Utilities / Philippines MER PM Utilities / Philippines 27 March 2015

Manila Electric

Manila Electric Target (PHP): 324.00 Upside: 19.9% MER PM 26 Mar price (PHP): 270.20

Initiation: powering through 1 Buy (initiation) • New power-generation investment underappreciated by the 2 Outperform market, overshadowed by worries of a lower distribution tariff 3 Hold • However, we factor this into our forecasts; we expect 12% YoY 4 Underperform declines in electricity distribution rates for 2016/17E 5 Sell • Initiating coverage with a Buy (1) rating and DCF-based 12- month target price of PHP324

How do we justify our view?

its expansion projects. We estimate as distribution recovers and new it has a 2015E dividend yield of power projects become operational. 4.9%, one of the highest among PSEi index constituents. ■ Risks The main risks to our call would be Bianca Solema ■ Catalysts an adverse decision by the regulator (63) 2 737 3023 Progress on tariff reset. This on the tariff and delays/issues in the [email protected] could be a welcome development for execution of generation projects. investors, as we believe the market has already priced in a lower tariff ■ Investment case scenario relative to the current tariff. We initiate coverage on Manila In addition, our forecasts factor in Share price performance Electric Co (Meralco), the lower distribution rates and a 1-year (PHP) (%) Philippines’ largest electricity- delay in the implementation of a 295 105 distribution utility company, with a 284 98 tariff change. We forecast Meralco’s 273 90 Buy (1) rating. average distribution rate to fall by 261 83 12% each for 2016 and 2017. 250 75 Power-generation assets not Mar-14 Jun-14 Sep-14 Dec-14 Mar-15 fully valued. In 2013, Meralco re- Manila Ele (LHS) New power plant. The 500MW Relative to PCOMP Index (RHS) entered the power-generating San Buenaventura coal plant is business. It now has an attributable Meralco’s first power-generation capacity of 379MW, with several 12-month range 251.20-292.40 project in which it has a majority Market cap (USDbn) 6.79 projects due to come on line in interest. Construction will start 3m avg daily turnover (USDm) 2.37 2017/18. However, we believe the when it receives regulatory approval Shares outstanding (m) 1,127 Major shareholder Beacon Electric Asset Hldgs (45.0%) market does not yet appreciate the for its power supply agreement. The potential value of the power- company expects the regulator’s Financial summary (PHP) generating business. Despite decision within 1Q15 or early 2Q15. Meralco’s new ventures in power Year to 31 Dec 14E 15E 16E Revenue (m) 266,336 306,392 314,003 generation, the stock has traded ■ Valuation Operating profit (m) 26,146 25,554 22,943 sideways since 2013, likely due to an We have a DCF-based 12-month Net profit (m) 18,053 18,198 16,637 anticipated reduction in the Core EPS (fully-diluted) 16.017 16.146 14.761 target price of PHP324, within which EPS change (%) 6.1 0.8 (8.6) electricity tariffs under its 4th our PHP293/share valuation for regulatory period, which we assume Daiwa vs Cons. EPS (%) 0.6 1.0 (8.8) electricity distribution already PER (x) 16.9 16.7 18.3 to start in June 2016. exceeds the current share price. Dividend yield (%) 4.8 4.9 4.6 Although the stock’s 2015E PER of DPS 12.870 13.334 12.501 High yield. Meralco’s strong cash- PBR (x) 3.8 3.7 3.6 16.7x exceeds the 15.1x average of its EV/EBITDA (x) 7.9 8.0 9.4 flow generation enables it to pay out regional peers (Bloomberg forecasts), healthy cash dividends and supports ROE (%) 23.4 22.5 19.9 we believe its valuations will increase Source: FactSet, Daiwa forecasts

See important disclosures, including any required research certifications, beginning on page 38 Utilities / Philippines MER PM 27 March 2015

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 ...... 11 Generation: new source of power...... 13 Need for new capacity ...... 13 Re-entry into power generation ...... 13 Partnering with established generation players ...... 14 Growing contribution from power generation ...... 17 Valuation: power-generation assets ascribed zero value ...... 18 SOTP-based TP of PHP324 ...... 18 Earnings multiples at the high end in the near term ...... 19 Steady and healthy dividends ...... 20 Key risks ...... 21 Regulatory and political risks ...... 21 Operational and execution risks ...... 21 Market risk ...... 21 Appendix I: company profile ...... 22 Largest electricity distributor ...... 22 Ownership history ...... 23 World-class operations ...... 24 Other projects leveraging the strength of the distribution platform ...... 25 Appendix II: performance-based regulation (PBR) ...... 28 Appendix III: positive macroeconomic drivers ...... 31 Appendix IV: power supply-demand scenario...... 34

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1 Buy (initiation) How do we justify our view? 2 Outperform

3 Hold  Growth outlook

4 Underperform  Valuation 5 Sell  Earnings revisions

 Growth outlook  Meralco: breakdown of Daiwa’s net income forecasts (PHPm) Meralco posted a 6% YoY rise in its core net income for 20,581 19,417 2014. Growth should be more modest for 2015, as 18,053 18,198 16,637 16,914 distribution is likely to be dragged down by the full-year 14,793 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 18,070 17,660 15,858 16,451 17,367 tariff estimates for the fourth regulatory period 13,862 15,031 (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. 2014E 2015E 2016E 2017E 2018E 2019E 2020E We forecast earnings to reach PHP16.91bn (+14% YoY) MER parent (distribution) and others Pacific Light San Buenaventura Power GBP for 2018 and PHP19.42bn for 2019 (+15% YoY). Source: Daiwa forecasts Note

 Valuation  Meralco: 12-month forward PER bands We value each of Meralco’s distribution and generation (PHP/sh) businesses using a DCF methodology to arrive at our 500 SOTP target price of PHP324. Our target price implies 450 28.8x 400 potential upside of 20% and is equivalent to a 2015E 23.0x PER of 20.2x. 350 300 17.1x We apply varying WACCs, ranging from 6.08% to 250 200 9.66%, and a terminal growth rate of 3% for the 11.3x 150 domestic units and 2% for the company’s Singapore- 100 5.4x based affiliate. In our valuation of the generation 50 business, we include the company’s 3 ventures: 0 PacificLight (28% stake), Global Business Power (22% Dec-05 Dec-06 Dec-07 Dec-08 Dec-09 Dec-10 Dec-11 Dec-12 Dec-13 Dec-14 stake) and San Buenaventura Power (51% stake). Source: Daiwa

 Earnings revisions  Meralco: Bloomberg consensus 2015 EPS forecast The Bloomberg consensus cut its 2014 EPS forecast for (PHP/sh) (PHP/sh) Meralco in May last year with the announcement of the 300 18.0 290 lower approved tariff, or maximum average price 17.5 (MAP), for Meralco’s distribution business (effective 1 280 17.0 July 2014 to 30 June 2015). This started a series of 270 downward revisions to 2015 forecasts as analysts most 260 16.5 250 likely began to recognise the high probability of a 16.0 further rate reduction for the fourth regulatory period. 240 15.5 Our 2015 EPS forecast of PHP16.15 is in line with the 230 consensus figure. 220 15.0 Jan-14 Apr-14 Jul-14 Oct-14 Jan-15 Price (RHS) 2014 EPS (LHS) Source: Bloomberg

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Financial summary

 Key assumptions Year to 31 Dec 2009 2010 2011 2012 2013 2014E 2015E 2016E Ave distribution rate (PHP/kWh) 1.15 1.45 1.59 1.55 1.65 1.60 1.56 1.37 Distribution electricity sales growth 1.7 9.9 1.1 7.1 4.0 3.2 3.6 3.7 (YoY %) System losses (%) 8.6 8.0 7.4 7.1 6.9 6.5 6.5 6.5 Inflation (%) 4.1 3.8 4.6 3.2 3.0 4.0 3.5 3.5

 Profit and loss (PHPm) Year to 31 Dec 2009 2010 2011 2012 2013 2014E 2015E 2016E Sale of electricity 178,686 239,077 253,989 282,991 294,849 261,740 301,107 308,295 Sale of other services 2,072 1,856 2,819 2,279 3,787 4,596 5,285 5,708 Other Revenue 00000000 Total Revenue 180,758 240,933 256,808 285,270 298,636 266,336 306,392 314,003 Other income 00000000 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) 1,044 819 1,041 (307) (726) (717) (675) Assoc/forex/extraord./others 921 (19) 88 1,873 484 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 281 390 467 836 (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) 5.328 8.593 11.765 15.187 15.270 16.017 16.146 14.761 EPS (adjusted)(PHP) 6.213 10.784 13.208 14.431 15.103 16.017 16.146 14.761 EPS (adjusted fully-diluted)(PHP) 6.213 10.784 13.208 14.431 15.103 16.017 16.146 14.761 DPS (PHP) 4.650 6.450 9.250 10.100 12.080 12.870 13.334 12.501 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 2009 2010 2011 2012 2013 2014E 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) 0 0 0 Other investing CF items (1,657) 1,364 653 (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) 6,168 155 8,917 (3,878) 35,116 (286) Net share issues/(repurchases) 445 221 208 308 142 (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 85 844 362 265 (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 00000000 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

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Financial summary continued …

 Balance sheet (PHPm) As at 31 Dec 2009 2010 2011 2012 2013 2014E 2015E 2016E Cash & short-term investment 17,068 24,370 44,141 60,500 59,851 68,127 103,098 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 92,243 107,486 113,899 153,254 133,300 Fixed assets 102,112 103,250 105,510 109,312 112,586 116,313 130,403 159,473 Goodwill & intangibles 0 0 000000 Other non-current assets 25,332 15,715 9,805 15,336 43,932 29,271 30,427 31,173 Total assets 172,129 178,968 211,088 216,891 264,004 259,483 314,084 323,946 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 93,675 101,625 Total liabilities 110,983 115,772 144,219 148,741 188,669 178,969 228,914 233,776 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 4,713 248 173 1,231 2,716 5,170 Total equity & liabilities 172,129 178,968 211,088 216,891 264,004 259,483 314,084 323,946 EV 311,864 305,299 288,713 267,088 265,033 254,244 255,457 277,968 Net debt/(cash) 4,748 (3,149) (19,698) (35,887) (26,260) (38,414) (38,269) (17,703) BVPS (PHP) 50.900 52.319 55.147 60.245 66.686 70.343 73.155 75.415

 Key ratios (%) Year to 31 Dec 2009 2010 2011 2012 2013 2014E 2015E 2016E Sales (YoY) (5.7) 33.3 6.6 11.1 4.7 (10.8) 15.0 2.5 EBITDA (YoY) 9.9 46.1 28.2 5.7 22.6 6.5 (1.0) (7.4) Operating profit (YoY) 10.4 61.1 45.1 7.1 26.4 8.3 (2.3) (10.2) Net profit (YoY) 150.1 73.6 22.5 9.3 4.7 6.1 0.8 (8.6) Core EPS (fully-diluted) (YoY) 144.9 73.6 22.5 9.3 4.7 6.1 0.8 (8.6) Gross-profit margin 16.5 16.6 19.9 18.6 20.2 23.7 20.2 18.3 EBITDA margin 6.9 7.6 9.1 8.7 10.1 12.1 10.4 9.4 Operating-profit margin 4.2 5.1 6.9 6.7 8.1 9.8 8.3 7.3 Net profit margin 3.9 5.0 5.8 5.7 5.7 6.8 5.9 5.3 ROAE 12.7 20.9 24.6 25.0 23.8 23.4 22.5 19.9 ROAA 4.2 7.2 7.9 7.7 7.1 6.9 6.4 5.2 ROCE 12.7 20.9 24.6 25.0 23.8 23.4 22.5 19.9 ROIC 9.0 15.4 17.8 18.2 17.2 17.0 14.5 11.4 Net debt to equity 7.8 net cash net cash net cash net cash net cash net cash net cash Effective tax rate 28.9 30.2 31.8 26.1 29.0 31.5 30.2 30.2 Accounts receivable (days) 59.7 35.8 38.9 36.6 37.2 42.0 36.7 38.8 Current ratio (x) 1.1 1.3 1.5 1.5 1.1 1.6 2.1 1.9 Net interest cover (x) 2.0 21.9 12.3 12.5 16.3 18.2 18.0 16.4 Net dividend payout 73.8 59.8 60.0 70.0 80.0 80.0 80.0 80.0 Free cash flow yield 6.2 3.1 5.8 8.1 8.7 3.1 5.5 0.7 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.

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interest rates today versus 4 years ago (the time of the last tariff reset).

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 2017. We Investment thesis 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 Powering through updating the inputs for current values of risk-free rates, asset beta, country risk premium and inflation. We initiate coverage on Meralco with a Buy (1) rating and DCF-based 12-month target price of PHP324. In addition, we factor in a 1-year delay in the implementation of the new rates under the fourth Unparalleled scale and experience in regulatory period, which was originally scheduled for power distribution July 2015. Meralco holds a monopoly in terms of power distribution in the Philippines capital, Metro Manila,  Meralco: distribution revenue and average distribution rate 1.65 and nearby provinces. It is also the country’s oldest 1.59 1.55 1.60 1.56 distribution utility, established in 1903. The company’s 1.37 1.25 scale and experience have equipped it with strong 1.21 technical expertise that enables it to outperform all 56,105 56,382 56,706 50,892 51,781 50,946 regulatory performance standards and run its 48,606 47,319 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 2011 2012 2013 2014 2015E 2016E 2017E 2018E support payment of dividends and expansion projects. Distribution revenues (PHPm) Ave distribution rate (PHP/kWh) Based on its current share price, we estimate Meralco’s Source: Company, Daiwa forecasts dividend yield in 2015 at 4.9%, one of the highest among the constituents of the PSEi. New power-generation investments appear underappreciated  Meralco: dividend yield estimates for index stocks – 2015 (%) 6 We believe, however, that Meralco’s new power- generation investments are being overshadowed by the 5 concerns in the market about the distribution business’

4 impending tariff reset.

3 Meralco re-entered the power generation business in

2 2013 through the acquisition of a 22% interest in Global Business Power (GBP) and a 28% effective 1 interest in an LNG power plant in Singapore (PacificLight). Today, Meralco has an attributable 0 capacity of 379MW and is preparing for several new AP AC SM ALI BPI ICT AGI MPI TEL JFC LTG JGS RLC AEV SCC EDC GLO MBT EMP BDO URC MER SMC DMC MEG FGEN SMPH PCOR projects to come on line. The most advanced of these GTCAP BLOOM Source: Bloomberg, Daiwa for Meralco new projects in terms of development is the 500MW San Buenaventura Power, for which the company Factored in decline in distribution tariff targets to begin construction this year.

We recognise that the investors’ main concern at this Although still accounting for a very small proportion of point is the likely downward adjustment in distribution earnings today, we expect the power-generation rates during the upcoming tariff reset for Meralco business to be a significant earnings driver once the (originally scheduled for July 2015). The reduction company’s new projects become operational. For 2018 should mainly arise from lower allowed returns (lower and 2019, we estimate the combined contribution from regulatory WACC), due to a decline in applicable

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the 3 units to reach PHP1.88bn and PHP2.97bn, or 11% price. Meralco was one of the laggards in 2014, and 15% of the consolidated net profit, respectively. underperforming the PSEi by 20.77pp. In addition, we have barely seen sustained positive movement in  Meralco: breakdown of Daiwa’s net income forecasts (PHPm) MER’s share price, even after its re-entry into the 20,581 19,417 power generation business in 2013. The stock has been 18,053 18,198 16,637 16,914 trading in a range of PHP250-290 range since 2H13. 14,793  Meralco: Share price (PHP) 450 18,070 17,660 15,858 16,451 17,367 400 13,862 15,031 350 300

2014E 2015E 2016E 2017E 2018E 2019E 2020E 250 200 MER parent (distribution) and others Pacific Light San Buenaventura Power GBP 150 Source: Daiwa forecasts 100 50 Also overlooked by the market, in our view, is the 0 competitive advantage that Meralco gains from the Dec-08 Dec-09 Dec-10 Dec-11 Dec-12 Dec-13 Dec-14 scale of its distribution business for its generation Source: Bloomberg projects. Although the regulator must sign off any contract between Meralco’s distribution unit and a We see 2 main positive catalysts for the stock that power supplier, Meralco’s generation projects, at least could materialise in the near term. those in Luzon, have the advantage of being prioritised by Meralco’s distribution unit in terms of signing Resolution or clearer picture on tariff reset power supply agreements. With the negative scenario about the direction of tariffs

likely priced into Meralco’s share price, we think Getting power-generation assets “for free” progress on the tariff reset could be a welcome Our target price of PHP324 offers potential upside of development for investors at this point, as it would 19.9% against the stock’s closing share price of lessen the overhang resulting from this issue. PHP270.20 on 26 March 2015. Based on our SOTP Moreover, our forecasts also factor in a decline in valuation, we value the distribution business at tariffs for the next rate rebasing period, as we assume a PHP293.07/share and the company’s 3 power- 12% YoY reduction in average distribution rates for generation units combined at PHP31.09/share. both 2016 and 2017. Against our estimated value for the distribution business alone, the stock is trading at a discount of We expect to see a resolution on the tariffs soon as the 7.8%. rate reset was originally scheduled to begin on 1 July 2015, upon the start of the fourth regulatory period for  Meralco: SOTP valuation Meralco. In case the process is delayed, we should at Total equity Meralco’s Attributable Value per % of value stake equity value share total least see the applicable rules and guidelines for the (PHPm) (PHPm) (PHP/sh) fourth regulatory period being announced, as well as a Parent (distribution) and others 330,314 100% 330,314 293.07 90% much clearer stance from the regulator on this matter, PacificLight 26,357 28% 7,380 6.55 2% within the year. San Buenaventura Power (SBP) 27,722 51% 14,138 12.54 4% Global Business Power (GBP) 61,142 22% 13,451 11.93 4% Total 324.09 100% Commencement of the construction of a Target price (TP) 324.00 major power-generation project

No of outstanding shares 1,127.10 Once the Energy Regulatory Commission (ERC) Source: Daiwa estimates approves Meralco’s power supply agreement (PSA) with San Buenaventura Power, Meralco says it will immediately finalise the financing agreement for the Key near-term catalysts project. Thereafter, Meralco should begin construction of the project. All hearings with the regulator for the We believe that the expected tariff reduction and, petition to approve the PSA have been concluded and a consequently, the lower near-term earnings prospects decision on the PSA is expected by 1Q15/early 2Q15. of Meralco have been priced into to the current share - 7 - Utilities / Philippines MER PM 27 March 2015

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 power- generation 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 2015. 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.

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 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 74% Distribution business: 40,000 73% 73% 74% 73% 30,000 unparalleled power 54% 55% 55% 55% 55% 20,000

10,000

Poised to benefit directly from 0 economic growth 2009 2010 2011 2012 2013 MER Energy Sales Luzon Energy Sales PH Energy Sales Source: Company, CEIC Growing Philippines economy should continue to drive demand for electricity The company’s consolidated volume sales have grown The Philippines has been one of the best-performing steadily at an 11-year CAGR of 3.6%, from 23,834GWh economies in the region, registering real GDP growth in 2003 to 35,160GWh in 2014. Similarly, we factor in of 6.1% YoY in 2014. Although the performance in 2014 a 3.6% annual growth rate for our forecast period. was lower than the 7.2% YoY growth posted in 2013, the country was the fastest-growing economy in  Meralco: electricity sales Southeast Asia and the second-fastest in Asia (next to ('000 GWh) 40.6 45 37.8 39.2 China) for a third consecutive year. 35.2 36.4 40 32.8 34.1 35 30.2 30.6 26.2 27.0 27.5 Heightened economic activity should result in 30 24.7 24.8 25.1 increased demand for electricity. There is a high 25 correlation between electricity demand and real GDP 20 15 growth, with an average elasticity of 0.97x computed 10 since 1990. 5  0  Philippines: historical electricity demand and GDP per capita 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

16% 3.0 2015E 2016E 2017E 2018E 14% Residential Commercial Industrial Streetlights 12% 2.5 Source: CEIC, Daiwa forecasts 10% 2.0 8% 6% 1.5 4% Regulatory headwinds factored in 2% 1.0 0% 0.5 (2%) The tariff reset process (4%) 0.0 Under the performance base regulation (PBR), base 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 Real GDP growth (LHS) tariffs for Meralco’s distribution business are approved Growth in electricity consumption (LHS) at the start of every regulatory period, and the Ave elasticity (since 1990) (RHS) applicable annual average rate, called the Maximum Source: CEIC, Daiwa Average Price (MAP), is approved at the beginning of each of the 4 regulatory years (RY) in a regulatory Meralco should benefit directly from the economic period. Meralco is currently in the fourth RY of its third growth of the country, as around 55% of the country’s regulatory period, and was originally scheduled for a energy sales and 50% of GDP are consumed and reset on 1 July 2015, once the fourth regulatory period generated in Meralco’s franchise area. We believe starts. electricity demand from its 4 customer groups – residential, commercial, industrial and streetlights – To describe the PBR computations in simple terms, the will continue to grow with the population, private base tariffs are based on an annual revenue consumption and a resurgence of the manufacturing requirement (ARR) and projected energy consumption sector in the country. 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 - 9 - Utilities / Philippines MER PM 27 March 2015

necessary operating and maintenance expenses, and Using the same formula but updating the variables applicable recoverable taxes. The PBR uses a forward- such as the risk-free rate, asset beta, country risk looking approach and it defines “capital” as the “rolled- premium and inflation rates, we arrive at a regulatory forward optimised regulatory asset base (RAB)”, which WACC of 11.02% as at 31 December 2014 and 10.82% is composed of the initial opening value and future as at 5 February 2015. In our forecasts, we factor in a capex. regulatory WACC of 11%. Our sensitivity analysis shows that for every 10bps increase/decrease in the regulatory The approved MAP will then be translated into a rate WACC, our target price would go down/up by about table, which indicates respective rates per customer PHP2/sh. class. Factoring in a 1-year delay Lower interest rates to drive down The fourth regulatory period, together with a new tariff regulatory WACC base, was originally scheduled to begin in July 2015. One of the key components of return on capital is the We believe, however, that the process will be delayed regulatory weighted average cost of capital (WACC), based on the regulator’s progress to date. According to which serves as the rate of return on the regulatory Meralco, there is a high possibility of the new tariff asset base. For the third regulatory period, the being delayed as the regulators have not yet issued the approved regulatory WACC has been 14.97%. This was rules that will apply to the fourth regulatory period and computed using economic variables during the final the tariff reset. rate determination in the third regulatory period (around February 2011). Interest rates have drastically As such, we have factored in a 1-year delay in the come down since then, which should reduce the implementation of the new rates. For RY2016 (1 July regulatory WACC for the fourth regulatory period. For 2015 to 30 June 2016), we have maintained the status example, using the same indirect method (using USD quo and the current MAP of PHP1.5562/kWh in our treasury bonds and applying a country risk premium), forecasts. When the rates for the fourth regulatory the yield for 20-year USD treasury bonds (averaged for period are determined, we assume that any difference 60 days) was 2.93% as at 9 January 2015, against between the should-be rate for RY2016 and the status- 4.32% as at 28 February 2011. quo rate of PHP1.5562/kWh will be recovered over the remaining regulatory period.

 Regulatory WACC calculation – previous and Daiwa forecasts 3rd Regulatory Period 4th Regulatory Period 4th Regulatory Period (actual) As at 31 December 2014 As at 4 February 2015 Parameters Low Mid High Low Mid High Low MidHigh 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 0.818 0.667 0.538 0.818 0.667 0.538 0.818 0.667 0.538 Asset beta Ba 0.276 0.449 0.721 0.258 0.504 0.751 0.258 0.504 0.751 Risk-free rate (nominal – 20-yr USD bond yields in USA) 20 4.07% 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 0 0 0 0 0 0 0 0 0 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) 0.50 0.83 1.11 0.50 0.83 1.11 0.5 0.83 1.11 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

- 10 - Utilities / Philippines MER PM 27 March 2015

Our forecast of a tariff reduction beginning in 2H16 Forecasts: distribution business outweighs our electricity volume growth assumption for the same period. We forecast distribution revenue We forecast lower distribution rate to fall by 9% YoY to PHP51.78bn for 2016. And a By factoring in a lower regulatory WACC of 11% further 9% YoY decline in distribution revenue is (compared with 14.97% used for the third regulatory expected for 2017 with the first full-year of period) and adjusting for a 1-year delay in the implementation of new tariffs. implementation of the lower rate, we forecast a MAP of PHP1.1857/kWh for RY2017, down 24% vs. the Recovery with continued improvement in PHP1.5562/kWh for RY2016. Thereafter, we expect an margins inflationary increase in tariffs up to PHP1.2783/kWh Significant gains in operating efficiency have boosted for RY2019. Meralco’s margins. Its EBIT margin based on revenues excluding pass-through items showed a marked  Meralco: maximum average price (PHP/kWh) with 1-year delay improvement from 24% in 2009 to 46% in 2014. 3rd regulatory period 4th regulatory period (1 July 2011 - 30 June 2015) (1 July 2015- 30 June 2019)  Meralco: EBIT and EBIT margin on revenue (excluding pass- through items) 1.6333 1.6510 1.6012 1.5562 1.5562 46% 45% 45% 1.2783 43% 43% 43% 1.1857 1.2312 37% 38% 26,166 25,754 24,150 28% 23,143 22,141 24% 20,339 17,839 19,108

12,293 7,633

RY12 RY13 RY14 RY15 RY16E RY17E RY18E RY19E Source: Energy Regulatory Commission, Daiwa forecasts Note: Rates for the 3rd RP are all actual based on the ERC; 4th RP are Daiwa forecasts 2009 2010 2011 2012 2013 2014 2015E 2016E 2017E 2018E EBIT (PHPm) EBIT margins on revenues (ex-pass through items) With the full-year implementation of a Source: Company, Daiwa forecasts PHP1.5562/kWh MAP in 2015, we expect the average distribution rate to fall by 3%. Meanwhile, we forecast We expect Meralco to sustain the operating efficiencies a further decline in the distribution rate as we factor in that have led to the improvement in its margins. In the new tariffs for the 4th regulatory period beginning addition, we factor in a gradual decline in provisions RY2017. As RY2017 begins in 1 July 2016 and ends on for probable charges (considered as operating 30 June 2017, the 24% decline in the MAP will be expenses), as we expect the company is in the tail end distributed over 2016 and 2017. We estimate the of its provisioning for pending legal cases involving average distribution rate to fall by 12% YoY for both possible refunds to consumers. Between 2011 and 2015 and 2016, and begin to see an improvement in 2013, Meralco made provisions for a total of 2018. PHP28.04bn or an average of PHP9.35bn a year. This  compares with its 2009 and 2010 provisioning of  Meralco: distribution revenue and average distribution rate PHP2.17bn and PHP4.12bn, respectively. As a result, 1.65 1.59 1.55 1.60 1.56 we expect the company’s EBIT margin to hold up above 1.37 43% for the period 2015-18E, despite our lower 1.21 1.25 distribution revenue estimates for the same period.

56,105 56,382 56,706 50,892 51,781 50,946 48,606 47,319 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 2011 2012 2013 2014 2015E 2016E 2017E 2018E distribution rate assumption for the 4th regulatory Distribution revenues (PHPm) Ave distribution rate (PHP/kWh) period will only be seen beginning 2016, as our forecast Source: Company, Daiwa forecasts points to a 10% YoY decrease in the distribution business’s core income, to PHP15.86bn, for 2016.

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The decline should continue, but bottom out, in 2017 as The distribution business provides stable and strong this will be the first full (calendar) year of the cash-flow generation, enabling Meralco to be in a net implementation of new tariffs. We estimate a net profit cash position since 2010. As at the end of 2014, its cash of PHP13.86bn, down 13% YoY. The distribution and interest-bearing debt amounted to PHP69.47bn business should start to recover in 2018 alongside the and PHP30.04bn, respectively, putting the company in increase in tariff and continued EBIT margin a net cash position of PHP39.43bn. Its gearing ratio improvement. For 2018, we forecast the net profit of was also low, at 0.5x, as at end-2014. the distribution business to grow by 8% YoY to PHP15.03bn. Meralco has historically churned positive free cash flows despite its high capex requirements. Although we Strong balance sheet to support expansion estimate free cash flows to fall to PHP10.46bn in 2014  Meralco: net cash (debt) (PHPm) from PHP26.62bn in 2013 due to a big negative working capital change of PHP13.50bn, we expect the 35,887 39,426 distribution business to maintain its positive free cash 26,260 19,698 flow generation throughout the rest of our forecast 3,149 (4,748) period to 2024. Our negative working capital forecast in 2014 arose from the sudden increase in trade (21,221) (21,816) (24,443) (24,613) (33,591) (30,042) payables at the end of 2013 (generation charges for (17,068) (24,370) November and December 2013 spiked and the courts put a temporary restraining order on Meralco to collect (44,141) from customers). (60,500) (59,851) (69,467) 2009 2010 2011 2012 2013 2014 Meralco’s strong balance sheet and cash flow Cash Interest-bearing debt Net cash (debt) generation gives it the financial flexibility to take on

Source: Company new projects such as its ventures into power generation.

 Meralco: free cash flow – parent (distribution) and others 2009 2010 2011 2012 2013 2014E 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

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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 Generation: new and Meralco must be signed off by the ERC, this arrangement still gives MGEN a big competitive source of power advantage over plants of similar profiles.

Current regulations allow cross-ownership between Meralco’s re-entry into the power- distribution and generation companies. The law, generation business should serve as its however, limits the DU from sourcing more than 50% of its total power demand from bilateral contracts with next leg of growth, as well as complement associated generation companies to prevent an abuse its distribution business by securing a of power. The restriction is only applicable to the DU’s cheap and stable power supply sourcing for its franchise area.

Based on Meralco’s 2013 electricity sales of Need for new capacity 34,084GWh, it is allowed to contract 17,042GWh from its affiliated power-generation companies. Assuming The Department of Energy (DoE) warns of a power an average capacity factor of 80%, this translates into shortage of up to 1,000MW in the Luzon grid during an allowance of up to 2,432MW of installed capacity. the summer months of 2015. A combination of high This limit will go up as demand in Meralco’s franchise demand due to the hotter weather, the planned area increases. maintenance shutdowns of large plants, and a possible El Niño effect on the water levels of hydro plants are Also benefits its distribution business the contributing factors for the looming power Meralco highlights that another reason the company shortage. The government has implemented stop-gap ventured into the power-generation business, measures, such as an interruptible load programme particularly its projects in Luzon, is to serve as support and ensuring the president of the country has for its distribution business. Having its own generation emergency powers to contract capacity from readily plants helps ensure a stable supply for the distribution available sources like generation sets. However, even if business, particularly with the current demand-supply this immediate issue is addressed, the much more scenario of thin reserves and looming power shortage important message presented by this is the fact that in summer 2015. new capacity is still very much needed. By securing more bilateral contracts, Meralco is minimizing the effect of any price spike in the spot Re-entry into power generation market. Although generation charges are just pass- through charges, Meralco usually bears the brunt of Until the early 1970s, Meralco was into both power consumer anger for any increase in electricity price. distribution and generation. However, during the The most recent example was in December 2013, where martial law regime, the country’s electricity generation Meralco was the first to be blamed for the and transmission facilities were nationalised, forcing PHP4.15/kWh increase in the monthly electricity the company to sell all its power-generation assets to charge, though the actual reason was the spike in the government and turning Meralco’s core business generation charges, particularly those sourced from the exclusively into distribution. However, in 2013 Meralco spot market. This issue even resulted in the Supreme re-entered the power generation business both through Court issuing a temporary restraining order on Meralco partnerships with existing players and the development to collect the increase in rates. Meralco is in fact of new power plants. Its power-generation assets are already going in this direction. As of 9M14, we saw a lodged under its subsidiary Meralco PowerGen Corp big decline in purchases from the spot market to 2.9%, (MGEN). from 5.3% in 2013.

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 Meralco: breakdown of net system input (GWh)  Global Business Power Corp (GBP) Project type Minority investment 36,673 35,176 Plant type Various coal and diesel 32,644 33,081 Capacity 410MW (gross) coal; 29,922 28,112 217MW (gross) diesel Location Visayas region % Meralco equity 22% Partner GT Capital Holdings (GTCAP:PM), First Metro Investments Corp, Orix Corp (of 34,724 Japan) 30,661 32,918 26,077 28,028 27,307 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

2009 2010 2011 2012 2013 9M14 Source: company Contracted Wholesale Electricity Spot Market  GBP: power-generation facilities Source: Company Effective Gross/Net gross/net Type of Effective capacity capacity Partnering with established plant ownership (MW) (MW) Cebu Energy Development Corp (CEDC) Clean coal 52.1% 246/216 128/113 generation players Panay Energy Development Corp (PEDC) Clean coal 89.3% 164/144 146/129 Toledo Power Corp (TPC) TPC – Sangi Coal 100.0 60/50 60/50 Having just re-entered the power-generation business, TPC – Carmen Fuel oil 100.0 40/36 40/36 Meralco’s strategy is to partner with established players TPC – 1A Fuel oil 100.0 82 82 in the business, both through acquiring stakes and Panay Power Corp (PPC) undertaking new projects with existing players. This PPC – Iloilo 1 Fuel oil 89.3 72/69 64/62 PPC – Iloilo 2 Fuel oil 20/18 20/18 18/16 allows Meralco to leverage on its partner’s technical PPC – Nabas Fuel oil 13/11 11/10 100 know-how and experience in power plant operations. PPC – New Washington Fuel oil 5/4.5 4.5/4 100 Global Power Resources Inc (GPRI) Fuel oil 8/7 8/7 88.2 Through its partnerships, Meralco is also able to Source: GTCAP expand its footprint beyond Luzon where its franchise area is situated. In fact, Meralco currently has In October 2013, Meralco purchased a 20% stake in GBP operating plants in other regions in the Philippines from First Metro Investment Corp for PHP7.15bn. This (Visayas) and overseas (Singapore). marked Meralco’s official re-entry in the Philippines power-generation industry. An additional 2% stake was  Meralco: timeline of attributable power-generation capacity (MW) purchased by Meralco for PHP184.87m in May 2014. In 644 total, Meralco holds a 22% interest in GBP for a total acquisition cost of PHP7.33bn. Based on GBP’s 2013

232 financials, the transaction is equivalent to 17.2x PER. 412 412 379  GBP: geographical distribution of power plants

224 224 224 224

155 188 188 188

2015 2016E 2017E 2018E

GBP Pacific Light San Buenaventura Power Source: company, Daiwa forecasts

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 Note: TPC1A and PEDC Unit 3 not yet included in map the southwest area of Luzon. Source: GTCAP

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GBP allows Meralco to have access to a fast-growing PacificLight: testing the waters overseas market in the Visayas region, for which the DoE In March 2013, MGEN acquired a 28% effective stake projects average annual growth in peak demand of in PacificLight Power Pte Ltd (PacificLight) which, at 4.5% until 2030. GBP has 2 brownfield expansion that time, was at the final construction phase for a projects. The first is the 82MW coal-fired power plant 2x400MW LNG-fired power plant in Jurong Island, in Toledo City, Cebu (TPC1A), which has been Singapore, for a consideration of USD217.4m (total operational since September 2014, three months ahead project cost was USD965m). The plant started full of target. Next is the 150MW coal-fired plant in Iloilo commercial operations in February 2014. MGEN has City. An equity call amounting to PHP4.43bn partnered with First Pacific (Meralco’s effective major (Meralco’s share is PHP1.07bn) was conducted by GBP shareholder) and Petronas Power, a subsidiary of in 1H14. The construction of this plant commenced in Malaysia’s state energy firm Petronas, which July 2014 and the company expects it to be completed respectively have 42% and 30% effective stakes in by July 2016. PacificLight.

 82MW Toledo (TPC 1A) coal plant  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 power- generation capacity currently. From 2009 to mid-2014, its ratio of peak system demand to installed electricity

Source: GTCAP 9M14 presentation materials generation capacity averaged at around only 60%. Similar to the Philippines, Singapore has an electricity  PEDC ground-breaking ceremony 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 Source: GTCAP 9M14 presentation materials energy-efficiency F-class combined cycle gas turbines

from Siemens and has a fast ramp-up time of only 60 Meralco’s partners in GBP are GT Capital Holdings Inc minutes which makes it one of the most efficient and (GTCAP PM) and First Metro Investment Corp (an flexible power plants in Singapore. 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.

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 Singapore: historical electricity demand-supply Actively looking for more power- 14,000 generation projects 12,000 MGEN’s thrust is to build its domestic power- 10,000 generation portfolio by 2020 to up to 3,000MW. (Note 8,000 that for the 3,000MW target, Meralco attributes full 6,000 capacity once control of the project is with the 4,000 company, regardless of the actual interest.) Against this target, Meralco’s current attributable domestic 2,000 capacity, including the under-development 150MW 0 PEDC Unit 3 and 500MW San Buenaventura Power,

Jul-09 Jul-10 Jul-11 Jul-12 Jul-13 totals only around 688MW. Although this still leaves a Apr-09 Oct-09 Apr-10 Oct-10 Apr-11 Oct-11 Apr-12 Oct-12 Apr-13 Oct-13 Apr-14 Jan-09 Jan-10 Jan-11 Jan-12 Jan-13 Jan-14 Installed electricity generation capacity (MW) Peak system demand (MW) lot of room to fill in terms of capacity, MGEN currently has 2 big power projects under study that could allow Source: Energy Market Authority of Singapore MGEN to reach its target capacity. San Buenaventura coal: advanced stages of First is the 600MW coal-fired power plant in Subic development through a consortium called Redondo Peninsula In August 2013, MGEN partnered with Thailand’s Energy (RP Energy). The project is designed to use the Electricity Generating Public Co (EGCO TB) for the most advanced supercritical circulating-fluidized bed construction of a 500MW (455MW net) supercritical (CFB) technology and is estimated by Meralco to cost pulverised coal-fired power plant that will be an USD1.2bn. Meralco’s partners in the consortium are expansion of its existing 460MW coal plants in established power-generation companies Aboitiz Power Mauban, Quezon. The new project will be under San Corp (AP PM) and Taiwan Cogeneration International Buenaventura Power Ltd Co (San Buenaventura Corp. Power) which is 51%-owned by MGEN and 41%-owned by New Growth B.V., a 98%-owned subsidiary of RP Energy was supposedly Meralco’s first power- EGCO. generation project. The partnership agreement was signed as early as July 2011, but it met opposition when A power supply agreement (PSA) covering the plant’s a writ of kalikasan, filed by militant groups, was issued entire output was signed on 2 June 2014 with Meralco by the Court of Appeals, which in turn invalidated its and immediately submitted to the ERC for approval. environmental compliance certificate (ECC). Meralco The selection of the EPC contractor and financing appealed to the Supreme Court and on 3 February 2015 agreement are in the final stages, but both are pending was granted a favourable decision that reversed the the approval of the PSA. The project cost is still to be earlier ruling. With this development, Meralco said it determined as the EPC contract has to be finalised, but would proceed with the project and start renegotiating based on benchmark projects, the cost of developing a its EPC contract and financing agreement. RP Energy coal plant ranges from USD2.3m-2.4m per MW, which has spent PHP1bn on site development costs for the translates into a total cost of around USD1.15bn-1.2bn. project. Meralco targets to commence construction the project is targeted for completion between late- within 2015. 2017 and 2018. Assuming construction on the project begins this year,  San Buenaventura Power Ltd we think the plant could be ready in late-2018 or 2019. Project type Brownfield However, we have not yet factored RP Energy into our Plant type Supercritical coal-fired Capacity 455MW (net) model or DCF valuation pending more concrete Location Mauban, Quezon developments from the company. % 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

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 Redondo Peninsula Energy Inc (RP Energy) Going forward, we expect a significant improvement in Project type Greenfield the contribution of its power-generation business. Plant type Circulating fluidized bed coal-fired Capacity 2x300MW Meralco has 3 power-generation projects that it has Location Subic Bay Freeport Zone just completed or expects to complete in 2015-18, % Meralco equity 47% which should provide a continuous boost to Meralco’s Partner Aboitiz Power Corp (AP PM), Taiwan Cogeneration Expected COD Currently n/a net profit until 2019. 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  Meralco: timeline of attributable power-generation capacity of kalikasan on the project and invalidated the environment compliance (MW) certificate. The Supreme Court also upheld the legality of the lease and development agreement for the project. 644 Offtake agreement Currently n.a. Source: Company, Daiwa 232 412 412 379 Meralco is also involved in ongoing development activities for a 2x600MW supercritical pulverized coal- 224 224 224 fired power plant in Atimonan, Quezon (Atimonan One 224 Energy). An international engineering firm has been engaged as Meralco’s engineer while it is in the process 155 188 188 188 of the engineering, procurement and construction prequalification. Meralco is also currently applying for 2015 2016E 2017E 2018E an ECC. GBP Pacific Light San Buenaventura Power Source: Company, Daiwa forecasts In late February 2015, it emerged that Meralco is in preliminary talks with Osaka Gas (9532 JP) to build a First in the pipeline is the 82MW Toledo (TPC 1A) coal- liquefied natural gas (LNG) facility in the Philippines. plant expansion, construction of which was completed The project could potentially include a gas power plant in late-4Q14. We expect a full-year contribution to with a generating capacity of 1,200-1,500MW at a cost earnings from TPC 1A in 2015. By 2H17, we expect of up to USD2bn. It could also comprise a another project to have come online, the 150MW PEDC regasification facility for the imported LNG. The Unit 3 coal-plant expansion. The construction of PEDC company said it intends to finalise negotiations with Unit 3 began in July 2014, and the company is Osaka Gas within 2015. targeting completion within 24 months of that date. We expect this to start contributing to earnings in late- 2017 and its full-year contribution to be felt in 2018. Growing contribution from Both TPC 1A and PEDC Unit 3 are expansion projects power generation of Meralco’s 22%-owned affiliate GBP. Between 2015 and 2017, we expect the net profit from the power- For 9M14, the power-generation business was still a generation business to grow from PHP538m for 2015 drag on earnings, with GBP’s PHP222m equity to PHP931m in 2017 as a result. earnings offset by PacificLight’s loss of PHP294m, as it is still in the early stages of its operations. Combined, By 2H18, we expect the completion of Meralco’s first we expect these units to only nearly break even in 2014. majority-owned generation project, the 500MW San Buenaventura coal plant project. It should provide a  Meralco: contribution from power-generation units (PHPm) boost in earnings for 1H18 and for the full-year 3,214 beginning 2019. We expect the combined net profit 2,966 contribution for the power-generation business to 891 863 jump to PHP1.88bn in 2018 and PHP2.97bn in 2019. 1,883

931 897 779 538 1,904 2,103 (17) 736 896 (71) 550 808 222 372

9M14 2014E 2015E 2016E 2017E 2018E 2019E 2020E San Buenaventura Power PacificLight Global Business P ower Source: Company, Daiwa forecasts Note: 9M14 total only for 2014, comprises Global Business Power and Pacific Light

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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 2015-17, especially in 2016 when we expect bulk of the capex for San Buenaventura coal will be needed. However, once these projects become operational, in Valuation: power- 2017 for PEDC Unit 3 coal, and 2018 for San Buenaventura coal, we expect strong free cash flow generation assets generation resulting in significant improvement in the DCF-based valuations. ascribed zero value  Meralco: projected free cash flows to the firm (PHPm) Initiating coverage with a Buy (1) rating 24,082 16,681 22,739 14,675 2,649 and a 12-month target price of 10,404 2,981 PHP324.00. Based on our DCF valuation, 2,232 9,546 21,357 18,332 20,045 14,924 16,907 investors are essentially getting Meralco’s 14,126 power-generation assets “for free”. 10,457 (4,481) (5,941) (3,740) (12,005) SOTP-based TP of PHP324 2014E 2015E 2016E 2017E 2018E 2019E 2020E We separately value Meralco’s power-distribution and GBP MER parent San Buenaventura Power Pacific Light generation businesses using a DCF methodology, which Source: Daiwa forecasts gives us our SOTP target price of PHP324.00. In our valuation and forecasts, we have not factored in Distribution still the biggest asset, but Meralco’s other potential power-generation projects, generation becoming a substantial such as the Subic coal plant, Atimonan One Energy, contributor and LNG plant (partnered with Osaka Gas), as we are The distribution business remains Meralco’s biggest waiting for more concrete developments. earnings driver, accounting for more than 90% of the company’s consolidated equity value. Nevertheless, the DCF parameters growing contribution of its power-generation business We have discounted the 10-year free cash flows to firm is notable from essentially nil a few years ago to 10% of of the parent (for the distribution business) and for the the total equity value today. 3 power-generation units using appropriate WACCs for each.  Meralco: SOTP valuation Total equity Meralco’s Attributable Value per % of We use a WACC of 9.66% for the distribution business. value stake equity value share total (PHPm) (PHPm) (PHP/sh) This is higher than the computed discount rates of Parent (distribution) and others 330,314 100% 330,314 293.07 90% 7.18% for both SBP and GBP and 6.08% PacificLight. PacificLight 26,357 28% 7,380 6.55 2% The key difference is the weights of the market value of San Buenaventura Power (SBP) 27,722 51% 14,138 12.54 4% equity and debt, except for PacificLight, for which we Global Business Power (GBP) 61,142 22% 13,451 11.93 4% have used the different risk and return parameters Total 324.09 100% Target price 324.00 applicable in Singapore.

No of outstanding shares 1,127.10 With strong cash flow generation from its distribution Source: Daiwa estimates business, Meralco (parent) has minimal debt on its balance sheet and is currently in a net cash position. As Among Meralco’s power-generation projects, its 51% a result, its debt/equity mix is skewed to the (market stake in SBP’s 500MW coal plant provides the largest value of) its equity, with the weighting at 90:10. contribution to our TP, at PHP12.54, followed by its Meanwhile, we have applied a 50:50 weighting for debt 22% stake in GBP, at PHP11.93, and its 28% effective and equity for the unlisted power units. We assume interest in the 800MW LNG plant in Singapore, at terminal growth rates of 3% for the company’s PHP6.55. Philippine-domiciled business and 2% for its Singapore-based power unit.

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Meralco: DCF parameters of 8.0x for 2015E and 9.4x for 2016E. These compare San Global with the estimated regional peer averages for 2015 and Parent and Buenaventura Business others Power Power PacificLight 2016 of 2.4x and 2.2x PBR, and 9.4x and 8.9x WACC 9.66% 7.18% 7.18% 6.08% EV/EBITDA. Cost of equity 10.34% 10.50% 10.50% 8.00% Risk-free rate 4.50% 4.50% 4.50% 2.50%  Meralco: 12-month forward PER bands Equity beta 0.97 1.00 1.00 1.00 Market risk premium 6.00% 6.00% 6.00% 5.50% (PHP/sh) After-tax cost of debt 3.50% 3.85% 3.85% 4.15% 500 28.8x Terminal value 3.0% 3.0% 3.0% 2.0% 450 Terminal year 2024E 2024E 2024E 2024E 400 23.0x Source: Da