. However, the effect of our lower distribution rate assumption for the 4 th regulatory period will only be seen beginning 2016, as our forecast points to a 10% YoY decrease in the distribution business s core income, to PHP15.86bn, for

12 The decline should continue, but bottom out, in 2017 as this will be the first full (calendar) year of the implementation of new tariffs. We estimate a net profit of PHP13.86bn, down 13% YoY. The distribution business should start to recover in 2018 alongside the increase in tariff and continued EBIT margin improvement. For 2018, we forecast the net profit of the distribution business to grow by 8% YoY to PHP15.03bn. Strong balance sheet to support expansion Meralco: net cash (debt) (PHPm) (4,748) Source: Company 3,149 19,698 35,887 26,260 (21,816) (21,221) (24,443) (24,613) (33,591) (30,042) (17,068) (24,370) (44,141) (60,500) (59,851) (69,467) Cash Interest-bearing debt Net cash (debt) 39,426 The distribution business provides stable and strong cash-flow generation, enabling Meralco to be in a net cash position since As at the end of 2014, its cash and interest-bearing debt amounted to PHP69.47bn and PHP30.04bn, respectively, putting the company in a net cash position of PHP39.43bn. Its gearing ratio was also low, at 0.5x, as at end Meralco has historically churned positive free cash flows despite its high capex requirements. Although we estimate free cash flows to fall to PHP10.46bn in 2014 from PHP26.62bn in 2013 due to a big negative working capital change of PHP13.50bn, we expect the distribution business to maintain its positive free cash flow generation throughout the rest of our forecast period to Our negative working capital forecast in 2014 arose from the sudden increase in trade payables at the end of 2013 (generation charges for November and December 2013 spiked and the courts put a temporary restraining order on Meralco to collect from customers). Meralco s strong balance sheet and cash flow generation gives it the financial flexibility to take on new projects such as its ventures into power generation. Meralco: free cash flow parent (distribution) and others E 2015E 2016E 2017E 2018E 2019E 2020E 2021E 2022E 2023E 2024E EBIT 7,633 12,293 17,839 19,108 24,150 26,166 25,754 23,143 20,339 22,141 24,200 26,212 27,934 29,747 31,658 33,668 Add: Depreciation and amortisation 4,831 5,911 5,504 5,576 6,118 6,093 6,357 6,608 6,868 7,137 7,415 7,698 7,974 8,245 8,510 8,770 Add: Provisions 2,172 4,119 7,869 8,948 10,736 10,114 9,000 7,000 5,000 5,000 5,000 5,000 5,000 5,000 5,000 5,000 Less: Working capital 15,835 (321) 1,177 6,518 2,421 (13,503) 193 (2,887) 2,140 3,107 3,345 3,494 2,571 3,900 4,208 4,564 Capital expenditure (8,101) (8,510) (8,343) (9,353) (9,311) (9,629) (11,649) (12,107) (12,585) (13,083) (13,602) (13,692) (13,785) (13,882) (13,984) (14,089) Income taxes (2,331) (4,023) (5,953) (5,741) (7,054) (8,353) (7,872) (7,211) (6,434) (6,946) (7,550) (7,965) (8,618) (9,155) (9,754) (10,342) Tax benefit of interest expense (1,140) (168) (434) (458) (444) (432) (426) (420) (403) (449) (475) (701) (584) (639) (683) (749) Free Cash Flow to Firm 18,899 9,301 17,660 24,598 26,616 10,457 21,357 14,126 14,924 16,907 18,332 20,045 20,491 23,216 24,955 26,822 Source: Company, Daiwa forecasts

13 Generation: new source of power Meralco s re-entry into the powergeneration business should serve as its next leg of growth, as well as complement its distribution business by securing a cheap and stable power supply Need for new capacity The Department of Energy (DoE) warns of a power shortage of up to 1,000MW in the Luzon grid during the summer months of A combination of high demand due to the hotter weather, the planned maintenance shutdowns of large plants, and a possible El Niño effect on the water levels of hydro plants are the contributing factors for the looming power shortage. The government has implemented stop-gap measures, such as an interruptible load programme and ensuring the president of the country has emergency powers to contract capacity from readily available sources like generation sets. However, even if this immediate issue is addressed, the much more important message presented by this is the fact that new capacity is still very much needed. Re-entry into power generation Until the early 1970s, Meralco was into both power distribution and generation. However, during the martial law regime, the country s electricity generation and transmission facilities were nationalised, forcing the company to sell all its power-generation assets to the government and turning Meralco s core business exclusively into distribution. However, in 2013 Meralco re-entered the power generation business both through partnerships with existing players and the development of new power plants. Its power-generation assets are lodged under its subsidiary Meralco PowerGen Corp (MGEN). Leveraging the distribution business MGEN s power projects, at least those in Luzon, have the advantage of being backed by Meralco (distribution) in terms of the offtake of capacity. While any power supply agreement between MGEN s plants and Meralco must be signed off by the ERC, this arrangement still gives MGEN a big competitive advantage over plants of similar profiles. Current regulations allow cross-ownership between distribution and generation companies. The law, however, limits the DU from sourcing more than 50% of its total power demand from bilateral contracts with associated generation companies to prevent an abuse of power. The restriction is only applicable to the DU s sourcing for its franchise area. Based on Meralco s 2013 electricity sales of 34,084GWh, it is allowed to contract 17,042GWh from its affiliated power-generation companies. Assuming an average capacity factor of 80%, this translates into an allowance of up to 2,432MW of installed capacity. This limit will go up as demand in Meralco s franchise area increases. Also benefits its distribution business Meralco highlights that another reason the company ventured into the power-generation business, particularly its projects in Luzon, is to serve as support for its distribution business. Having its own generation plants helps ensure a stable supply for the distribution business, particularly with the current demand-supply scenario of thin reserves and looming power shortage in summer By securing more bilateral contracts, Meralco is minimizing the effect of any price spike in the spot market. Although generation charges are just passthrough charges, Meralco usually bears the brunt of consumer anger for any increase in electricity price. The most recent example was in December 2013, where Meralco was the first to be blamed for the PHP4.15/kWh increase in the monthly electricity charge, though the actual reason was the spike in generation charges, particularly those sourced from the spot market. This issue even resulted in the Supreme Court issuing a temporary restraining order on Meralco to collect the increase in rates. Meralco is in fact already going in this direction. As of 9M14, we saw a big decline in purchases from the spot market to 2.9%, from 5.3% in

14 Meralco: breakdown of net system input (GWh) 29,922 26,077 28,028 Source: Company 32,644 33,081 35,176 36,673 30,661 32,918 34,724 Partnering with established generation players 28,112 27, M14 Having just re-entered the power-generation business, Meralco s strategy is to partner with established players in the business, both through acquiring stakes and undertaking new projects with existing players. This allows Meralco to leverage on its partner s technical know-how and experience in power plant operations. Through its partnerships, Meralco is also able to expand its footprint beyond Luzon where its franchise area is situated. In fact, Meralco currently has operating plants in other regions in the Philippines (Visayas) and overseas (Singapore). Meralco: timeline of attributable power-generation capacity (MW) 379 Contracted Wholesale Electricity Spot Market Global Business Power Corp (GBP) Project type Minority investment Plant type Various coal and diesel Capacity 410MW (gross) coal; 217MW (gross) diesel Location Visayas region % Meralco equity 22% Partner GT Capital Holdings (GTCAP:PM), First Metro Investments Corp, Orix Corp (of Japan) Expected COD n/a Status Additional 82MW (gross) coal-fired plant started commercial operations Sep 2014; additional 150MW (gross) coal-fired plant by 3Q2016 (company's target) Offtake agreement VECO, PECO, export/industrial zones, mining/industrial companies Source: company GBP: power-generation facilities Type of plant Effective ownership Gross/Net capacity (MW) Effective gross/net capacity (MW) Cebu Energy Development Corp (CEDC) Clean coal 52.1% 246/ /113 Panay Energy Development Corp (PEDC) Clean coal 89.3% 164/ /129 Toledo Power Corp (TPC) TPC Sangi Coal /50 60/50 TPC Carmen Fuel oil /36 40/36 TPC 1A Fuel oil Panay Power Corp (PPC) PPC Iloilo 1 Fuel oil /69 64/62 PPC Iloilo 2 Fuel oil 20/18 20/18 18/16 PPC Nabas Fuel oil 13/11 11/ PPC New Washington Fuel oil 5/ /4 100 Global Power Resources Inc (GPRI) Fuel oil 8/7 8/ Source: GTCAP In October 2013, Meralco purchased a 20% stake in GBP from First Metro Investment Corp for PHP7.15bn. This marked Meralco s official re-entry in the Philippines power-generation industry. An additional 2% stake was purchased by Meralco for PHP184.87m in May In total, Meralco holds a 22% interest in GBP for a total acquisition cost of PHP7.33bn. Based on GBP s 2013 financials, the transaction is equivalent to 17.2x PER. GBP: geographical distribution of power plants E 2017E 2018E Source: company, Daiwa forecasts GBP Pacific Light San Buenaventura Power Global Business Power: dominant player in the Visayas Global Business Power is one of the largest power producers in the Visayas region, with total dependable capacity of 704MW (one-third of total installed capacity in the region). GBP was established in 2002 and has 9 power-generation facilities across the Visayas Islands and 1 in Mindoro, an island towards the southwest area of Luzon. Note: TPC1A and PEDC Unit 3 not yet included in map Source: GTCAP

15 GBP allows Meralco to have access to a fast-growing market in the Visayas region, for which the DoE projects average annual growth in peak demand of 4.5% until GBP has 2 brownfield expansion projects. The first is the 82MW coal-fired power plant in Toledo City, Cebu (TPC1A), which has been operational since September 2014, three months ahead of target. Next is the 150MW coal-fired plant in Iloilo City. An equity call amounting to PHP4.43bn (Meralco s share is PHP1.07bn) was conducted by GBP in 1H14. The construction of this plant commenced in July 2014 and the company expects it to be completed by July MW Toledo (TPC 1A) coal plant Source: GTCAP 9M14 presentation materials PEDC ground-breaking ceremony Source: GTCAP 9M14 presentation materials Meralco s partners in GBP are GT Capital Holdings Inc (GTCAP PM) and First Metro Investment Corp (an affiliate of GTCAP), and a Japanese firm, Orix Corp. Each has 51.3%, 4.7% and 22% interests, respectively, in GBP. GTCAP is one of biggest conglomerates in the country with businesses in banking, automotive, power, property development, and insurance. PacificLight: testing the waters overseas In March 2013, MGEN acquired a 28% effective stake in PacificLight Power Pte Ltd (PacificLight) which, at that time, was at the final construction phase for a 2x400MW LNG-fired power plant in Jurong Island, Singapore, for a consideration of USD217.4m (total project cost was USD965m). The plant started full commercial operations in February MGEN has partnered with First Pacific (Meralco s effective major shareholder) and Petronas Power, a subsidiary of Malaysia s state energy firm Petronas, which respectively have 42% and 30% effective stakes in PacificLight. PacificLight Power Co Ltd Project type Effective minority Plant type Liquefied Natural Gas-fired Capacity 2x400MW Location Jurong Island, Singapore % Meralco equity 28% Partner(s) First Pacific Co Ltd (142 HK), Petronas Power Status In commercial operations since February 2014 Offtake agreement Vesting contracts with the Singapore government, retail contracts, merchant Source: Company Singapore s electricity market has excess powergeneration capacity currently. From 2009 to mid-2014, its ratio of peak system demand to installed electricity generation capacity averaged at around only 60%. Similar to the Philippines, Singapore has an electricity spot market that also follows a market-clearing process, wherein the price is set at the point where offers by the generators meet total demand. All generators that offered until that point will then be cleared and paid at the market-clearing price. In effect, the market favours the lowest-cost power producer. Generators are free to enter into bilateral contracts but are limited to purely financial arrangements. Both the oversupply scenario and spot market encourages generators to be more efficient. As one of the newest plants in Singapore, PacificLight has the advantage of being equipped with the latest and most efficient technology available. The plant uses the energy-efficiency F-class combined cycle gas turbines from Siemens and has a fast ramp-up time of only 60 minutes which makes it one of the most efficient and flexible power plants in Singapore

16 Singapore: historical electricity demand-supply 14,000 12,000 10,000 8,000 6,000 4,000 2,000 0 Jan-09 Apr-09 Jul-09 Oct-09 Jan-10 Apr-10 Jul-10 Oct-10 Jan-11 Apr-11 Jul-11 Oct-11 Jan-12 Apr-12 Jul-12 Oct-12 Jan-13 Apr-13 Jul-13 Oct-13 Jan-14 Apr-14 Installed electricity generation capacity (MW) Source: Energy Market Authority of Singapore San Buenaventura coal: advanced stages of development In August 2013, MGEN partnered with Thailand s Electricity Generating Public Co (EGCO TB) for the construction of a 500MW (455MW net) supercritical pulverised coal-fired power plant that will be an expansion of its existing 460MW coal plants in Mauban, Quezon. The new project will be under San Buenaventura Power Ltd Co (San Buenaventura Power) which is 51%-owned by MGEN and 41%-owned by New Growth B.V., a 98%-owned subsidiary of EGCO. A power supply agreement (PSA) covering the plant s entire output was signed on 2 June 2014 with Meralco and immediately submitted to the ERC for approval. The selection of the EPC contractor and financing agreement are in the final stages, but both are pending the approval of the PSA. The project cost is still to be determined as the EPC contract has to be finalised, but based on benchmark projects, the cost of developing a coal plant ranges from USD2.3m-2.4m per MW, which translates into a total cost of around USD1.15bn-1.2bn. the project is targeted for completion between late and San Buenaventura Power Ltd Peak system demand (MW) Project type Brownfield Plant type Supercritical coal-fired Capacity 455MW (net) Location Mauban, Quezon % Meralco equity 51% Partner New Growth BV (subsidiary of EGCO of Thailand) Expected COD 2018 Status EPC contract in final stages of discussion; finalising project financing agreement of up to PHP40bn Offtake agreement Power-supply agreement with Meralco signed in May 2014 and awaiting ERC approval Source: company Actively looking for more powergeneration projects MGEN s thrust is to build its domestic powergeneration portfolio by 2020 to up to 3,000MW. (Note that for the 3,000MW target, Meralco attributes full capacity once control of the project is with the company, regardless of the actual interest.) Against this target, Meralco s current attributable domestic capacity, including the under-development 150MW PEDC Unit 3 and 500MW San Buenaventura Power, totals only around 688MW. Although this still leaves a lot of room to fill in terms of capacity, MGEN currently has 2 big power projects under study that could allow MGEN to reach its target capacity. First is the 600MW coal-fired power plant in Subic through a consortium called Redondo Peninsula Energy (RP Energy). The project is designed to use the most advanced supercritical circulating-fluidized bed (CFB) technology and is estimated by Meralco to cost USD1.2bn. Meralco s partners in the consortium are established power-generation companies Aboitiz Power Corp (AP PM) and Taiwan Cogeneration International Corp. RP Energy was supposedly Meralco s first powergeneration project. The partnership agreement was signed as early as July 2011, but it met opposition when a writ of kalikasan, filed by militant groups, was issued by the Court of Appeals, which in turn invalidated its environmental compliance certificate (ECC). Meralco appealed to the Supreme Court and on 3 February 2015 was granted a favourable decision that reversed the earlier ruling. With this development, Meralco said it would proceed with the project and start renegotiating its EPC contract and financing agreement. RP Energy has spent PHP1bn on site development costs for the project. Meralco targets to commence construction within Assuming construction on the project begins this year, we think the plant could be ready in late-2018 or However, we have not yet factored RP Energy into our model or DCF valuation pending more concrete developments from the company

17 Redondo Peninsula Energy Inc (RP Energy) Project type Greenfield Plant type Circulating fluidized bed coal-fired Capacity 2x300MW Location Subic Bay Freeport Zone % Meralco equity 47% Partner Aboitiz Power Corp (AP PM), Taiwan Cogeneration Expected COD Currently n/a Status On 3 Feb 2015, the Supreme Court reversed the earlier ruling of the Court of Appeals, which had granted the petition for the issuance of a writ of kalikasan on the project and invalidated the environment compliance certificate. The Supreme Court also upheld the legality of the lease and development agreement for the project. Offtake agreement Currently n.a. Source: Company, Daiwa Meralco is also involved in ongoing development activities for a 2x600MW supercritical pulverized coalfired power plant in Atimonan, Quezon (Atimonan One Energy). An international engineering firm has been engaged as Meralco s engineer while it is in the process of the engineering, procurement and construction prequalification. Meralco is also currently applying for an ECC. In late February 2015, it emerged that Meralco is in preliminary talks with Osaka Gas (9532 JP) to build a liquefied natural gas (LNG) facility in the Philippines. The project could potentially include a gas power plant with a generating capacity of 1,200-1,500MW at a cost of up to USD2bn. It could also comprise a regasification facility for the imported LNG. The company said it intends to finalise negotiations with Osaka Gas within Growing contribution from power generation For 9M14, the power-generation business was still a drag on earnings, with GBP s PHP222m equity earnings offset by PacificLight s loss of PHP294m, as it is still in the early stages of its operations. Combined, we expect these units to only nearly break even in Meralco: contribution from power-generation units (PHPm) 1,883 2, , Going forward, we expect a significant improvement in the contribution of its power-generation business. Meralco has 3 power-generation projects that it has just completed or expects to complete in , which should provide a continuous boost to Meralco s net profit until Meralco: timeline of attributable power-generation capacity (MW) Source: Company, Daiwa forecasts E 2017E 2018E GBP Pacific Light San Buenaventura Power First in the pipeline is the 82MW Toledo (TPC 1A) coalplant expansion, construction of which was completed in late-4q14. We expect a full-year contribution to earnings from TPC 1A in By 2H17, we expect another project to have come online, the 150MW PEDC Unit 3 coal-plant expansion. The construction of PEDC Unit 3 began in July 2014, and the company is targeting completion within 24 months of that date. We expect this to start contributing to earnings in late and its full-year contribution to be felt in Both TPC 1A and PEDC Unit 3 are expansion projects of Meralco s 22%-owned affiliate GBP. Between 2015 and 2017, we expect the net profit from the powergeneration business to grow from PHP538m for 2015 to PHP931m in 2017 as a result. By 2H18, we expect the completion of Meralco s first majority-owned generation project, the 500MW San Buenaventura coal plant project. It should provide a boost in earnings for 1H18 and for the full-year beginning We expect the combined net profit contribution for the power-generation business to jump to PHP1.88bn in 2018 and PHP2.97bn in (17) (71) ,904 2,103 9M E 2015E 2016E 2017E 2018E 2019E 2020E San Buenaventura Power PacificLight Global Business Power Source: Company, Daiwa forecasts Note: 9M14 total only for 2014, comprises Global Business Power and Pacific Light

18 Valuation: powergeneration assets ascribed zero value Initiating coverage with a Buy (1) rating and a 12-month target price of PHP Based on our DCF valuation, investors are essentially getting Meralco s power-generation assets for free. SOTP-based TP of PHP324 We separately value Meralco s power-distribution and generation businesses using a DCF methodology, which gives us our SOTP target price of PHP Distribution still the biggest asset, but generation becoming a substantial contributor The distribution business remains Meralco s biggest earnings driver, accounting for more than 90% of the company s consolidated equity value. Nevertheless, the growing contribution of its power-generation business is notable from essentially nil a few years ago to 10% of the total equity value today. Meralco: SOTP valuation Total equity Meralco s Attributable Value per % of value stake equity value share total (PHPm) (PHPm) (PHP/sh) Parent (distribution) and others 330, % 330, % PacificLight 26,357 28% 7, % San Buenaventura Power (SBP) 27,722 51% 14, % Global Business Power (GBP) 61,142 22% 13, % Total % Target price No of outstanding shares 1, Source: Daiwa estimates Among Meralco s power-generation projects, its 51% stake in SBP s 500MW coal plant provides the largest contribution to our TP, at PHP12.54, followed by its 22% stake in GBP, at PHP11.93, and its 28% effective interest in the 800MW LNG plant in Singapore, at PHP6.55. Since San Buenaventura coal and GBP s 150MW PEDC Unit 3 coal are still under development, investments in these projects should weigh down free cash flows over , especially in 2016 when we expect bulk of the capex for San Buenaventura coal will be needed. However, once these projects become operational, in 2017 for PEDC Unit 3 coal, and 2018 for San Buenaventura coal, we expect strong free cash flow generation resulting in significant improvement in the DCF-based valuations. Meralco: projected free cash flows to the firm (PHPm) 9,546 10,457 16,681 21,357 (4,481) Source: Daiwa forecasts 2,232 14,126 (12,005) 10,404 14,675 14,924 16,907 18,332 20,045 (5,941) (3,740) 22,739 2,981 24,082 2, E 2015E 2016E 2017E 2018E 2019E 2020E GBP MER parent San Buenaventura Power Pacific Light In our valuation and forecasts, we have not factored in Meralco s other potential power-generation projects, such as the Subic coal plant, Atimonan One Energy, and LNG plant (partnered with Osaka Gas), as we are waiting for more concrete developments. DCF parameters We have discounted the 10-year free cash flows to firm of the parent (for the distribution business) and for the 3 power-generation units using appropriate WACCs for each. We use a WACC of 9.66% for the distribution business. This is higher than the computed discount rates of 7.18% for both SBP and GBP and 6.08% PacificLight. The key difference is the weights of the market value of equity and debt, except for PacificLight, for which we have used the different risk and return parameters applicable in Singapore. With strong cash flow generation from its distribution business, Meralco (parent) has minimal debt on its balance sheet and is currently in a net cash position. As a result, its debt/equity mix is skewed to the (market value of) its equity, with the weighting at 90:10. Meanwhile, we have applied a 50:50 weighting for debt and equity for the unlisted power units. We assume terminal growth rates of 3% for the company s Philippine-domiciled business and 2% for its Singapore-based power unit

19 Meralco: DCF parameters Parent and others San Buenaventura Power Global Business Power PacificLight WACC 9.66% 7.18% 7.18% 6.08% Cost of equity 10.34% 10.50% 10.50% 8.00% Risk-free rate 4.50% 4.50% 4.50% 2.50% Equity beta Market risk premium 6.00% 6.00% 6.00% 5.50% After-tax cost of debt 3.50% 3.85% 3.85% 4.15% Terminal value 3.0% 3.0% 3.0% 2.0% Terminal year 2024E 2024E 2024E 2024E Source: Daiwa estimates Earnings multiples at the high end in the near term The stock is trading currently at a 2015E PER of 16.7x and 18.3x 2016E PER (based on the closing share price of PHP on 26 March 2015). Granted, these are at the high end of the Bloomberg consensus estimates for the regional comparable power distribution/generation companies, which range from x (average of 15.4x) for 2015 and x (average of 13.5x) for of 8.0x for 2015E and 9.4x for 2016E. These compare with the estimated regional peer averages for 2015 and 2016 of 2.4x and 2.2x PBR, and 9.4x and 8.9x EV/EBITDA. Meralco: 12-month forward PER bands (PHP/sh) Dec-05 Dec-06 Dec-07 Dec-08 Dec-09 Dec-10 Dec-11 Dec-12 Dec-13 Dec-14 Source: Daiwa Meralco: 12-month forward EV/EBITDA bands (PHP/sh) x 23.0x 17.1x 11.3x 5.4x Our high earnings multiples are due to our tepid 1% YoY net profit growth forecast for Meralco in 2015 and decline of 9% YoY for 2016, resulting from our lower tariff assumptions x 10.4x 7.8x 5.3x Similarly, Meralco remains at the high end of the PBR and EV/EBITDA metrics when compared with its regional peers (Bloomberg data). At its current share price, Meralco is trading at PBRs of around 3.7x for 2015E and 3.6 for x 2016E, and EV/EBTIDA multiples x 0 Dec-05 Dec-06 Dec-07 Dec-08 Dec-09 Dec-10 Dec-11 Dec-12 Dec-13 Dec-14 Source: Daiwa Power sector regional peer comparison Market PER PER PBV PBV EV/EBITDA EV/EBITDA Div Yield Div Yield ROE ROE ROA ROA Ticker Capitalisation 2015E 2016E 2015E 2016E 2015E 2016E 2015E 2016E 2015E 2016E 2015E 2016E Company & Exchange (PHPm) (x) (x) (x) (x) (x) (x) (%) (%) (%) (%) (%) (%) Aboitiz Power Corp AP PM 332, Energy Development Corp EDC PM 159, First Gen Corp FGEN PM 109, GD Power Development Co-A CH 616, n.a. Inner Mongolia Mendian Hu-A CH 192, n.a. n.a. n.a. n.a. n.a. n.a n.a. n.a. n.a. Manila Electric Co 305, Power Grid Corp of India Ltd PWGR IN 545, Ratchaburi Electricity Generating Holding PCL RATCH TB 120, Semirara Mining and Power Co SCC PM 172, Shenergy Co Ltd-A CH 255, n.a. n.a. n.a. n.a. n.a. n.a n.a. n.a. Shenzon Energy Group Co L-A CH 250, n.a. n.a. Tata Power Co Ltd TPWR IN 147, Tenaga Nasional Bhd TNB MK 992, YTL Power International Bhd YTLP MK 128, Average Max Min Daiwa estimates* Manila Electric Co At current price n.a. n.a. n.a. n.a. At target price n.a. n.a. n.a. n.a. Source: Bloomberg, *Daiwa forecasts for Meralco

20 E earnings forecast summary Meralco posted a 6% YoY increase in its core net income for We expect more modest growth for 2015 as distribution will be dragged down by the fullyear impact of the lower distribution rate implemented in 2H14, offsetting the improving revenue contribution from its generation businesses. We forecast 2015 core net profit to increase by 1% YoY to PHP18.20bn. For 2016 and 2017, we see core net profit declining by 9% and 11% YoY, respectively, due to our lower tariff estimates for the fourth regulatory period beginning July We start to see a recovery in 2018, with 2019 being the banner year, driven by improvements in the distribution business coupled with the contributions from its new generation projects. Affiliate GBP s 150MW PEDC Unit3 is targeted to finish construction in 2H17, with a full-year earnings contribution registered in Meanwhile, we expect the 500MW San Buenaventura plant to start operations in 2H18. We see core net profit reaching PHP16.91bn (+14% YoY) in 2018 and PHP19.42bn in 2019 (+15% YoY). Steady and healthy dividends Meralco s strong cash flow generation enables it to pay out healthy cash dividends to its shareholders. The company has a dividend policy of paying regular cash dividends equivalent to 50% of core net profit plus a look-back approach, which allows the company to pay additional special cash dividends. Since 2013, Meralco has been declaring cash dividends at around 80% of core earnings. Meralco: dividend payments and payout ratio Source: Company, Daiwa forecasts Note: *Adjusted to reflect the timing of dividend payments based on the core earnings base Meralco: dividend yield (%) forecasts for index stocks (2015) % % 70% Source: Bloomberg, Daiwa for Meralco 80% 80% 80% 80% 80% 80% 80% 80% E 2016E 2017E 2018E 2019E 2020E DPS (annual) Dividend payout* TEL MER GLO AP DMC AEV SCC EDC EMP BPI BDO URC RLC AGI FGEN SM SMC JFC SMP H ALI MPI MBT ICT PCOR MEG AC LTG JGS GTCAP BLOOM Meralco s dividend yield is one of the highest of the constituent members of the PSEi. Based on the current share price, we estimate a dividend yield of 4.9% for Although dividend amounts might be slightly reduced in the short term due to the expected lower core net profit, assuming the company maintains its 80% payout, we still see Meralco as one of the top-10 dividend-paying index constituents. As net profit recovers and fresh cash flows from new generation projects pour in, we expect dividends to significantly improve as well

21 Operational and execution risks Key risks Regulatory and political risks are the key risks for Meralco s distribution business. With its entry into the power-generation business, other risks include technical and operational, market and execution risks. Regulatory and political risks Meralco s distribution business is regulated by the government. Among others, its franchise must be renewed every 25 years and its tariffs must be approved by the regulator. In addition, Meralco has been bearing the brunt of consumer anger as it is in charge of collecting payments for electricity bills, including passthrough charges such as generation and transmission. DU s tariffs still in the hands of the regulator and franchise requires renewal Currently, the tariffs for the distribution business are determined through the PBR scheme, wherein rates are reset every 4 years. Although the PBR scheme has a general template when it comes to calculating rates, there is still flexibility to change the methodology of computation for certain parameters, such as the riskfree rates, energy sales, operating and capital expenditure. The regulator essentially has the power to decide on the rates as long as it is able to justify an equitable return for the DUs. And since the top officials of the regulating body are political appointees, the possibility of politics affecting the regulator s decisions cannot be discounted. In addition, Meralco s franchise is renewed every 25 years and approved by congress. Its last renewal was in 2003 and its current franchise is valid until 28 June The renewal process could be affected by the motives of the politicians. Serving as Meralco s defence amid a hostile political atmosphere is its important role of delivering a vital public service (electricity) to more than 25% of the population and the country s economic centre. Any disruption or discontinuation of the electricity distribution service that Meralco provides will likely cause severe inconvenience to the people, as well as negative economic consequences. Facilities prone to natural disasters The Philippines was ranked the third-most disasterprone country in the world due to its high exposure to natural disasters, according to a United Nations-led study in Consequently, Meralco s facilities are also vulnerable to such natural disasters. Meralco can apply to recover any additional costs relating to force majeure events. In addition, any disruption in service will be disregarded under the tariff determination methodology for the purpose of determining any service-related rewards or penalties. However, the time it takes to obtain such recoveries is uncertain. In addition, Meralco will not be able to recover any lost sales from service disruptions. As of 9M14, 2 major typhoons interrupted Meralco s service and resulted in total unrealised sales of 263GWh. Meralco: impact of major weather conditions for 9M14 Typhoon Mario Typhoon Glenda Inclusive dates (including completion of restoration) 19 September July 2014 Circuits affected at the height of the typhoon % of total circuits 12.98% 89.44% Sustained interruption events Momentary interruption events Customers affected during the height of typhoon 397,714 4,640,000 % of total customers 7.49% 87.50% Unrealized sales (GWh) Total damage to facilities in PHPm (poles, wires, others) Source: company No experience in power generation Meralco can be considered a newcomer when it comes to power generation as it has no recent experience in the construction and operations of power plants. However, we think the execution and operational risks of its power projects due to this lack of experience should be mitigated by Meralco s strategy of partnering with established power-generation players such as GBP and EGCO. Market risk The key market risks for Meralco relate to important elements of its tariff determination risk free rate and forecast electricity sales. As discussed earlier, the risk free rate is a key variable in the computation of Meralco s required return. If the risk free rate drops, Meralco s required return (and consequently its tariff) will likewise be lower. Another component of the tariff determination is forecast electricity sales. As Meralco bears the power distribution volume risk, if the actual distribution volume is lower than forecast, Meralco will shoulder the shortfall in the form of lower revenue. The opposite scenarios would be the upside for the company

22 Appendix I: company profile Largest electricity distributor The company began operations in 1903 as the Manila Electric Railroad and Light Company, providing electric light and power and an electric street railway system in Manila and its suburbs. However, its railway system was destroyed during World War II, paving the way for the company to focus on electricity generation and distribution, beginning Under the Martial Law regime in 1972, the company s power-generation assets were forcibly nationalised, leaving its electricity distribution as its primary business. Meralco: its 1900s Tranvia in Manila Meralco is the largest electricity-distribution company in the Philippines. Its franchise area spans 9,337 sq km and covers Metro Manila and the provinces of Rizal, Cavite, Bulacan and parts of Pampanga, Batangas, Laguna, and Quezon. It serves more than 5m customers, which translate into nearly 25m people. In addition, through its 65%-owned subsidiary Clark Electric Distribution Co (CEDC), it holds the franchise for the Clark Industrial Zone in Clark, Pampanga, which covers 44 sq km. Meralco: customer count per group ( 000s) 4,701 4,847 5,027 5,189 5, ,277 4,412 4,580 4,735 4, Residential Commercial Industrial Streetlights Total Source: Company Source: Today, Meralco is involved in other electricity-related services that primarily are integrated into the distribution business. These include electromechanical, construction, consulting and related manpower, as well as light-rail-related maintenance services, e-transaction and bills collection, insurance and e-business development and energy-systems management. Meralco: subsidiaries Company Meralco stake Business focus Power Clark Electric Distribution Corp 65% Distribution utility in the Clark Economic Zone, a 320 sq km urban centre. Location of high-end IT-enabled industries, aviation, and logistics enterprises, tourism and other sectors Meralco PowerGen Corp 100% Organised to develop competitive and reliable power plants of up to 3,000MW of capacity Services Meralco Industrial Engineering Services Corp 99% Contractor-specialist engaged in engineering, construction and maintenance activities relating to power generation, transmission and distribution, as well as water resources and telecommunications Meralco Energy Inc 100% Provides beyond-the-meter energy services to Meralco's key accounts, covering energy-efficiency services, power quality solutions, innovative systems in advanced metering infrastructure CIS Bayad Center Inc 100% Bills-payment collection service operating nationwide; accepting payments for a wide range of companies including banks, telecoms, utilities, and cable television, among others Radius Telecoms Inc 100% Data-connectivity solutions provider which operates a fibre-based telecommunications infrastructure, expanding to more than 2,000km across the Meralco franchise area Meralco Financial Services Corp (Finserve) 100% Provides innovative customer-based products and services that support Meralco's core business Lighthouse Overseas Insurance Ltd 100% Non-life insurance company that reinsures Meralco's major catastrophic risk exposure Republic Surety and Insurance Co Inc 100% Insurance company licensed to write all lines of non-life insurance and surety, both on a direct and reinsurance basis Miescorrail Inc 100% Design and construction of power-supply substations and distribution systems for railways, maintenance of railway-power systems, consultancy services for railway projects Source: Company

23 Meralco: organisational chart (as of 31 December 2013) Source: Company Ownership history Meralco is majority-owned by the First Pacific Group of Indonesia s Salim Family and under the management of Manuel V. Pangilinan. The group s ownership is through its Philippine Long Distance Telephone Co (TEL PM) and Metro Pacific Investments Corp (MPI PM), which collectively owns 49.96% of Meralco. In addition to MPI s 5% direct stake, TEL and MPI each hold 50% of Beacon Electric Asset Holdings, which directly has a 44.96% stake in Meralco. Meanwhile, Meralco s other major shareholders are JG Summit Holdings (JGS PM) of the Gokongwei Family with its 27.12% stake, and the Lopez family with its 3.95% interest through First Philippine Holdings (FPH PM) and First Philippine Utilities Corp. The remaining 18.97% is owned by institutional investors and the public. Meralco: ownership structure (January 2015) Metro Pacific Investments Corp (MPI) 5.00% Source: Company Beacon Electric Asset Holdings Inc (Beacon) JG Summit Holdings Inc (JGS) Manila Electric Co (MER) First Philippine Holdings Corp (FPH) and First Philippine Utilities Corp Institutional Investors and public float 44.96% 27.12% 3.95% 18.97% Meralco s ownership has gone through several hands throughout its history. It was founded by an American entrepreneur but was briefly transferred to Japanese control during World War II. In 1961, a group of Filipino investors led by Eugenio Lopez Sr bought the company from its American owners, and it was the first major American enterprise to be Filipinized. Until 2009, the Lopez family had control of Meralco except during the Martial Law years ( ) when the Marcos regime stripped away the company s ownership from the Lopez family. In more recent years, Meralco has been at the centre of board-room battles. In early 2008, the Government Service Insurance System

24 (GSIS), a state-owned pension fund, went into a proxywar with the Lopez family but failed to secure control of the company, and eventually sold its 27% stake for PHP90/share to San Miguel Corp (SMC PM) by the end of The following year, the Lopez family sold most of its interest in the company to the First Pacific Group (through separate transactions priced between PHP90/share and PHP295/share) and another fight for control ensued between First Pacific group and SMC. First Pacific group eventually retained control and, in 2013, SMC sold all of its interest in Meralco for PHP235/sh to JGS. World-class operations Meralco has reaped several international awards for its operations such as the Platts Top Global Energy Company Award in 2013, where it ranked 42 nd in Asia, and 149 th in the 250 Global Energy Company Rankings. Has a strong IT system as the backbone of its operations The reliability of Meralco s network comes from its ability to deliver electricity to customers according to the quantity and quality demanded. Various events could compromise delivery of electricity such as generation-plant-related outages, transmission-line failures, distribution-line outages resulting from public action, equipment breakdowns, repairs and scheduled construction or maintenance within the system. In order to mitigate these, Meralco uses a computerbased system called a Supervisory Control and Data Acquisition System that provides real-time and centralised monitoring of electric-system data within the network. Meralco also uses other tools, such as equipment condition monitoring devices, remotecontrolled line switches, reclosers and fault indicators, strategically installed within its network, which enables the fast restoration of electricity supply whenever a power outage occurs and better planning of system loss reduction. Minimised system losses (wastage or losses from input to output) Although Meralco s system losses are well below the regulatory limit, it is still pursuing ways to further reduce them. For technical losses, Meralco has installed equipment to improve power factors, and ensure more substation and distribution facilities. It is also constantly upgrading and rehabilitating facilities, or even replacing them. At the same time, to eliminate pilferage, Meralco strongly pursues violators of the Anti-Electricity and Electric Transmission Line/Materials Pilferage Act of 1994 (or RA 7832), which imposes heavy penalties and possible imprisonment on electric thieves. The law gives Meralco the right to immediately disconnect electric service for those caught for the first time and impose a surcharge of up to 100% of their current monthly bill for third and subsequent apprehensions. Initiatives to improve customer service Leveraging on a strong centralised control system, Meralco has created its Operating Trouble Management System, which is designed for faster customer assistance by facilitating the isolation of the source of power trouble and providing information to expedite the restoration of power. For new customer applications, Meralco has created an e-service application system that allows customers to submit and process applications via . It has also streamlined the application process and started the Accredited Meralco Contractors programme, which assists in the technical requirements of customers applying for electricity service. Meralco has also ramped up its information campaigns regarding several relevant customer concerns such as typhoon preparedness and safety, and a monthly Meralco Advisory that gives information on electricity rate movements and bright ideas for more efficient and safer ways to consume electricity. It has also opened new channels to reach its customers through its MeralcO Virtual Engine (MOVE) app (available in Google play and App Store) and social-media pages such as Facebook and Twitter. Meralco: customer service improvement campaigns Source: Company

25 To better meet the specific needs of its large customers (corporate, industrial, commercial and government), Meralco has extended its channel partnership programmes and conducted Power-up Forums that update these customers on relevant developments and industry-specific concerns. These initiatives have resulted in higher customer satisfaction, with Meralco s customer satisfaction index reaching a record high of 7.79 in 2013, above the company s goal of More importantly, higher customer satisfaction should result in stronger relationships with its customers and a better corporate image for the company. Other projects leveraging the strength of the distribution platform To further its growth and to leverage on its experience and expertise in the electricity-distribution business, Meralco is now seeking to expand its footprint beyond its current franchise area and take advantage of opportunities arising from changes in the power industry. Retail competition and open access allow Meralco to earn on sourcing of power supply Since the passing of the Electric Power Industry Reform Act (EPIRA) in 2001, the Philippines power industry has been going through major reforms towards privatisation and active competition. The Pre-EPIRA industry structure latest among these reforms is retail competition and open access (RCOA) scheme, which was launched in December RCOA allows both power suppliers and contestable customers to enter into the most competitive agreement by allowing them to directly transact with one another. Contestable customers are electricity end-users who have the power to choose their supplier of electricity from a group of retail electricity suppliers (RESs) or local RESs. Local RESs consist of existing distribution utilities which are allowed to serve as retail electricity suppliers within their respective franchise areas. Currently, contestable customers comprise customers with a minimum monthly average peak demand of 1 megawatt (MW), but the threshold will be lowered to 750kW by end Prior to RCOA, a DU such as Meralco does the sourcing, supply, billing and payment collection. The DU takes on the credit risk as payment collection is its responsibility, but it is not allowed to earn on supply. Under RCOA, a DU can serve as a local RES or supplier of last resort for contestable customers located in its existing franchise area, any of which will allow the DU to earn margins on the sourcing of power. In addition, a DU is still kept whole for its distribution business as the DU is still paid wheeling charges regardless of whether the contestable customer is under the DU s local RES. Note: the wheeling charge is the cost or charge for use of a distribution system and/or availment of related services. Post-EPIRA industry structure Generation Pool Transmission Distribution Consumers Generation Transmission Distribution Consumers NPC IPPs NPC Gencos DU s IPPs NPC transmission Distribution utilities Industrial Commercial Residential Others Privatized Gencos Privatized NPC-IPPs DU s IPPs Own Generation WESM System Control NPC transmission Retail Supply Distribution (Wires business) Contestable consumers Commercial Energy Transaction Power Flow Energy Transaction Power Flow REGULATED Source: Energy Report: Philippines Edition (KPMG Global Energy Institute) Source: Energy Report: Philippines Edition (KPMG Global Energy Institute)

26 Meralco: RCOA structure Meralco has also made its presence in Pampanga, another province to the north of Metro Manila, through Pampanga II Electric Cooperative Inc (PELCO II). Meralco has a 20-year technical service agreement with ComsTech Integrated Alliance Inc (ComsTech), which won the investment management contract to operate the electric cooperative in May Management of PELCO II was officially turned over to the Meralco- ComsTech partnership in August Source: Company Meralco has capitalised on this emerging market by creating its own retail electricity supply (RES) team called MPower. MPower is now the biggest RES in the country, with a 60.31% market share in As of 3Q14, there were 823 qualified contestable customers in Meralco s franchise area. And of this, 337 customers opted for contestability. MPower has secured 205 of these contestable customers. Expanding beyond its current franchise Meralco has been more aggressive in the past 2 years in finding opportunities to expand its current distribution network. In 2014, Meralco ventured into 2 projects. First is the 25-year concession agreement to operate, maintain and improve the Cavite Economic Zone (CEZ) distribution system that Meralco signed in May A total investment of PHP300m will be provided by Meralco for the improvement of the CEZ power distribution system and customer service facilities during the term of the concession agreement. CEZ is a special economic zone, a ready-to-occupy business location where locators can enjoy both fiscal and nonfiscal incentives from the government. It covers 275 hectares in Cavite, a province just south of Metro Manila, and has around 400 multinational industrial and commercial locators. Meralco: details of the Cavite Economic Zone project Project Cavite Economic Zone (CEZ) Type of agreement Concession agreement to operate, maintain and improve the CEZ distribution system Partner(s) None % Meralco equity n/a Coverage Rosario and General Trias, Cavite Term 25 years Fees Concession Fee (potential for adjustment every 4 years) Status Contract signed May 2014; effective 1 June 2014 Source: Company Details of the Pampanga II Electric Cooperative (PELCO II) Project Pamapanga II Electric Cooperative Inc (PELCO II) Type of agreement Technical services agreement between ComsTech and Meralco Partner(s) ComsTech Integrated Alliance Inc (ComsTech) % Meralco equity n/a Coverage Pampanga (7 municipalities) Term 20 years Fees Technical service fee Status NEA approved the IMC 8 May 2014; handover to ComsTech on August 2014 Source: company Meralco aims to become an international power company. In 2013, it took the opportunity to become a technical partner of Lagos-based Integrated Energy Distribution and Marketing Ltd (IEDM) in its bid for the privatisation of distribution utilities in Nigeria. The IEDM-Meralco consortium was successful and was awarded the Ibadan and Yola franchises. Ibadan is the capital city of Oyo State on the eastern side of Nigeria, with a population of 1.4m, while Yola is an academic town with a smaller population of 89,000. Meralco has a 5% stake in the joint-venture company but has an option to increase its equity to 20% in the future. Meralco started operating and maintaining these DUs in November More importantly, we think being selected by IEDM over every other DU in the world highlights Meralco s good reputation. Meralco: details of IEDM-Meralco partnership in Nigeria Project Yola and Ibadan Distribution Utilities Type of agreement Technical services agreement Partner(s) Integrated Energy Distribution and Marketing (IEDM) % Meralco equity 5% of IEDM Coverage Ibadan and Yola, Nigeria Term 5 years Fees Management fee + Performance-based remuneration Status Ongoing Source: company Aside from these distribution-related projects, Meralco is also part of the PHP1.72-bn Automatic Fare Collection System (AFCS), one of the government s Public Private Partnership (PPP) projects. Meralco has a 10% stake in the consortium that won the project together with its affiliate-company Smart Communications and the Ayala group. The AFCS concession agreement involves the creation, operation

27 and maintenance of a contactless-based smart-card technology for the Metro Manila train system (LRT Line 1 and 2 and MRT Line 3). The target roll-out date for the AFCS is September Meralco: details of the AFCS Project Automated Fare Collection Services Inc (AFCSI) Type of agreement Concession agreement to build and implement the automated fare collection system for the LRT and MRT lines Partner(s) Ayala Corp's (AC PM) AC Infrastructure Holdings, BPI Finance Card Corp, Globe Telecom Inc (GLO PM), Philippine Long Distance Telephone Co's (TEL PM) Smart Communications Inc % Meralco 10% of AFCSI equity Coverage LRT and MRT lines in Metro Manila Term 10 years Fees Transaction fee Status Contract signed 31 March 2014; target roll-out date is September 2015 Source: Company

28 Appendix II: performance-based regulation (PBR) Meralco: tariff-setting process under PBR Source: company An incentive scheme Under the PBR, prices/revenue are determined using forward-looking expenditure estimates (ex-ante). This has the effect of ensuring that firms are encouraged to be efficient since improving efficiency under fixed prices means additional profits for the DU. This compares with the previous tariff-setting methodology for DUs of a rate-of-return base (RORB), which is backward-looking (ex-post) because actual historical costs are used as inputs. The current tariff-setting mechanism adopted by the Energy Regulatory Commission (ERC) is a price cap variation of the PBR. In particular, tariffs are based on the allowed annual revenue requirement for the DU, which fully compensates investors for the return on its capital, required operating and capex necessary in order to meet operational performance and service level requirements for the projected energy consumption. Sharing efficiency benefits between the DU and customers The PBR uses a customer-centric approach that promotes investments that deliver long-term value to customers. Through incentives, it encourages exceptional performance from DUs while at the same time remaining affordable to the consumers via operational efficiencies and sharing cost savings with customers. A reward and penalty mechanism called the performance incentive scheme is incorporated into the PBR. The scheme can be divided into: 1) an S-factor (price-linked incentive) scheme, and 2) a Guaranteed Service Level (GSL) scheme. Under the S-factor scheme, rewards or penalties are determined using a weighted performance measure based on the performance levels achieved for a number of indices. The GSL scheme provides a guarantee to customers on the responsiveness and effectiveness of DUs through the imposition of penalties if set standards are not met