MASTERS IN FINANCE EQUITY RESEARCH GAS NATURAL FENOSA COMPANY REPORT. LNG in the spotlight UTILITIES 06 JANUARY 2013 RITA CASTRO HENRIQUES

Transcription

1 MASTERS IN FINANCE EQUITY RESEARCH GAS NATURAL FENOSA UTILITIES 06 JANUARY 2013 RITA CASTRO HENRIQUES LNG in the spotlight are current margins sustainable? Recommendation: HOLD Vs Previous Recommendation - Price Target FY14: 19,63 Our HOLD recommendation lies on an anticipation of a negative impact on the back of the Spanish regulatory reform, partial normalization in gas supply margins, exposure to volatile oil prices and disruptions from Egyptian gas supplies. We view uncertainty risk for the gas reform. The FCF story is positive. Gas Natural Fenosa ( GAS ) is experiencing a transition from the focus on deleveraging after the Unión Fenosa acquisition to a medium/long term growth story. Balance sheet is healthy. We see the exposure to the LNG markets as a positive differentiating feature. Conservative 62% payout ratio, but all-in-cash dividend. Downside risks include additional regulatory revisions in Spain, macro environment in Spain and LatAm, FX, and commodity fluctuations (shrinkage of gas spot price differentials and exposure to oil prices). Moreover, there can be some overhang of shares due to Repsol interest in selling its 30% stake in GAS. We initiate coverage with a HOLD recommendation, and a price target of EUR 19,63. Our PT implies an upside of 5% to the current share price of 18,71. The target price is based on a sum-ofthe-parts valuation, and we use a DCF and multiples analysis for the business units. Company description Gas Natural Fenosa is a Spain-based company active in the utility sector. Its operations include Natural Gas Supply (R&D projects, production and transportation); Power Generation under the special and ordinary regimes; Distribution in the electricity and gas sectors; Marketing of gas, electricity and services on the retail market, and other non-core businesses (telecommunication services). After the merger with Unión Fenosa, the company became a leading integrated gas and power utility. Vs Previous Price Target - Price (as of 3-Jan-2014) 18,71 Reuters: GAS.MC, Bloomberg: GAS.SM 52-week range ( ) Market Cap ( m) ,90 Outstanding Shares (m) 1.000,69 Free float 31% Source: Reuters, Bloomberg, Company data Source: Bloomberg IBEX 35 GAS SX6E (EUR millions) E 2014E Revenues EBITDA EBITDA Margin 17,75% 18,42 18,99% % Net Debt Net Debt / EBITDA 3,2x 2,9x 2,7x ROIC 8,07% 8,06% 8,18% EPS 1,66x 1,68x 1,75x DPS 1,03x 1,04x 1,09x EV/EBITDA 7,34x 7,29x 7,14x ICR 2,90x 3,15x 3,33x D/E 126% 116% 105% Source: Company data, Analyst s estimates THIS REPORT WAS PREPARED BY RITA CASTRO HENRIQUES A MASTERS IN FINANCE STUDENT OF THE NOVA SCHOOL OF BUSINESS AND ECONOMICS, EXCLUSIVELY FOR ACADEMIC PURPOSES. THIS REPORT WAS SUPERVISED BY ROSÁRIO ANDRÉ WHO REVIEWED THE VALUATION METHODOLOGY AND THE FINANCIAL MODEL. (SEE DISCLOSURES AND DISCLAIMERS AT END OF DOCUMENT) See more information at Page 1/38

2 Table of Contents INVESTMENT CASE... 3 COMPANY OVERVIEW... 4 BUSINESS DESCRIPTION... 5 SHAREHOLDER STRUCTURE... 7 FINANCIAL POSITION... 8 MACRO ENVIRONMENT...10 COST OF CAPITAL VALUATION METHODOLOGY...14 ELECTRICITY DISTRIBUTION IN SPAIN GAS DISTRIBUTION IN SPAIN ELECTRICITY GENERATION LATAM OPERATIONS GAS OPERATIONS Demand Price differentials FINAL REMARKS...31 APPENDIXES ) MERIT ORDER CURVE ) MARKET BENCHMARKING ) SUM-OF-THE PARTS ) FINANCIAL STATEMENTS ) EV / EBITDA MULTIPLE ANALYSIS FOR ELECTRICITY DISTRIBUTION IN MOLDOVA AND GAS DISTRIBUTION IN ITALY ) FINANCIAL RATIOS DISCLOSURES AND DISCLAIMER...38 PAGE 2/38

3 Figure 1: Price differentials between gas hubs Investment Case Gas Natural Fenosa is a Spanish integrated utility, active in the value chain activities of gas and electricity, and has a vertically integrated organization. GAS is the leader in natural gas sales in Iberia and it is the main gas distributor in LatAm. Moreover, it has a sound position in the LNG market, globally. Our HOLD recommendation rests on three main reasons: Source: Bloomberg; Analyst s estimates Figure 2: Liquefaction output from the Damietta plant (GWh) Source: Company data; Analyst s estimates Figure 3: Gas tariff deficit (EUR millions) Source: Company data Figure 4: Electricity tariff deficit (EUR millions) (1) Exposure to volatile gas supply / LNG trading activities, currently at peak price differentials, in our view. Whereas between 2004 and 2008 the Henry Hub and the NBP diverged, on average by USD 0,3/mmbtu, by the end of 2012 this difference was already at USD 6,6/mmbtu. Even more prominent is the relationship between the Asian spot and the Henry Hub: the average price divergence between 2004 and 2008 was of USD 2,5/mmbtu, while by the end of 2012 this difference ascended to USD 12,7/MMBtu (see Figure 1). These activities are subjected to the risks of a mismatch between the duration of the contracts with suppliers (usually 20 to 25 years and commonly linked to oil spot prices) and the duration of contracts with customers (usually one year, and linked to gas spot prices). The disruptions from the Damietta plant are still negatively impacting Unión Fenosa s operations and resolution talks with the Egyptian government seem to have no outcome. In fact, the liquefaction output from Damietta decreased by 64% between 2011 and (2) On-going regulatory risk, not only in the electricity segment, but also gas. Spanish electrical system has an accumulated deficit of more than EUR 26bn. The still pending details on the regulatory reform deserve caution. Having undertaken electricity reform, the secretary of state for energy has mentioned they will be looking into the gas sector as well. Remuneration is likely to continue to depend on the number of consumers and on volumes, but there is a problem of excess capacity in the face of current demand. (3) We believe the share price is now closure to its fair value, due to recent appreciation. Moreover, there is a risk of stock overhang, as Repsol is looking to sell out its 30% stake in GAS due to reduced strategic importance after the February sale of its liquefied natural gas business. GAS has a sound cash flow generation and a healthy balance sheet, having considerably improved its leverage position since the merger with Unión Fenosa. Stock catalysts include improved power prices, maintenance of the price differentials between gas hubs supported by the sustained closure of the Japanese nuclear plants, and a clarification regarding pending details of regulatory revisions in Spain, currently being discussed. We have a HOLD rating, based on a sum-of-the-parts valuation which yielded a YE14 target price of EUR 19,63, implying a 5% upside to the current share price of EUR 18,71. Source: Company data PAGE 3/38

4 Figure 5: Growth and Profitability Source: Company data, Analyst s estimates Figure 6: Margin Trends Company overview Gas Natural Fenosa is a Spain-based company, active in the utilities sector. Its operations include natural gas supply and transport, power generation, under the special and ordinary regimes, distribution of electricity and gas, marketing and services on the retail market, and other non-core businesses. After the merger with Unión Fenosa in 2009, the company became a leading integrated gas and power utility. The company is listed on Madrid stock exchange, and is part of the primary Spanish stock market index, IBEX 35, with a weight of 2,25% as of December 31, Gas Natural opts for a diversification both in terms of geography and operations. 58% of gas activities are regulated 1, and by the end of 2012, 31% of GAS sales were generated in LatAm and 56% in Spain. In GAS recent strategic presentation (November 5, 2013) it was emphasised the company s more recent strengths: the LNG business and its geographical expansion into LatAm countries. Figure 8: EBITDA Breakdown 24% 24% 18% 19% 25% 25% 19% 19% Source: Company data, Analyst s estimates Figure 7: Sales Breakdown (2012) 13% 11% E Electricity distribution EU Gas distribution EU Latin America Electricity Gas Others Source: Company data, Analyst s estimates Figure 9: EBITDA CAGR per BU 17% 20% 6% 0% 1% 9% 5% 4% 4% 9% Source: Company data Electricity distribution EU Gas distribution EU Latin America Electricity Gas CAGR CAGR Includes gas and electricity distribution and infrastructures (underground storage, transport and regasification). PAGE 4/38

5 Figure 10: Gas generation mix and installed capacity per technology (%) Source: Company data Figure 11: Spain versus GAS installed capacity in 2012 (only plants from the ordinary regime in Spain) Source: Company data; EDP (DPE) Figure 12: GAS' installed capacity by geography Business description Electricity Gas Natural is active in all steps of the electricity value chain from generation, to distribution and supply. Its electricity operations are split into two different business units: Distribution, which includes the regulated electricity distribution business and network services for customers, and other business related to third party access to the distribution network (presence in Spain, LatAm and Italy); and Generation, which includes the electricity production, the supply of electricity to wholesale markets and the wholesale and retail commercialisation of electricity in the de-regulated Spanish market (presence in Spain, LatAm and Kenya). The electricity distribution segment (Spain, LatAm and Moldova) represented 20% of GAS EBITDA by the end of 2012, and 89% of that EBITDA was generated in Spain. Since 2009, revenues in Spain are the result of a return over the regulatory asset base ( RAB ), but the final RAB settings were only defined in 2010 (we estimated 2012 RAB at EUR 5,46bn). Regulated revenues include also recognized amortisation and costs. The current remuneration rate is based on the yield on 10-year Spanish treasury bond plus a 200bp spread (~6,5% pretax) 2. After the sale of the Nicaraguan and Guatemalan units, the electricity distribution operations in LatAm, conducted by GAS are concentrated in Colombia and Panama, and regulatory revisions are expected in both countries in Revenues in these countries are also RAB-based. GAS capacity mix is biased to CCGT power generation, representing 65% of the installed capacity of the ordinary regime in Spain (and 60% if we include the international and special regime operations). Most of GAS generation assets are located in Spain (12,8 GW), yet GAS has a coal power plant in Kenya with 100 MW of installed capacity and slightly more than 2,6 GW of installed capacity in Latin America. GAS operates in both the ordinary and the special regimes however, 90% of the Spanish installed capacity is of the ordinary regime 4. Considering the deleverage policy followed by GAS in this segment, capex plans for the generation business are mostly maintenance, unless Greenfield projects in LatAm. Source: Company data; Analyst s estimates 2 Spain has 4-year regulatory periods (current: ) 3 Colombia has 5-year regulatory periods and Panama 4-year regulatory periods. 4 The special regime includes renewables and co-generation, and the idea behind the implementation of the special regime was to incentivize investments and provide a competitive and profitable environment for special regime plants to compete with those of the ordinary regime. PAGE 5/38

6 Figure 13: Installed Capacity between Competitors (2012) 7% 31% 29% 33% 2% 16% 16% 8% 30% 6% 16% 8% 39% 60% Iberdrola EDP Verbund RWE Enel E-On Gas Natural Total installed capacity: CCGT Renewables Hydro Cogeneration Nuclear Coal Figure 14: Gas Value Chain MW MW MW MW MW 67,732 MW MW NG: Gas compression plant LNG: Source: Companies Reports Gas Gas Natural Fenosa operates in all parts of the gas value chain, having some R&D and exploration activities, and being active in the treatment, storage, transportation, liquefaction, regasification, and distribution channels. Its operations are split in four different business units: (1) Distribution, which includes third party access and secondary transportation, as well as the distribution activities for outside the regulated remuneration in Spain. It also includes operations in Italy and in LatAm. The regulatory methodology for the gas distribution in Spain is not revised since 2002, and revenues are updated by a formula that takes into account the Spanish PPI, CPI, an efficiency factor, the number of connection points and volumes sold. Source: Analyst s research Figure 15: Gas Supply Breakdown (2) Infrastructures 5, which includes the exploration and production of gas and the LNG value chain activities, from the exporting countries to the entry points of final markets, including the regasification process. This unit also includes the Maghreb-Europe pipeline operation, contracted in dollars and thus exposed to euro-dollar exchange rate fluctuations. 3) Supply and Commercialisation, which includes the supply and commercialisation of natural gas to wholesale and retail customers in the deregulated Spanish market, as well as the sales of natural gas to customers outside of Spain. Source: Company data; Analyst s (4) Unión Fenosa, which includes the liquefaction activities in Egypt, sea transport, re-gasification in Sagunto (Spain) and supply and commercialisation of 5 Transport, underground storage and regasification are regulated activities. For the revenues estimation we used the same regulatory model as the transmission one. PAGE 6/38

7 Figure 16: ROIC - Gas Activities gas. Gas Natural together with Eni 6 (Italian Oil & Gas Company) owns 80% of Unión Fenosa (50% GAS and 50% Eni). Where GAS has been able to obtain the largest margins is in the gas supply unit, having increased the company s presence internationally (by engaging into more flexible gas contracts), and taking advantage of hub price differentials. Whether or not this trend is likely to continue is a point of uncertainty: there is little evidence of a short-term price differential reduction between Asian/LatAm, European and American hubs, but it makes little sense to assume the current historically high price differences between world gas markets to continue in the long run 7. This topic is further discussed in the subchapter Price differentials. Source: Company data; Analyst s estimates Figure 17: GAS' shareholder structure Source: company data Shareholder structure Since the capital increase of June 2011 (3,85% shareholding position sold at a price of EUR 13,48 to Sonatrach), Gas Natural Fenosa s equity is made up of shares with a 1 euro face value each. The shares are floated on the four Spanish stock exchanges through the continuous market. The company has around shareholders, with La Caixa and Repsol having the largest stakes (35% and 30%, respectively). Repsol is sounding out banking advisers about a potential sale of (at least) 25% out of its 30% stake in GAS, because of reduced strategic importance after the February sale of its liquefied natural gas business to Royal Dutch Shell. The sale intentions are suspended as long as Repsol is under no financial pressure. The sale will come down to either an attractive price or an appealing investment project. According to the Financial Times, the management is considering freeing cash for further investment in upstream oil exploration, but no specific investment opportunities are in sight yet. Temasek (Singapore s sovereign wealth fund) and Sinopec (Chinese statecontrolled refiner) have both approached Repsol over buying its stake in Gas Natural. Repsol views both firms interest favourably due to their already existing relationships, meaning that both La Caixa and the Spanish government view them as stable potential shareholders (FT). However, according to an unconfirmed article in Cinco Dias, Sinopec stated that it is no longer interested in acquiring Repsol s stake in GAS. This represents an additional risk exposure: if Repsol finds an attractive investment opportunity, the more likely scenario is a 6 ENI consolidates Unión Fenosa using the equity method. GAS will have to do the same as IFRS 11 (to be applied from Jan onwards) requires using the equity method for joint ventures, which are defined as those with joint control, and where the parties have a right to their net assets. We use the old framework in our estimates. 7 By the end of 2012, the Henry Hub was trading at USD 2,7/MMBtu, the NBP at USD 9,3/MMBtu and the Asian spot at USD 15,4/MMBtu. PAGE 7/38

8 sale of Repsol s stake to more than one investor, and a shares placement. The sale of the shares in the market would create an overhang to the stock. Table 1: GAS S&P Credit Rating Date 15/10/12 BBB 06/10/11 BBB 17/12/10 BBB Long term 05/06/09 BBB+ 20/02/09 BBB+ 22/02/08 A 05/02/07 A+ 06/05/03 A+ 10/03/03 A+ 23/07/01 A+ 10/05/00 AA- 16/02/99 AA- Source: Bloomberg Table 2: Spanish-Sovereign S&P Credit Rating Date 10/10/12 BBB- Long term 24/06/12 BBB+ 13/01/12 A 05/12/11 AA- 13/10/11 AA- 28/04/10 AA 19/01/09 AA+ 12/01/09 AAA 13/12/04 AAA 31/03/99 AA+ Source: Bloomberg Repsol chairman said later in November that he is willing to spend as much as 10 billion dollars in acquiring assets in Canada, the U.S. or Northern Europe after selling its stake in Gas Natural. The investment target will have to add value in terms of risk, profitability, technology and portfolio (said the Chairman), emphasising the idea that only at an attractive opportunity will Repsol exit GAS. Moreover, it is of political interest to keep GAS under Spanish hands. Financial Position Gas Natural obtained its first rating in It is currently border-line investment grade, with a BBB+ rating by Fitch and Baa2 by Moody s. S&P s rating evolution since 1999 can be seen in Table 1. On November 28, the S&P improved GAS outlook from negative to stable, on the back of their new rating methodology for entities rated above sovereign. Under S&P s new methodology a company that is considered to have a high country risk exposure can be rated two notches above a sovereign that is rated B or higher. GAS current rating situation concerns a difficult economic environment in Europe and more particularly, in Spain. Although the sovereign ceiling rule 8 no longer applies, there is still a high correlation between corporate s rating and that of its sovereign. The Spanish government is currently rated BBB- by the S&P. Moody s improved Spanish rating outlook on December 4, from negative to stable. In its strategic program of , Gas Natural stated its intentions to sustain an A credit rating (as per S&P) but, not long after the merger with Unión Fenosa, the three rating agencies downgraded Gas Natural, in the face of a worse position in terms of financial ratios. GAS consolidates Unión Fenosa since Table 3: Leverage ratios E ND 9 / EBITDA 1,6x 1,7x 2,0x 5,2x 4,1x 3,6x 3,1x 2,8x ICR 10 3,8x 5,3x 4,3x 2,6x 2,5x 2,7x 2,9x 2,9x D/E 11 67% 79% 108% 191% 170% 153% 148% 132% Source: Company data, Analyst s estimates 8 Defines that no company can have a credit rating that is superior to that of the sovereign rating. 9 Net debt defined under GAS assumptions (= Short-term and Long-term Borrowings minus Cash & Cash Equivalents). 10 Interest Coverage Ratio (= EBIT / Interest). 11 At book values. D is the Interest Bearing Debt only and E is Total equity PAGE 8/38

9 Table 4: Long-term Credit Rating Competitors SP& Moody's Fitch GAS BBB Baa2 BBB+ EDP BB+ Ba1 BBB- Enel BBB Baa2 BBB+ RWE BBB+ Baa1 BBB+ Eon A- A3 A- Iberdrola BBB Baa1 BBB+ Enagas BBB Baa3 A- REE BBB NA A- EDF A+ Aa3 A+ Snam BBB+ Baa1 NA Fortum A- A2 A- Figure 18: Expected Dividend Yield (%) for Different Payout Ratios Immediately after the merger, GAS net debt increased from 5 to 20 billion euros, but by the end of 2012 it was already at EUR 15,6bn. During the strategic presentation, GAS stated that the possibility of having its credit rating improved is now more dependent on the macro environment. Since 2010, the company has gone into a series of divestments, and the net debt to EBITDA ratio is already around the 3x benchmark defined in the strategic plan of The CEO is comfortable with the current ratio, and accepts a potential decrease to levels of 2,5x. The company is now experiencing a transition from the emphasis on the debt reduction after the Unión Fenosa acquisition, and towards growth under a stable leverage position, both in terms of how it compares to its peers, and in terms of the guidelines defined by the management. GAS Net Debt-to-EBITDA for 2012 is below that of its main peers, and particularly of the Iberian peers EDP (5,2x) and Iberdrola (3,4x). However, its long-term rating still concerns us as it is below most of its peers (Table 4). Figure 20: Net Debt-to-EBITDA Ratio (x)- Competitors Source: Company data; Analyst s estimates - EDP SNAM REE ENAGAS IBE ENEL FORTUM GAS EDF ND/EBITDA 08 ND/EBITDA 12 Figure 19: GAS debt by currency (2012) Source: Bloomberg GAS solvency position has improved from a debt-to-equity ratio (at book values) of 191% in 2009 to 148% in 2012, and this trend is expected to continue. By the end of 2012, GAS interest coverage ratio was of 2,9x. During the strategic presentation, GAS emphasised its main financial goals: i) commitment to cash dividend, ii) flexibility to increase investments when in the presence of growth opportunities (accumulated excess cash of EUR 2,9bn by the end of 2012) and iii) strategic guidelines aligned with financial discipline. GAS Source: Company data argues that it executed a deleveraging plan ahead of its peers, but this is just a reflection of the Unión Fenosa acquisition. GAS target payout ratio of 62% is conservative considering its cash flow generation and we believe GAS has a sufficiently healthy balance sheet to increase this ratio. For our estimates we assume a 62% payout ratio in line with GAS guidelines until 2017, and from then 12 With respect to Bloomberg s assumptions for the calculation of net debt PAGE 9/38

10 onwards we assume a 70% payout. Figure 18 shows expected dividend yields for different payout ratios. GAS wants to maintain a certain level of cash to face the potentiality of new investments and to maintain a conservative leverage position. GAS finances its operations with local currency, so as to be exposed to business risk only. The debt by currency as of 31 December, 2012 can be seen in Figure 19. Figure 21: GAS share price vs target price Source: Bloomberg Figure 22: Yield on Spanish and German Treasury Bonds (10-year) Source: Bloomberg Macro Environment Since the beginning of the year, the consensus target price and the share price have been evolving hand-in-hand. This is mostly a result of better macro variables, and more transparency with respect to the gas supply activities, which resulted in a better market perception. Potential upsides are now priced-in. We identified two main macro risks for the Spanish operations: country risk and the future of the euro zone. With respect to the country risk, the market has come to perceive a smaller risk associated with Spain, as the country is technically out of the recession thanks to the GDP growth experienced in the last two quarters. This goes in line with Moody s improved outlook to the sovereign from negative to stable as of December 4, By looking at Figure 22, we clearly see the divergence between yields on the Spanish 10-year sovereign bonds and the German 10-year sovereign bonds, created immediately after the crisis hit. One should only include a penalization for country risk into the discount factor if it is able to estimate the part of that risk that is systematic. We estimated the country beta 13 to analyse whether Spain has an increased volatility to the market and reached a value of less than 1, This regression has an implied 73% R- square, suggesting that about 30% of the country risk is diversifiable. Also common is to estimate the country risk based on default-spreads. Damodaran suggests two ways to estimate the default spread: (1) difference between a long-term local bond s yield and a US government bond yield of the same maturity (2,05% for Spain); or (2) the difference between the CDS spread for the local economy minus the US CDS spread (3,14% for Spain) 15. We do not incorporate any default spread in our cost of capital estimation as this difference 13 Regression between IBEX 35 and MSCI Europe. Despite liquidity concerns regarding the IBEX 35 and lack of uncertain regarding this index as a good proxy for the Spanish economy, we still found deem this analysis. 14 Regression parameters: Standard deviation=0,02; standard error=0,01 15 According to Damodaran analysis, the way the default spread is incorporated in the discount rate depends on our assumptions regarding the country risk premium: if we believe all companies are equally exposed to country risk we just add the spread to the total cost of equity calculated based on the CAPM; if we believe the company has a similar exposure to country risk as to market risk we add it to the equity risk premium; and if we want to treat country risk as a separate risk factor we add a new factor to the CAPM. PAGE 10/38

11 would only be a reasonable estimate for country risk premium if GAS cash flows moved closely in line with the payments on government bonds 16. The effects of the sovereign debt crisis are still felt in the European macroeconomic scenario. Although the uncertainty of the future of the monetary union prevails, it is on a much smaller scale and we did not find proof to support the development of such a scenario. Figure 23: Net debt as a % of GDP (Spain) Figure 24: Real GDP growth (Spain) 100% 3% 80% 60% 40% 20% 0% 43% 50% 57% 67% 0% -3% -5% -0,1% 0,7% -1,8% -3,7% E 2014E 2015E 2016E 2017E E 2014E 2015E 2016E 2017E Figure 25: Inflation (Spain) Figure 26: Electricity demand in Spain 4% 3% 2% 1% 0% 0,0% 2,9% 2,4% 1,7% E 2014E 2015E 2016E 2017E E 2014E TWh 2015E 2016E 2017E Source: Company data, IMF, Analyst s estimates Moving on to Latin America, GAS already has a strong presence in Mexico, Colombia and Brazil, and is looking to strengthen its position and to broaden its presence into other LatAm countries. Brazil and Mexico are seen as the countries with more potential market growth. Until the 90s, LatAm countries lacked transport and distribution infrastructures, had unsound industrial development and were strongly affected by the recession of the 80s, factors that had a strong impact on energy demand and that explain the low level of natural gas use in the past. Since the early 1990s, renewed economic growth, market liberalization and environmental concerns led to an increase in energy demand in LatAm countries 17. While Latin America is self-sufficient in natural gas production, the investment in infrastructures was essential to support this increase in demand. The local governments promoted regulatory changes to move from a 16 From the McKinsey Valuation book. 17 GAS started its expansion into Latin America in 1992, first in Argentina, and then in Brazil, Colombia and Mexico. PAGE 11/38

12 monopolistic model to a competitive one. Although these economies are growing, there are macro risks one should be aware of when valuing local operations. FX movements are a key concern. Even though GAS finances all its operations with local currency, it is still exposed to business risk. In fact, during the strategic update, GAS CEO admitted a potential decrease in returns from Brazil due to FX effects. We conducted a similar analysis to that of Spain. Colombia has a 2% default spread, Mexico 1,5%, and Brazil 1,75%. We estimated the slope between the MSCI LatAm and MSCI World, which yielded a country beta of 1,33 18, with a 73% implied R-square, suggesting that only 27% of the LatAm risk is diversifiable 19. Reasons for this increased volatility include the dependence of the economies on commodities exports (mostly minerals and agricultural products). According to the World Bank report 20 there has been a shift in exports, from advanced to emerging economies whose demand has increased (mostly from Asian markets). Nevertheless, it seems like emerging economies have been cooling down: Mexico is moving away from the extraordinary 7% growth rate (in 2000) to the historical 30-year average of 2,5%, and the same goes for Brazil (historical average of 2,6% versus 2012 GDP growth rate of 3%), and in a smaller scale for Colombia (historical average of 3,5% versus 2012 GDP growth of 4,7%). Yet, these rates are still significantly superior to the ones experienced in Europe (more particularly, in Spain, with an expected GDP growth rate for 2013 of 0,1% 21 ). LatAm companies have often small gearings, a signal of country risk and higher probability of default. Figure 27: Mexico Figure 28: Brazil Real GDP growth 10% 5% 0% -5% -10% E 2014E Real GDP growth 2015E 2016E 2017E Inflation 5% 4% 3% 2% 1% 0% Inflation Real GDP growth 8% 6% 4% 2% 0% -2% E 2014E Real GDP growth 2015E 2016E 2017E Inflation 8% 6% 4% 2% 0% Inflation 18 Regression parameters: Standard deviation=0,07; standard error=0,04 19 Since we could not separate the estimation for LatAm operations between countries we simplified the country risk premium analysis to a LatAm-risk only. Nevertheless we find this simplification reasonable because the additional systematic risk for the LatAm economies is likely to be similar, as economies are alike and dependent on natural resources. 20 World Bank report: Natural Resources in Latin America and the Caribbean: Beyond Booms and Busts?. This report explains that the applicability of a commodities curse may no longer hold to emerging economies as these are moving from exporters to importers. Nevertheless, we still believe the commodities risk deserves caution. 21 IMF estimates PAGE 12/38

13 Figure 29: Colombia Figure 30: FX Accumulated % changes Real GDP growth 8% 6% 4% 2% 0% E 2014E Real GDP growth 2015E 2016E 2017E Inflation 4% 3% 2% 1% 0% Inflation 40% 30% 20% 10% 0% -10% -20% -30% EURBRL Curncy EURMXN Curncy EURCOP Curncy Source: Bloomberg, IMF Cost of Capital The estimation of the discount rate is a critical issue, as its impact on the company s value is remarkable. The discount rate must be consistent with the nature of the cash flows: same currency (euros), in nominal terms and, because we are estimating cash flows to the firm, the appropriate discount rate is the cost of capital. To accurately assess GAS operations we estimated a long-term cost of capital for each business unit, taking into consideration comparable companies. We calculated the cost of equity based on the capital asset pricing model (CAPM), applying a market risk premium of 6% 22 and a risk-free rate of 2,06% 23, based on the average yield on a 10-year US treasury-bond, converted to euros. We assume that the marginal investor is well-diversified, and the only risk that should be incorporated in the discount rate is the non-diversifiable risk, including the country beta whose estimation was previously described. As for the comparable firms, we included companies that operate in the business sector under question and/or geographical location. The computations and results are summarised in Table 5. The idea was to find company betas that are appropriate benchmarks for GAS. To re-lever the asset betas of the comparable firms we assumed a target gearing that was equal to the average of the comparable firms. In the lack of a good estimate of optimal gearing, we assumed that all companies aim at efficiency, and thus, companies aim at an optimal capital structure. The cost of debt is the result of a weighted average between the recovery rate and 1+yield, weighted by the probability of default. We found suitable the use of a probability of default and recovery rate that were consistent with the utilities 22 Implied market risk premium on January 1, 2012 according to Damodaran. 23 As of December PAGE 13/38

14 Table 5: Weighted Average Cost of Capital (in EUR) sector: 1,5% 24 and 90% 25, respectively. For the yield, we looked at GAS traded bonds and used one that matched the currency of the cash flows (euros), with the longer maturity (9 years duration) and sufficiently liquid (issue amount of EUR 750 millions). With the yield of 5,19% we reached a cost of debt of 4,97%. If we had rather applied a probability of default that was consistent with GAS credit rating (4,9%), we would reach a cost of debt of 4,4%, more in line with the cost of debt calculated based on Damodaran s method. Damodaran suggests adding a spread to the risk free rate that is consistent with the company s leverage position, based on the interest coverage ratio. GAS ICR relates to a synthetic rating of BBB and the result is a cost of debt of 4,05%. Networks in Europe Networks in LatAm Power Europe Power LatAm Gas Operations Industry/target D/E 100% 100% 96% 96% 100% 126% Relevered Beta 0,89 0,89 0,93 0,93 1,32 1,03 Risk-free Rate 2% 2% 2% 2% 2% 2% Market Risk Premium 6% 6% 6% 6% 6% 6% Cost of Equity 7,8% 9,1% 8,1% 9,4% 10,6% 8,7% Cost of Eebt 5,0% 5,0% 5,0% 5,0% 5,0% 5,0% D/V 50% 50% 49% 50% 48% 56% E/V 50% 50% 51% 50% 52% 44% WACC 5,6% 6,3% 5,8% 6,5% 7,2% 5,8% Source: Bloomberg; Analyst s estimates GAS Valuation Methodology We valued GAS based on a sum-of-the parts approach, and the analysis was divided into the following units: (1) Electricity distribution in Spain; (2) Gas distribution in Spain; (3) Electricity generation in Spain and Kenya; (4) LatAm operations, which includes gas distribution, electricity distribution and generation; (5) Gas operations, which includes infrastructures, supply & commercialisation and Unión Fenosa Gas. For (1) to (5) we used a DCF model so as to properly take into account each unit s value drivers. The explicit period of analysis was set until 2022, and for the 24 From Moody s investor service 25 Moody's Ultimate Recovery Database PAGE 14/38

15 terminal value we used a perpetual growth formula. All cash flows are expressed in euros 26. We reached a price target of EUR 19,63, which implies a potential 5% upside to the current share price of 18,71. Besides these units, we valued the gas distribution operations in Italy (2% of EBITDA) and the electricity distribution operations in Moldova (1% of EBITDA) using the Enterprise Value to EBITDA multiple approach 27. Figure 31: Sum-of-the-parts (EUR/share) ,6 9 Gas Dist. Europe Electricity Dist. Europe Power Spain & Kenya LatAm Gas Others and Adj. EV Net Debt Provisions Minorities Tariff Def. PT Source: Company data; Analyst s estimates Electricity Distribution in Spain The Spanish electricity sector is one in which regulated and de-regulated activities coexist. The main features of the regulatory reform of the industry were the creation of a wholesale electricity market, vertical unbundling of the networks and a gradual liberalisation of the market. The Iberian framework went further than the European Directives by introducing regulated third-party access to the network and vertical unbundling not only of electricity but also of gas networks. GAS electricity distribution operations in Spain include the regulated network and distribution services, as well as third-party access to GAS networks. By the end of 2012 this unit represented 12% of EBITDA. It is the regulatory authorities role to foment the functioning of the market, allowing for both an economic and financial sustainability of the sector by which all market participants should obey. Nonetheless, in the last decade, the Spanish electrical system has been generating a tariff deficit: between 2004 and 2012 the revenues from the tolls paid by consumers increased by 122%, while the regulated costs increased by 197%. The costs that contributed the most for this discrepancy were the ones from the special regime (+6x) and the annuities from 26 No sufficient data to analyze units in local currencies. 27 Multiples results summarized in Appendix 6). 28 Deductions to the Enterprise Value are at 2014E Book Values. PAGE 15/38

16 Figure 32: Spanish Electric Deficit / Superavit (EUR million) Source: CNE (liquidación 14) Figure 33: Tariff REvenue vs System Costs Source: CNE the accumulated deficits (+9x). According to the CNE 29, by May 10, 2013 there was an accumulated debt of ,51 million euros (excluding securitization). The Spanish tariff deficit is mostly the result of: i) energy prices above the tariff s assumptions, ii) insufficient increase of tariff to cover costs, iii) special regime over-costs, iv) lower demand than the tariff s assumptions and v) non-mainland costs 30. The CNMC 31 emits on a regular basis a document on the provisional liquidation of the electric sector. The liquidation of August 2013 reported an accumulated deficit of 4.519,5 million euros between January and August To correct the mismatches produced by the expansive evolution of the electric costs, there have been several measures adopted in the last few years that affect both the cost and the revenue side. The latest Decree-Law, RDL 9/2013, articulates on an urgent basis, a series of measures designed to ensure the financial stability of the electrical system, the budget economic sustainability and the security of supply. The current electricity distribution remuneration is thus defined as the sum of the return on investment, plus the reward for operation, maintenance and other costs associated with the assets in service ( ROM&OCD ) and plus a variable for incentives/penalties related to service quality. With regards to the return on investment, this includes the linear depreciation and amortisation of assets and the financial remuneration, which is, the result of the regulated asset base times the allowed rate of return. The current remuneration rate (defined by RDL 9/2013) is dependent on the yield of a 10-year Spanish treasury bond plus a 200bp spread, from 2014 onwards, which yields a 6,5% remuneration rate, almost 1% lower than the previous allowed return. ROM&OCD is calculated based on previous year ROM&OCD and adjusted by the Spanish PPI, CPI and an efficiency factor ( 0,97). Prior to RDL 9/2013, the indexation to inflation was applicable not only to ROM&OCD but also to the depreciation and financial remuneration items. Moreover, the efficiency factor is a new parameter. GAS has no control over the regulatory impact, and it is seeking to reassess operating expenses and investments so as to be able to sustain decent cash flow generation. We expect capex spending of around 200 million per year. The main value drivers of this unit include opex/capex efficiencies, evolution of demand in the face of economic recovery in Spain, and regulatory items. For the estimation of the remuneration rate, it was particularly interesting its comparison to our estimation for this unit s weighted average cost of capital (~5,6%) 32. The 29 Comisión Nacional de Energía 30 In the islands fuel-oil is the used technology, which is more expensive. 31 Comisión Nacional de los Mercados e la Competencia 32 The WACC estimation was further developed in the sub-title Cost of Capital. PAGE 16/38

17 regulator sets a remuneration rate that shall not exceed the minimum necessary to cover costs, and to be competitive in the market, while enabling a reasonable profitability. The remuneration rate is consistent with a low-risk economic activity, since the network activities are not directly linked to market risk arising from production. This leads us to conclude that, for the long-run, it makes sense to have the remuneration rate (after taxes) in line with the weighted average cost of capital, and the enterprise value of the electricity distribution close to the value of the regulated asset base. We estimated a EUR 5,3 value per share for the Spanish electricity distribution business, while the estimate RAB for 2022 is EUR 5,77bn. Figure 34: RRAB, ROIC and WACC Comparison 8,0% 7,0% 6,0% 5,0% 4,0% RRAB WACC 2013E 2014E 2015E 2016E 2017E 2018E 2019E 2020E RRAB after taxes ROIC Source: Company data; Analyst s estimates Table 6: FCF Electricity Distribution in Spain (EUR m unless stated otherwise) E 2014E 2015E 2016E 2017E Regulated Asset Base Return on RAB (%) 7,43% 7,43% 6,48% 6,42% 6,42% 6,42% 7,42% D&A ROM&OCD Penalties/Incentives 53 (21) Revenues EBIT Adj. Taxes (138) (116) (122) (103) (104) (105) (122) NOPLAT D&A Operating CF Net Capex (173) (210) (171) (220) (225) (236) (236) NWC (5) 4 (0) 6 0 (0) (6) in other op. A&L 10 (2) (9) 5 1 (1) (1) Investing CF (167) (208) (181) (208) (224) (237) (243) Electricity Distribution Spain FCF Source: Company data; Analyst s estimates We anticipated a long-run growth rate for this unit of 0,5% due to the mature nature of the business. This implies a Reinvestment Rate of 7,5%, given our PAGE 17/38

18 Table 7: Sensitivity Analysis to the WACC (Vertical Axis) and Growth Rate (Horizontal Axis) for the Electricity Distribution unit in Spain 0,0% 0,5% 1,0% 1,5% 2,0% 4,0% 7,0 7,8 8,8 10,2 12,3 4,5% 6,2 6,8 7,5 8,5 9,9 5,0% 5,6 6,1 6,6 7,3 8,3 5,5% 5,1 5,5 5,9 6,4 7,1 5,6% 5,0 5,3 5,7 6,2 6,8 6,0% 4,7 5,0 5,3 5,7 6,2 6,5% 4,4 4,6 4,9 5,2 5,6 Source: Analyst s estimates Figure 35: Fixed Assets per Connection Point Source: Company data; Analyst s estimates Figure 36: Gas Consumption in Spain (bcm) Source: Eurostat projected ROIC for 2022 of 6,7% 33. A 1% growth rate would imply a 15% Reinvestment Rate. The problem of the electricity tariff deficit has, however, not been resolved. On the beginning of December, the Senate acknowledged there will be a tariff deficit again for This increases uncertainty about the final outcome to utilities from the energy reform. The government will no longer disburse a EUR 2,2bn credit line to fund the deficit, nor pay for 50% of the non-mainland costs. The 2013 deficit will be 14% funded by GAS, according to FADE (Fondo de Titulización del Déficit del Sistema Eléctrico) 34. The Ministry of Finance has agreed to work with the Ministry of Economy, the Ministry of Industry and with the electricity sector, in order to define possible mechanisms for the securitization of the electricity tariff deficit by the utilities or by FADE. Nevertheless, these are clear negative news for the sector. Gas Distribution in Spain The gas distribution operations in Spain include the third-party access to GAS distribution networks and regulated distribution activities. By the end of 2012 it represented 18% of total EBITDA. The remuneration of the gas distribution unit is regulated and it is the result of prior year revenues inflated by a formula that incorporates the Spanish PPI and CPI, an efficiency factor, connection points growth, and volume growth. This remuneration scheme is not updated since 2002, year in which GAS annualised revenue was set at 809 million euros. Value drivers include change in connection points and in volume, gas penetration level (currently at 27% in Spain, according to GAS) and opex/capex efficiencies. Adding connection points for low levels of capital expenditure can add value. Being dependent on volumes, the evolution of gas consumption in Spain is also relevant. From 1985 up to the year of the beginning of the financial crisis (2008/09), the consumption of natural gas in Spain grew strongly, with a compounded annual growth rate of 11% between 2002 and This was motivated by an increased use of gas in industrial processes and the introduction of CCGT power plants in the face of improved performance and reduced CO 2 emissions. However, a noticeable drop in the consumption levels was felt immediately after the crisis hit, with a drop from 37,2 to 33,2 bcm between 2008 and This negative trend endured until 2012 (30 bcm). We expect a 33 If we include goodwill for the ROIC estimation, then ROIC would be equal to 5,4% by the end of 2022, implying a Reinvestment Rate of 9,3%. 34 FADE is a finance vehicle designed to finance the regulatory receivables through capital markets. For further reading on this issue: Informe 10/2011 de la cne sobre la propuesta de modificación del real decreto 437/2010, de 9 de abril, por el que se desarrolla la regulación del proceso de titulización del déficit del sistema eléctrico. PAGE 18/38

19 recovery of demand to be felt in the near future fomented by improved economic outlook, but not yet to the levels of Table 8: FCF Gas Distribution in Spain (EUR million) E 2014E 2015E 2016E 2017E EBIT Adjusted taxes (184) (183) (202) (201) (200) (201) (202) NOPLAT D&A Operating CF Net Capex (99) (221) (303) (364) (374) (366) (366) NWC 12 (8) (10) (2) (2) (2) (2) in other op. A&L 1 1 (2) Investing CF (86) (229) (315) (364) (374) (367) (367) Gas Distribution Spain FCF Source: Company data, analyst estimates We estimate this unit s value per share to be equal to EUR 8,6. The gas sector presents also a tariff deficit. Although not comparable in size to that of the electricity sector (accumulated 300 million euros vs 26 billion euros), we trust that it should not be disregarded. Having undertaken electricity reform, the Secretary of State for Energy has Figure 37: Gas Prices for Industrial Consumers (EUR/KWh) mentioned that in 2014 they might look into the gas sector as well. The Secretary of State supports that remuneration should continue to depend on the number of consumers and on gas volumes, however there is excess capacity of gas facilities in the face of current demand. The gas sector is different to the electricity sector in the following points: the penetration level is still low (7,5 million customers for a 47 million Spanish population, while there are 27,7 million electricity customers), and each new connection point is likely to have a positive impact on the tariff deficit and thus Source: Eurostat Figure 38: Gas Prices for Domestic Consumers (EUR/KWh) investments are encouraged. For this reason, we assume a capex plan for the gas distribution unit in Spain of around 300 million euros per year, in line with GAS guidelines. On top of volume and tariff deficit risks, there are three factors unfavourable ahead of a potential change in regulation: (1) The system is not revised since 2002, which increases the probability of revenue cuts, even if there was no tariff deficit; (2) The electricity reform was harsher than anticipated; and (3) Natural gas prices in Spain have been climbing up to European averages. Given that the quantifying impact of a new regulation has not been designed yet, Source: Eurostat we were cautious in its applicability to our current estimates. Having said this, we PAGE 19/38

20 Table 9: Sensitivity Analysis to the WACC (Vertical Axis) and Growth Rate (Horizontal Axis) for the Gas Distribution unit in Spain 0,0% 0,5% 1,0% 1,5% 2,0% 4,0% 11,3 12,5 14,2 16,4 19,8 4,5% 10,1 11,0 12,2 13,7 15,9 5,0% 9,1 9,8 10,7 11,8 13,3 5,5% 8,3 8,8 9,5 10,4 11,5 5,6% 8,1 8,6 9,2 10,0 11,0 6,0% 7,6 8,0 8,6 9,2 10,1 6,5% 7,0 7,4 7,8 8,3 9,0 Source: Analyst s estimates Figure 39: Prices per Technology (EUR/MWh) analysed a few hypothesis to try to understand the impact of a potential regulatory change. A common (and the easiest) approach is to cut revenues by the tariff deficit amount and distribute it in a proportional manner among the participating agents (GAS has a market share of about 60% in terms of supply). We believe this approach is unlikely, as it would not resolve the fact that the remuneration scheme is obsolete and it could produce distortions in the companies profitability as it would demand the same cuts to assets with different durations. Moreover, we do not expect a change of the gas distribution operations to the electricity distribution regulation formats, as the secretary of state has announced that such a remuneration scheme (that is, RAB-based) will not be applied to the gas sector. He stated that the gas tariff deficit, although it appears to be structural 35, is smaller than the electricity one, and the gas market is still immature. Nevertheless, we computed such an hypothesis and got a EUR 7,5 value per share (-13%) 36. We anticipated a long-run growth rate for this unit of 0,5% due to the mature nature of the business. This implies a Reinvestment Rate of 4%, given our projected ROIC for 2022 of 13,9%. A 1% growth rate would imply a 7% Reinvestment Rate. Source: EDP (Assumes working hours for CCGT power plants and for coal) Figure 40: Variable versus Fixed Costs per Technology Source: EDP Electricity Generation The electricity generation business in Spain includes the electricity production, and the supply & commercialisation of energy. We also incorporated the operation of the 100 MW coal power plant in Kenya. By the end of 2012 these two operations represented 18% of EBITDA. Technologies differ in terms of primary source of energy, flexibility (to meet demand at peak versus base-load hours), and cost structure. There are three methods for contracting for the electricity price: wholesale, bilateral contracts and auctions. The wholesale market has different moments: a day-ahead market, several intraday markets and the ancillary service market. The day-ahead market works in the following manner: generators offer the minimum price they are willing to receive to generate a certain amount of electricity (marginal cost 37 ) and offers are organized in ascending order, meaning that when demand is high technologies 35 Will not be solved unless tariffs are raised or system costs cut. 36 For this analysis we made simplifying assumptions and applied the exact same methodology as with the current electricity distribution remuneration scheme. We do not incorporate the results in our estimates. 37 The marginal cost of a thermal facility is given by / &!. PAGE 20/38

21 with higher marginal costs will be put into operation and vice versa. The convergence between this offer curve (merit order curve) and demand sets the regulated price at which energy is sold to retailers (more detailed explanation in Appendix 1)). The retailers are able to sell to end-users at unregulated tariffs. For the forecast of this unit s revenues we divided the business into two parts, the generation tariff part, which is dependent on the pool price, and the access tariff to cover the generation costs, which includes regulatory items such as capacity payments. Having said this, we identified for the generation business the following value drivers: i) electricity demand in the face of economic recovery; ii) load factors, spark spreads and pool prices; and iii) regulatory items such as capacity payments. We estimated a value per share of EUR 4,3 for this unit (including the operation of the coal power plant in Kenya). Table 10: FCF Electricity Generation in Kenya and Spain (EUR million) E 2014E 2015E 2016E 2017E EBIT Adjusted taxes (64) (84) (80) (111) (125) (156) (154) NOPLAT D&A Operating CF Net Capex (242) (140) (317) (451) (450) (487) (487) NWC 96 (109) (50) 69 (0) (23) (5) in other op. A&L 10 5 (8) 1 2 (0) (1) Investing CF (136) (244) (375) (382) (448) (509) (493) Electricity Generation Spain FCF Source: Company data, analyst s estimates Figure 41: Exports minus Imports to Spain (GWh) i) Demand: In terms of electricity demand one should not only look at Spain, but also at its trading partners: Portugal, France, Andorra and Morocco. It can be seen in Figure 41 that Portugal is the main importer, while France is the main exporter, relative to Spain. However, Spanish demand is clearly the most important factor, as Spain has one of the lowest levels of interconnection in the EU and efforts to improve cross-border capacity between Portugal and France are of the utmost importance to improve market competitiveness. Nominal shortrun marginal costs, nevertheless, are levelled for the three countries. Red Eléctrica de Espana identifies three explanatory variables for energy consumption: labour, temperature and state of economy. Demand and GDP growth have in fact a close relationship. During the financial crisis, electricity Source: REE consumption decreased significantly, in line with GDP, and the end-user forcedly PAGE 21/38

22 Figure 42: Electricity Demand in Spain and Relation with GDP Source: IMF; REE; Analyst s estimates Figure 43: CCGT Load Factors in Iberia became more energy efficient, something that we expect to be sustained even after the economic recovery. This means that energy consumption growth will follow economic growth with a lag, and a slight decouple between GDP growth and consumption growth is expected (Figure 42). Although all consumers were given the option to switch between power utilities in the EU, it has been mainly the medium-to-large size industrial consumers that took advantage of this opportunity to improve margins 38. Gross inland consumption of energy to GDP (energy intensity) is lower in Spain than in other European Countries. If electricity demand was to be flat at 2012 levels, this unit s value per share would decrease to EUR 3,7 ( -14%). ii) Load factors 39, spark spreads and pool prices: GAS has a capacity mix biased to CCGT power generation and this technology has recently experienced a decrease of average load factors in Iberia. The decrease in CCGT load factors is explained by recent high hydro levels and the development of renewables, which have dispatch priority. Moreover, the creation of the CO 2 40 market did not have the expected effect. Source: REE Figure 44: CO 2, Coal and Gas Prices Source: Bloomberg The spark spread is the gross margin of a gas-fired power plant, calculated using natural gas costs and on-peak power prices. It contrasts with the dark spread, a metric that is used to estimate returns over fuel costs of coal-fired electric generators. IHS CERA expects the recent negative trend in spark spread to continue, at least until 2017, re-enforcing the idea of low CCGT output in the future and increase of renewables supply in detriment of other technologies. This tendency for poor margins in gas-fired power plants is expected to be present in most European countries. The spread analysis is consistent with GAS strategy of reduced investment for the generation segment considering its high installed capacity in CCGTs (capex plans are 100% maintenance, while in the past 25% was allocated to growth). CCGT power plants emit less CO 2 than coal plants, but national coal is subsidized 41, and the position in the merit order curve varies between these two technologies, depending on the fuel and carbon prices magnitude. We do not 38 Unfortunately, we were not able to find data on energy demand for industrial versus domestic consumers, but we would expect that the demand from industrials is more elastic to changes in GDP. Competitive retail prices is crucial as industrials, unlike domestics, may be willing to take their operations abroad so as to improve cost efficiency. 39 Load factor is the ratio of energy demand (electricity generated) to the maximum energy it could have been produced at full capacity. 40 CCGT power plants emit less CO 2 than Coal power plants. According to the Kyoto protocol, each participant country was assigned with a respective ceiling for CO 2 emissions, which were then converted through the national plans for emission allocation in European Allowance Units (EAU). The licenses could be traded under three market mechanisms: the European Union Emission Trading Scheme; the Clean Development Mechanism; and the Joint Implementation. In practical terms, what the Kyoto protocol created was a new market: the market for carbon, in which market participants could trade according to their emission needs. Thus, the CO 2 price is now part of the value chain. 41 The subsidies for domestic coal production have been extended until the end of PAGE 22/38

23 Figure 45 CO 2 Price since 2008 Source: Bloomberg Figure 46: Clean Spark Spread, Clean Dark Spread and Pool Prices in Spain Source: IHS Cera; Analyst s estimates Table 11: Sensitivity Analysis to the WACC (Vertical Axis) and Growth Rate (Horizontal Axis) for the Electricity Generation unit in Spain 4 0,0% 0,5% 1,0% 1,5% 2,0% 4,5% 5,0 5,3 5,8 6,4 7,3 5,0% 4,6 4,8 5,2 5,7 6,3 5,5% 4,2 4,5 4,7 5,1 5,5 5,8% 4,1 4,3 4,5 4,8 5,1 6,0% 4,0 4,1 4,3 4,6 4,9 6,5% 3,7 3,9 4,0 4,2 4,5 7,0% 3,5 3,6 3,8 3,9 4,1 Source: Analyst s estimates expect CCGT load factors to recuperate, in line with the negative IHS CERA estimates for the clean spark spreads. CO 2 prices are dependent on political decisions and thus its estimation is unpredictable (we expect they will stay flat YoY, however, as backloading discussions progress a further rationalization of allowances is a possibility). Our expectations for the pool prices were the following - for 2013 we assumed the 2013 year-to-date pool price, and for we relied on the OMIP forward prices. For 2017 we relied on IHS Cera s estimates, and from then onwards we assume a stabilization of prices and a slight convergence of pool prices between France, Portugal and Spain. Although there were efforts to improve the level of liberalisation on the EU energy market, there are still significant differences in retail prices (by then end of 2012, Cyprus had the highest retail prices for domestic consumers, at 0,241 EUR/KWh and Macedonia the lowest at 0,037 EUR/KWh) and thus, it does only make sense to assume a price convergence between countries with electricity interconnections. iii) Regulatory items: The capacity payments include two types of services: an incentive to invest in long-term capacity (needed to ensure coverage of the demand in the long-term) and service availability in the medium-term. Prior to RDL 9/2013 capacity payments on investments were set at EUR 23,4k per MW installed per year for the first 10 years of operation. However, in the current context of low demand and reduced risk of capacity deficit, RDL 9/2013 considers the urgent reduction of the payment to EUR 10k/MW/year, but for twice as long as the time remaining until reaching the 10 years of operation. This change in remuneration has an impact of EUR 1 per share on this unit s value, assuming that for the long-run we are maintaining RDL9/2013 s remuneration format. Prior to RDL 9/2013 the capacity payments for the availability-of-service was set at EUR 4,7k/MW/year for the conventional plants and EUR 1,2k/MW/year for hydro plants. The recent decree law defined that the payment is now based on the opportunity cost of the most efficient technology (CCGT) and forecasts for capacity backups, while hydro plants will no longer receive payments. We also expect the availability-of-service capacity payments to remain stable throughout the period of analysis. The generation unit in Spain and Kenya has a value per share of EUR 4,3. During the strategic presentation, GAS admitted a long-run pool price (from 2017 onwards) of EUR 61. We do not found grounds to support such an increase in prices but, if we incorporate this 61 EUR/MWh into our model, the result would be an increase in the unit s value to EUR 7,2 per share, highlighting this unit s large PAGE 23/38

24 Figure 47: Electricity Activity Sales for the Electricity Distribution Unit in LatAm (GWh) Source: Company data (including estimations provided in the strategic presentation of November); Analyst s estimates (note that the drops in 2011 and 2013 are explained by the Nicaraguan and Guatemalan sales) Figure 48: Gasification Levels ('000) Source: Company strategic update of November 2013 Figure 49: Colombian GDP/Energy Demand Growth Source: Company data; Analyst s estimates, IMF exposure to pool prices. Capex plans for this business unit are only maintenance, and there are no announced projects for new generation plants. There will be a nuclear closure in 2020 (Almaraz 1) and two coal closures in 2015 (Narcea 1 and 2), and we assume no investment will be made to compensate these closures. LatAm Operations Since the early 90s GAS started its operations in Latin America, and by the end of 2012 LatAm results already accounted for 25% of EBITDA. LatAm operations include electricity distribution in Panama and Colombia, gas distribution in Mexico, Brazil, Colombia, Argentina and Peru, and electricity generation in Mexico, Puerto Rico, Dominican Republic, Panama and Costa Rica. The electricity distribution in LatAm accounts for 7% of EBITDA. This business relates to the regulated electricity distribution and sales to customers at regulated prices. The Guatemalan and Nicaraguan operations were sold on December 2011 and February 2013, respectively, but operations in Panama and Colombia were maintained. In fact, on August 2013, ASEP 42 adjudicated GAS to continue its operations of its two distribution companies, Edemet and Edechi 43 for the next 15 years. Panama represented 27% of 2012 s EBITDA for this unit. Panama s regulatory periods are 4 years-long and remunerations will be reviewed in 2014, although no expectations of a tariff drop are in place. The regulatory model is capital-based and relies on the book value of assets. The remuneration is the sum of the allowed return (equal to RAB times the return on RAB) plus estimated costs for an efficient and well-managed company model, plus recognized depreciation 44. ASEP defines a return on RAB at 10,44%, which is the yield on a 10-year US treasury bond plus an 800bp spread 45. The Colombian remuneration scheme is also capital-based, using replacement value, and costs are estimated on an average between real costs and previous year s recognized costs 46. The regulatory periods are 5-years long, and next revision will be set in 2014 by the regulatory authority - CREG 47. GAS owns more than 85% of the distribution company Electrificadora del Caribe. The return on RAB is 10,09% for a high-growth scenario and 10,62% for a poor-growth scenario (these rates are denominated in dollars and were converted to euros by an inflation differential). 42 Panama's Autoridad Nacional de los Servicios Públicos 43 51% owned by gas, 48% state-owned and 1% held by minorities. 44 It may also include a variable for the recognition of considered standard losses. Network loss ratio in Panama decreased from 19% to 10% between 2010 and We converted this rate to euros by an inflation differential. 46 As in Panama, there may also be a variable for the recognition of considered standard losses. Network loss ratio in Colombia stood at 17% by the end of Comisión de Regulación de Energia y Gas PAGE 24/38

25 Figure 50: Gas Activity Sales for the Gas Distribution Unit in LatAm (GWh) Source: Company data (including estimated provided in the strategic presentation of November); Analyst s estimates Figure 51: Mexican Gas Demand/GDP Growth Source: Company data; Analyst s estiamtes; IMF Figure 52: Percentage of Installed Capacity 2012 (LatAm) Source: Company data Operations were valued in euros. The main value drivers include expected demand in Colombia and Panama, which are expected to increase before economic development and high-growth prospects; regulatory items (GAS expects a negative impact on Colombian s 2014 revision); capex/opex efficiencies; and FX exposure (EBITDA from Colombia changed +1% between 2011 and 2012 in EUR, while in local currency it changed by +12%). Because GAS finances all its operations with local currency, it is only subjected to business risk. The electricity distribution unit in LatAm was valued at EUR 2,6 per share. Moving on to the gas distribution unit, its valuation was more complex as it includes the regulated distribution activities in 5 different countries with different regulatory frameworks (Brazil, Colombia, Mexico, Argentina and Peru) and the sales to customers at regulated prices, and GAS provides no breakdown by neither geography nor operation within this unit. Estimated revenues depend on volumes, evolution of the number of connection points and past relationship between these two variables and sales. GAS recognizes main value drivers as being: penetration levels (based on energy competitiveness), population growth and development of the middle class, GAS capex programme, with the goal of increasing the number of connection points together with an expansion of the grid line, and regulatory items. Capex is estimated at around 300 million euros per year. The gas distribution unit in LatAm accounted for 13% of 2012 total EBITDA and we estimated a value per share of EUR 4. The remuneration scheme is different across countries but they all have a feature in common, an additive tariff. Regulatory revisions are coming due: Brazilian CEG/CEG RIO happening in 2015 and Colombian and Mexican units will be subjected to revision in A noteworthy point is the entrance in the Peruvian gas distribution market: GAS is expected to distribute and sell gas to more than homes. The business will be operated through a virtual transport system, bringing liquefied natural gas from the Peru LNG plant to regasification systems in the cities. Finally, the electricity generation in LatAm represented 5% of 2012 EBITDA and includes CCGT power generation in Mexico and Puerto Rico, hydro generation in Costa Rica and Panama and oil-fired generation in Dominican Republic. Where GAS has a stronger presence, nevertheless, is in Mexico (80% of installed capacity). The electricity sector in Mexico is dominated by a public company, Comisión Federal de Electricidad (CFE), with exclusive rights for conduction, transformation, distribution and supply activities, and most of GAS sales are to CFE. PAGE 25/38

26 Figure 53: Population Growth Source: IMF Table 12: Sensitivity Analysis to the WACC (Vertical Axis) and Growth Rate (Horizontal Axis) for the LatAm Network Operations 6,6 0,0% 0,5% 1,0% 1,5% 2,0% 4,5% 7,2 7,5 7,9 8,4 9,1 5,0% 6,9 7,2 7,4 7,8 8,3 6,0% 6,5 6,6 6,8 7,0 7,2 6,3% 6,3 6,5 6,6 6,8 7,0 6,5% 6,3 6,4 6,5 6,7 6,9 7,0% 6,1 6,2 6,3 6,5 6,6 Source: Analyst s estimates Current projects in LatAm include a 234 MW wind farm in Mexico (Bii Hioxo) and a 50 MW mini-hydro in Costa Rica (Torito), both expected to be operational by GAS tries to invest in plants that correspond to the dominant technology in each LatAm country it operates: Mexico s electricity generation comes mostly from conventional thermal plants and the use of natural gas for electricity generation has recently increased. In Puerto Rico more than 60% of electricity generation comes from petroleum, while hydro in Panama accounted for almost 60% of power generation in 2010, according to EIA. GAS generation operations in LatAm are part of Power Purchase Agreements 48 and thus subject to a stable stream of cash flows. Moreover, GAS participates in markets that guarantee 100% of fixed costs. GAS has a presence across the entire generation value chain in LatAm: development, construction and O&M. Growth relies on demand evolution and development of Greenfield projects. The estimated value per share for the generation business was of EUR 2,1. Most expansion capex in LatAm will be allocated to the development of the gas distribution unit. Sociological and demographic variables are essential when valuing emerging markets namely population growth, macro evolution and change in social habits. Technological improvements and energy efficiencies in the distribution processes are also variables to take into consideration. We estimate a return on invested capital for the LatAm operations of 8,4% for 2022, which for a 1% growth rate implies a 12% reinvestment rate. This compares to the estimated LatAm-networks WACC of 6,3% and LAtAmgeneration WACC of 6,5%. Table 13: FCF LatAm Operations (EUR million) E 2014E 2015E 2016E 2017E EBIT Adjusted taxes (231) (252) (269) (272) (264) (269) (273) NOPLAT D&A Operating CF Net Capex (42) (282) (415) (518) (532) (534) (535) NWC (18) (110) (16) (18) in other op. A&L (105) (15) Investing CF (1) (332) (495) (462) (516) (550) (567) LatAm Operations Spain FCF Source: Company data; Analyst s estimates 48 PPA are long-term contracts known as Power Purchase Agreements by which all commercial terms for the sale of electricity between the participating partners are set. PAGE 26/38

27 Figure 54: EUR/USD Exchange Rate Source: Bloomberg Figure 55: LNG - Contract Destination Flexibility Source: Company data (strategy presentation) Figure 56: Pipeline Trade Movements to Spain in 2012 Source: BP statistical review 2013 Figure 57: LNG Trade Movements to Spain in 2012 Gas Operations The gas unit includes three different operations: (a) infrastructures, which includes the operation of the Maghreb-Europe gas pipeline, sea transport, development of LNG projects and some upstream operations; (b) Supply & Commercialization (GSC), which includes supply of natural gas to wholesale and retail customers (both domestic and international) and the supply of related products and services; and (c) Unión Fenosa Gas (UFG), which includes the liquefaction activities in the Egyptian Damietta plant, sea transport, the regasification at the Spanish terminal Sagunto and supply & commercialisation. These three units together represented 23% of 2012 total EBITDA. While the infrastructure unit is regulated and subject to remotely the same remuneration scheme as the electricity distribution previously explained, the other two units are liberalised and subject to the risks of a mismatch between the duration of the contracts with suppliers (usually 20 to 25 years and commonly linked to oil spot prices) and the duration of contracts with customers (usually one year, and linked to gas spot prices). Besides regulation, the value drivers of the gas infrastructures include the EUR/USD exchange rate, as contracts are denominated in dollars. While in euros EBITDA grew 22% between 2011 and 2012, if the whole unit was denominated in dollars it would have changed by +13% 49. The infrastructures business unit was valued at EUR 2,3 per share, for an estimated average EBITDA growth of 3% (between 2010 and 2022). This unit s weight on total EBITDA was of only 4% by the end of Focusing on the liberalised activities, Gas Natural does not disclose much detail regarding these operations. During the strategic presentation, there was an effort to increase information regarding the evolution of the liberalised gas business units (supply & commercialisation and UFG), which may result in increased investors confidence about the stability of the business. Demand The natural gas sector is dependent on foreign supplies of natural gas, representing 99,9% of the natural gas supply of GAS. European gas dependency on exports makes pertinent the investment in regasification plants, pipelines and LNG carrier fleets. Worldwide, gas consumption grew by 2,8% (CAGR) between 2002 and Spain surpassed this value with a CAGR for the same period of 4,2%. Source: BP statistical review Only the Maghreb-Europe gas pipeline contract and part of the sea transport operations are denominated in dollars and thus such analysis has limitations. PAGE 27/38

28 Table 14: Gas Natural Gas' Sources (grey shaded corresponds to Pipe) Regasification Current: Ecoelectrica, Puerto Rico Reganosa, Spain Sagunto, Spain - UFG Projected: Trieste, Italy Panigaglia, Italy Capacity lease in France Liquefaction Qalhat, Qatar Damietta, Egypt - UFG Long-term gas contracts Current: Trinidad & Tobago Nigeria Montoir, Norway Europe-Maghreb Egypt Qalhat, Oman Projected: USA Cheniere Yamal, Russia Algeria (Medgaz) Shah Deniz, Azerbeijan Source: Company data; Analyst s research Figure 58: LNG Demand Source: EIA The main gas producer in 2012 was the US, with an average production of 65,7 bcf per day, followed by Russia with an average daily production of 57,1 bcf. Russia is the main pipeline gas exporter in the world, with total exports of 185,9 bcm during The other two large pipeline-exporters, globally, are Canada and Norway. Russia s main client is Europe (130 billion cubic meters in 2012). Gas pipeline trades to Spain came, however, from Algeria (10,2 bcm), Norway (2,3 bcm) and other European countries (0,7 bcm) during The main LNG exporter during 2012 was Qatar (105,4 bcm) followed, by a large distance, by Malasya (31,8 bcm) and Australia (28,1). The main LNG importer is Japan (118,8 bcm in 2012), followed by South Korea (49,7 bcm in 2012) and Spain (21,4 bcm in 2012). Other large LNG exporters include Indonesia, Algeria and Egypt. These exporters are developing countries, meaning that strong domestic gas demand is restricting exports. Contractual obligations are typically being met, but there has been a reduction in un-contracted gas exports. Unión Fenosa Gas (UFG) has a LT gas contract with the Egyptian liquefaction plant, Damietta. This facility is currently not operating in full due to lack of feed gas as the country is diverting export supplies to its domestic market. We are conservative in our approach towards this issue, as the supply is now dependent on the Egyptian authorities. A UFG spokesman, however, has denied any intentions of selling out the project. Because of the restrictive contracts, even if there is no production at the plant, Damietta s partners are still obliged to pay for contracted LNG (UFG 60% and Egas 40%), as the contracted payments are necessary to cover operating costs and investments. According to Bloomberg, Unión Fenosa will seek arbitration on the stoppage of gas supply in the Damietta liquefaction plant, as its negotiations with the Egyptian government have failed. Standard drivers of LNG demand growth are: energy intensive economic growth in emerging markets and increased preference for gas for power generation as a result of environmental policies put in place (gas emits less CO 2 than coal), and closure of nuclear facilities globally as part of a political reaction to the Fukushima catastrophe. The development of regasification facilities is justified by the interest of having security of supply. Shale gas in China is typically found in rocky areas. Recent demand analysis shows an increase of LNG demand from China and India. There is a belief that China will become the second largest LNG importer by However, the drivers of China LNG demand are highly complex, and it will come down to the power switching from coal to gas, the imports through pipelines (from Russia), 50 Timera-energy.com PAGE 28/38

29 and the interest of the Chinese government in developing shale gas even before the geomorphologic difficulties (for political interest of energy security). Figure 59: US Natural Gas Production by Source Source: EIA Figure 60: Domestic vs International Gas Sales Evolution Source: Company data; Analyst s estimates Price differentials Where GAS has been able to achieve the largest margins is in the supply of gas. However, we have doubts about whether this trend will continue or not. The current global price divergence in the gas market is the result of two main facts: (1) the relatively immature nature of the market, with a limited volume of destination flexible supply, as flexibility is constrained by long-term contracts, and (2) the fact that the market is still inefficient, as it is expensive to liquefy, transport and store gas in its liquid form. However, point (1) may be altered in the face of the new flexible US export contracts, while point (2) is unlikely to prevail in the long run, as companies are moving further the learning curve and taking advantage of economies of scale. The US has moved from an importer position to a large prospective exporter one, due to the development of shale gas. US terminal developers such as Cheniere and Freeport are converting their regasification terminals into liquefaction facilities. For this purpose, they are marketing flexible LNG supply contracts. US export projects enable buyers to source Henry Hub indexed gas, and are more flexible in terms of final geographic destination of gas, allowing firms to take advantage of price differentials more freely. Moreover, these contracts do not include take-or-pay clauses, offering the right, but not the obligation, to purchase LNG. The contract buyer pays a fixed fee (to cover the capital costs) for the option to purchase gas at a premium to Henry Hub (around 115%). The premium over Henry Hub covers the variable costs. The value of these contracts will be driven by the spread between hub prices and shipping costs. GAS already has an agreement with Cheniere, starting operations by the end of This type of contract will allow GAS to diversify oil-indexed supply exposure, and to increase the flexibility of its LNG portfolio. It may also put pressure on other suppliers to change their contracts formats. Commonly, the market views future outcomes to be influenced by current market conditions. The price divergence between Asia and the other hubs started after the Fukushima catastrophe (March 2011), which made gas demand increase significantly from Japan through a transition from nuclear to CCGT power generation. This means this price divergence is only likely to prevail if there is not a restart of the Japanese nuclear power plants, which is also unlikely. The evolution of the hub prices is also strongly dependent on the strategic decisions of the largest producers: Russia and Qatar. The main uncertainty with Russia is the price at which they will sell (what indexation). As for Qatar, they PAGE 29/38

30 view Europe as a secondary export destination only, as they can benefit from price premiums from Asia. However, Qatar has maintained a certain level of exports to Europe not only for political reasons, but to decrease its impact on Asian prices, as depressing Asian spot prices may adversely impact Qatar s long term contracting opportunities. For that reason we expect the diminishing of the price divergence to happen in a slow manner. Figure 61: Hub-Price Differencials $/mmbtu Henry Hub NBP Asian Spot Source: Bloomberg, Analyst s estimates Table 15: Sensitivity Analysis to the WACC (Vertical Axis) and Growth Rate (Horizontal Axis) for the Gas Operations 8,6 0,0% 0,5% 1,0% 1,5% 2,0% 5,5% 10,0 10,5 11,1 11,9 12,9 6,0% 9,4 9,8 10,3 10,9 11,6 6,5% 8,9 9,3 9,6 10,1 10,7 7,0% 8,5 8,8 9,1 9,5 10,0 7,2% 8,3 8,6 8,9 9,3 9,7 7,5% 8,1 8,4 8,6 9,0 9,3 8,0% 7,8 8,0 8,2 8,5 8,8 The contracts indexation makes clear the importance of the evolution of the index prices with respect to the contract indexation format, and also the flexibility in terms of price renegotiation implicit in the contracts. Although the efforts in the last 5 years to change contracts indexation to gas hubs rather than oil-indexation, a Reuters study shows that only 10% of the Algerian contracts are linked to gas 51. For that reason, our costs estimations for the GSC unit are dependent on forecasted crude prices. For the revenue side, forecasts are dependent on demand evolution and weight of the international activities on total supply. Gas Natural continues to invest in this area every year, and we include a capex in the range of around 270 million euros per year until 2015, and from then onwards we assume a further increase in investments, in line with GAS guidelines. These investments will essentially be allocated to the development of the LNG carrier fleet: 4 newly built contracted and 1 already existent. 51 Source: timera-energy.com PAGE 30/38