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M

ASTERS IN

F

INANCE

E

QUITY

R

ESEARCH

- In our view, REN may be an attractive long-term

investment. Assuming our base case, it will be trading at a

6,99X EV/EBITDA (2012E), with the trend to increase and

converge with its European peers.

- Generous changes in Electricity regulation – Regulation gives now higher incentive for investors through greater rates of return on the remunerated asset base. With this, CAPEX continues to REN’s greatest value driver. - In the other side of the coin, come more demanding efficiency factors that will harm future revenues. - REN is controlled by the Portuguese Government through its 51% stake and 40% of this will be sold in two blocks (25% and 15%) within the next year allowing for a new major holder. We identify a strong relationship with the

Portuguese Republic such that REN is directly affected by

the increasing Portuguese sovereign debt issues. This will affect the company’s access to the capital markets to finance its investment plan. There will be a CAPEX

decrease for all sectors reducing the value of the company.

-Our price target considered the following scenarios:

R

EDES

E

NERGÉTICAS

N

ACIONAIS

C

OMPANY

R

EPORT

U

TILITIES

06

J

ANUARY

2012

S

TUDENT

:

M

ARIA

A

DELAIDE DO

C

ARMO

E

LIAS E

S

ILVA

T

AVARES

;

#299

mst16000299@novasbe.pt

Recommendation: HOLD

Vs Previous Recommendation BUY

Price Target FY12: 2,22 € Price (as of 3-Jan-2012) 2,09 €

Reuters: RENE.LS; Bloomberg: RENE:PL

52-week range (€) 2.63 - 1.81 Market Cap (€m) 1.051,980 Outstanding Shares (m) 534 Source:Bloomberg

Source: Bloomberg

(Values in € Millions) 2010 2011E 2012F Revenues 1.225 854 912 EBITDA 431 441 456 EBITDA growth 12,3% 2,3% 3,4% Net Profit 110,3 115,2 87,4 EPS 0,206 0,22 0,216 DPS (€) 0,168 0,168 0,168 ROE (%) 10,79 11,13 8,53% Dividend Yield (%) 6,48 6,04 4,91 EV/EBITDA 7,68 7,81 6,99 CAPEX 443 326 320 RAB 2.964 3.128 3.354 Source: Company data; Analyst estimates

Company Description

REN – Redes Energéticas Nacionais, SGPS, S.A., owns the monopoly of the electricity and natural gas transmission networks in Portugal through concession contracts. REN also has two residual businesses in telecommunications and electricity derivative market management.

Racing with Portugal…

Waiting for better macroeconomic conditions to

regain its identity.

Probability Price (€) Recommendation Base Case 60,00% 2,89 Buy Intermediate Case 25,00% 1,83 Hold Survival Case 3,88% 0,52 Sell REN Default 11,12% 0 Sell Price Target

Return

2,25

12,90% Hold

Considered scenarios Source: Analyst estimates

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Table of Contents

MACROECONOMIC OVERVIEW ... 3

ENERGY MARKET OVERVIEW ... 4

COMPANY OVERVIEW ... 6

SHAREHOLDERS STRUCTURE ... 7

SEGMENTS ... 8

ELECTRICITY ... 8 Description ... 8 Regulation Analysis ... 8 Valuation ... 14 Sensitivity Analysis ... 16 NATURAL GAS ... 17 Description ... 17 Regulation Analysis ... 18 Valuation ... 19 Sensitivity Analysis ... 21

WACC ... 21

SUM OF THE PARTS ... 23

IN A WORLD WHERE ANYTHING MAY HAPPEN ... 23

DEBT ANALYSIS ... 25

COMPARABLE COMPANIES ... 26

STILL SPACE FOR GROWTH? ... 27

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Macroeconomic Overview

Europe

Sovereign Debt, Euro Crisis and recession have definitely been the hot topics of the last few months and will likely remain so in next years’ debates. Severely deteriorating confidence, financial disorder and differences among Euro countries are adversely affecting consumption and investment. Couple this with a tightening of fiscal policies across countries; Europe has been facing a weakening of economic conditions and lower domestic demand. Following the 2008 financial crisis, speculation around the sovereign debt of European peripheral countries (as Greece, Ireland and Portugal) has been rising, skyrocketing yields and leaving these countries with many difficulties to meet their debt obligations. On April 2010, the Greek Government filled for the EU/IMF bailout package. This announcement had a strong impact on the economy. In the same month, Greek sovereign debt was downgraded to junk and stock markets across the world declined immediately. After this, in 2011, Portugal became the focus of Europe’s attention, The Portuguese government also requested for a rescue package and systemic contagion across the Eurozone started to be the primary concern. This is evident in figure 1, with the scaling of PIIGS bond spreads. Financial markets are now more risk averse and paying more attention to banks’ exposure to these countries’ debt. With the aim of overcoming the sovereign debt turmoil, Angela Merkel, Germany’s Chancellor, and Nicolas Sarkozy, President of the French Republic, have been leading several meetings to set new rules for the Eurozone. An important outcome may be new and more rigid limits on countries’ debt, but its efficiency is doubtful due to the failure of the former Stability and Growth Pact.

Portugal

2011 has been a tough year for the Portuguese economy. Besides the international financial crisis, Portugal has been facing many debt concerns. The impossibility to face its debt obligations required the need to fill for the IMF, ECB and EU rescue fund. This was followed by the constant credit downgrading from the major rating agencies. Credit agencies classify now the Portuguese long-term debt rating as Ba2/BBB-/BB- Figure 1 – Sovereign bond spreads

Source: ERSE

Figure 2 – Euro Area Macroeconomic indicators Source: IMF

Constant Credit downgrading is now leading to an economic recession vicious cycle…

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PAGE 4/32 (Moody’s/Standard&Poor’s/Fitch). In this situation, Portugal entered in a vicious cycle. The contracting policies will reduce the domestic demand and the natural result will be an even stronger slowdown of economy pace, postponing any recovery prospects. This prolonged recession will increase unemployment levels, which in turn will reduce again the demand. This cycle comes as an outcome of the fiscal measures required to correct the budget misalignment with the purpose of assuring a sustainable growth in the future. This macroeconomic scenario will present a big challenge for REN. This is a company which operates solely in Portugal (for now) and its debt is seen by the major rating agencies as a replica of the Portuguese Republic debt. The ability to finance its projects through debt will be seriously harmed by this situation as well as its value since every time the Country’s debt is downgraded, so is that of REN.

Energy Market Overview

Electricity accounts for a big part of the world’s energy demand. According to the U.S. Energy Information Administration (EIA), Internationl Energy Outlook

2011, Electricity generation in the European OECD nations will increase by

1,2% yoy until 2035. This represents an increase from 3,4 trillion kWh in 2008 to 4,8 trillion kWh in 2035. Because, most of the OECD countries already present a steady population growth, the electricity market is already considered as a mature one. Its growth comes mainly from nations with greater population growth rates such as Turkey, Ireland, and Spain and from recent OECD members whose estimated economic growth rates surpass that of the OECD average. A general trend that might materialize around all countries is the increasing environmental concerns. This may lead to the swap from coal and liquid fuels to electricity in the industrial sector. Additionally, there will be a major shift in the overall energy value chain since it is expected a strong increase in the technologies dependent on electricity as energy source (electric vehicles, heat pumps, etc). Electricity generated from renewable sources will also increase in the near future. According to the Europe’s Energy Portal, it is expected that the latter source will more than double in the period 2007-2020. All this will certainly have a positive impact in the electricity demand around Europe.

Portugal is the country from EU15 with the lowest per capita electricity consumption. One reason for this can be the low level of industrial production

3,8 4,4 5,7 5,9 6,7 7,1 8 8,8 10,6 13,8 16,4 Spain Ireland France Austria Europe (15) Italy Germany UK Belgium Netherlands Luxemburg Gas Consumption MWh per capita - 2008 Figure 3 – Portuguese macroeconomic

indicators Source: IMF 14,5 13,3 12,4 7,3 7,2 6,9 6,6 6,3 6,0 5,7 5,6 5,6 5,4 5,2 4,9 4,8 4,5 Finland Sweden Luxembourg EU15 Belgium Austria France Netherlands Germany Denmark Ireland Spain EU27 UK Greece Italy Portugal Final electricity consumption 2009 (MWh per capita)

Figure 4 – Electricity Consumption Source: Eurostat

Environmental concerns will in turn contribute to an increase in

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(SEE DISCLOSURES AND DISCLAIMERS AT END OF DOCUMENT) in Portugal. However, this low value shows that there is still a market to explore with growing prospects coupled with the aim of converging with the remaining European values. In fact, despite the global slowdown of the electricity use growth rate during the recession period of 2008-2009, 2010 experienced a rebound of the demand which was led mainly through robust recoveries in non-OECD economies. Therefore, we expect a general increase in this sector for the developed and emerging countries although we must look with care to the Portuguese market as there are little or no prospects of strong economic recoveries in the short-run.

With the expected electricity demand and renewable energy usage increase, REN will face many challenges. Electricity grids must be modernised and upgraded to respond to the demand increase. The generation of renewable energy in low populated regions will require the company to be more efficient in the energy transportation via higher voltage connections. Also the renewable energy and European energy efficiency targets will only be feasible with smarter grid services and more intelligent networks. This comes only as a positive aspect for REN since this will give space for the company to grow in a country where there is already a solid electricity network. These challenges will demand innovation that will most likely increase efficiency and create value for the company.

Natural Gas consumption in Europe has been growing and it is expected to keep pace with the growth in electricity consumption. Natural Gas is one of the most preferred sources for energy generation due to its low carbon intensity. Many Governments in Europe are strongly committed to reduce greenhouse gas emissions and develop cleaner energy production. Additionally, it allows a reduction in Europe’s oil dependency. According to EIA, Natural Gas will be the second energy source to face greater growth rates in Europe (with Renewable sources in first place). This growth will certainly include the Portuguese territory as Portugal presents one of the lowest values of gas consumption. Such as in electricity, the Gas sector also faced a decrease during the international economic recession but registered a recovery in 2010.

Figure 5 – Gas Consumption

Source: Eurostat 1,6 3,1 4,6 6,9 7,6 7,9 8,3 10,0 10,9 11,2 12,4 13,2 14,8 16,3 24,8 26,2 Sweden Greece Portugal France Finland Spain Denmark Austria Germany Ireland Italy EU15 UK Belgium Netherlands Luxembourg Final Gas consumption 2009 (MWh per capita)

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Company overview

REN – Redes Energéticas Nacionais is a Transmission System Operator (TSO) that incorporates both electricity and natural gas infrastructures. REN’s operations are mainly concentrated in these two sectors.

In electricity, REN operates the very-high voltage transmission services and the overall technical management of the National Electricity System in Portugal (SEN – Sistema Eléctrico Nacional). These activities are performed through a 50 years concession attributed by the Portuguese State in public service and exclusiveness to REN S.A. in 2007. In October 2010, the Portuguese State accredited REN, through ENONDAS, with a concession (lasting for 45 years) for the electricity generation by wave energy in a pilot zone in S. Pedro de Moel.

Regarding the Natural Gas services, REN is responsible for the high-pressure transmission, the overall technical management of the National Natural Gas System, the reception, storage and regasification of natural gas (LNG) and underground storage. This sector is operated also through a Portuguese State concession that started in 2006 and lasts for 40 years. Additionally (although representing a small stake in the business), REN is also present in the telecommunications sector, exploring the extra capacity from the electricity network. Also, REN trades energy derivatives in OMIP, S.A. (Operador do Mercado Ibérico de Energia, S.A.) which majority is owned by REN. The principal businesses (Electricity and Natural gas) account for almost 100% of the company’s revenues and value. In figure 6 one can see the EBITDA evolution regarding these two segments and the importance of each of them.

- History at a glance

REN firstly started as Rede Eléctrica Nacional (operating only in the electricity segment) as a subsidiary of EDP – Energias de Portugal which is the company now responsible for most of the electricity generation, distribution and commercialization. Only in the year 2000, REN got juridical independency from EDP. Step by step, REN has been entering in other sectors in which it currently operates. In 2007, Rede Eléctrica Nacional became REN – Redes Energéticas Nacionais and it is done its IPO

Figure 6 – EBITDA Evolution Source: Company data

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(SEE DISCLOSURES AND DISCLAIMERS AT END OF DOCUMENT) Today, the company is organized as shown in figure 7.

Shareholders structure

REN’s shareholder structure is highly concentrated with 51% being under the Portuguese Government through Capitalpor SGPS, S.A., Parpública, SGPS, S.A. and Caixa Geral de Depósitos.

With the Financial programme agreed with “Troika”’, the Portuguese Government is responsible for selling this 51% stake. Although in June 2011 the Prime-Minister announced that the privatization was expected to be closed by September 2011, it was postponed for 2012, waiting for better market conditions that would favour REN’s strategy and value. For the moment, the Government plans to keep 11,1% for a later third privatization, most likely for free-float increases. Concerning the remaining 40%, this will be divided in two blocks, one of 25% and other of 15% (there is also the possibility of this being divided in other 2 blocks of 10% and 5%). The main parties interested so far are the Chinese company State Grid, the English National Grid, Brookfield Management and Oman Oil.

REN - Redes Energéticas Nacionais, SGPS, S.A.

Electricity Concessions REN - Rede Eléctrica Nacional, S.A. 100% Enondas, Energia das ondas S.A. 100% Natural Gas Concessions REN Armazenagem, S.A. 100% REN Atlântico Terminal LNG, S.A 100% REN Gasodutos, S.A. 100%

REN Serviços, S.A. 100% RENTELECOM Comunicações , S.A. 100% OMIP, SGPS, S.A. 40%

REN Trading, S.A. 100%

Figure 7 – Organizational Chart Source: Company data

46% 4% 1% 5% 8% 6% 5% 5% 1% 19%

Shareholder

Structure

Capitalpor, SGPS,S.A. Parpública, SGPS, S.A. Caixa Geral de Depósitos, S.A. EDP - Energias de Portugal, S.A. EGF - GCF, S.A. Gestmin, SGPS, S.A. Oliren, SGPS, S.A. Red Eléctrica Corporación, S.A. Own shares Free float

Figure 8 – Shareholder Structure Source: Company data

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REN SEGMENTS

ELECTRICITY

The National Electricity System in Portugal (SEN – Sistema Eléctrico Nacional) is divided in five major functions: generation, transmission, distribution, supply and operation of the electricity market. Within this framework, REN is responsible for the electricity transmission.

REN has the following responsabilities:

Global use of the System: This function involves programming and

constantly monitoring the matching between the electricity demand and supply.

Transmission of Electrical Power: With its national grid, REN covers all

continental Portuguese territory. At the end of 2010 REN had an equivalent interruption time of 1,15 minutes and a total of 8.049 km of transmission lines of 400, 220 and 150 kv (the network map can be seen in figure 9).

Throughout these lines and the 63 transformer substations, REN is then able to connect to all electro producer centres and then transport and transform the energy until 60 kv to deliver do EDP Distribuição, the company responsible for the electricity distribution. Additionally, REN connects the Portuguese electricity system with Spain through nine lines.

Electricity Regulation Analysis

As regulated activities, REN revenues are defined by the Portuguese regulator ERSE – Entidade Reguladora dos Serviços Energéticos. The allowed revenues that concern the global use of the system and the transmission of electrical power are recovered by the tariff of Overall Use of the System and the tariff of the Use of the Transmission Grid. In the regulatory period of 2009-2011, the allowed revenues are illustrated in figure 10.

Figure 9 – Electricity Network map

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Since 2010, in addition to the revenues presented in figure 10 the company presents revenues and operational costs defined as Revenues (costs) from construction of concession assets that comes from the adaptation of IFRIC 12.

One of the most relevant changes in the regulatory period of 2009-2011 was the mechanism of valuing the new investments after January 1st 2009 at standard costs. This in what for remuneration concerns, the value of the assets is realized at a standard cost and not at its real/incurred cost (there is a 10% upside limit for the real costs when compared to the standard costs). This requires that the company must assure an efficient plan of its investments, controlling for excessive costs and benefiting electricity consumers. In our Base case we assume that the company is able to efficiently allocate 70% of its investment to assets remunerated at a rate with premium and the remaining 30% of the capex to be invested in “expensive” assets that surpass the standard costs in more than 10%.

The presented regulation parameters correspond to the 2009-2011 regulatory period. On 15th December, ERSE has disclosed the new

Allowed Revenues

Return on Capital • ROR*RAB(1) ROR=7,56%(2 (assets in operation before Jan 1st 2009, at incurred costs) ROR=9,06%(2) (assets in operation after Jan 1st 2009, at standard costs) +Depreciations Recovery of Net Operating Costs • OPEX growth is limited to (CPI-0,5%) • Additional OPEX induced by grid expansion is accepted by ERSE on incremental basis • Environmental and forest cleaning costs are treated as accepted costs Recovery of Tariff Deviations from Previous Year • Tariff Deviations in n-2*(1+3M Euribor Avg + spread2009)* (1+3M Euribor Avg + spread2010) • Spread for 2009 and 2010: 1,0% and 1,25% Fully Depreciated Assets in Use • α*(fully amortized assets/number of years)* (1+0,5*9,06%(2)) • α2009=20% • α2010=30% • α2011=50% Incentive to the Availability of the Network • -1M€≤Inc(I)≤1M€ • AR*≤96,5% -> I=-1M€ 96,5%<AR<97,5% -> -1M<I<0 • AR=97,5% -> I=0€ • AR≥98,5% -> I=1M€ 97,5%<AR<98,5% -> 0<I<1M€ • *AR: Availability Rate (1)

RAB = Regulatory Asset Base (2)

Rate of Return (ROR) = Indexed to 10 Year Portuguese Treasury Bonds (which is to be set annually as an average of daily yield

from 1st Sep (t-2) until 31st August. (t-1)) with a spread of 300 bps for investments prior to 2009and 450 bps for investments after Jan 1st 2009.

Figure 10 - Allowed Revenues Source: Company data

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0 0,5 1 1,5 2 2,5 3 3,5 4 4,5 01-01-2010 01-01-2011 01-01-2012 %

Yields AAA Euro Area Countries

AT FR

DE NL

FIN

Figure 11 – AAA Euro Area Yields Source: Bloomberg

parameters for the new regulatory period that starts in 2012 and lasts to 2014.

The new parameters have a significant impact in the value of the company. The more risk adjusted and increased rates of returns are able to compensate for a more demanding efficiency from the regulator.

One of the main turning points is regarding the RoR of the remunerated assets. To compute this, the regulator presented changes in both the risk

free rate and the additional spread. The risk free rate is computed as the

average of the 10y Treasury bonds for the main AAA Eurozone countries (Germany, Finland, France, Austria and Netherlands). The reason for this comes from the regulator believing that German Bonds are overrated due to its increasing demand which in turn comes as the general perception of this security as a refugee asset. The risk free rate was then computed as the average from the previous 3 years to August 2011. This value was set as 3,41% and will remain constant for the entire regulatory period for a more stable and transparent framework.

We do agree with this rational. However, we do not believe that the average of these countries’ rates is the most “risk free” solution since we consider that countries such as France face a relevant contagious risk from the current crisis which might come implicit in its rates. In turn, this will provide an upward bias to this rate. Indeed, one can see from figure 11 that the French yield is above the AAA countries average. Therefore, although 3,41% is a reasonable value, this must be reconsidered in the next regulatory period.

For the definition of cost of debt, the regulator considers a premium for the debt as a consequence of the downgrade of the Portuguese Republic credit rating and the alignment of the national companies with these credit rating changes (refer to ERSE document for the derivations of this conclusion). For the calculation of this value, ERSE assumed the average of the 5 year CDS from EDP for the period April-August 2011, resulting in a 4,3% debt premium. The reason for choosing EDP is that ERSE considers that although EDP registers a more favourable rating, the fact that REN’s debt has a substantial part coming from EIB, the latter company compensates its increased risks, getting to a more comparable position to EDP. Additionally, EDP is the only national electric company with a relevant international position that allows for

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(SEE DISCLOSURES AND DISCLAIMERS AT END OF DOCUMENT) a sufficient CDS liquidity to perform a solid analysis. Afterwards, this spread is summed to the risk free rate, resulting in the cost of debt.

However, we find some arguments opposing this methodology since the CDS values follow the yields spread movements which will approximate the cost of debt value to EDP’s yield: ( ) . This methodology will clearly overestimate the cost of debt and consequently the return on the company’s assets since what the debt holders expect to receive is the expected value of the debt return ( ) and not the maximum amount that they can receive. To analyse our considerations for the cost of debt refer to chapter WACC.

The 4,3% premium obtained is much higher than the common premium considered by the remaining regulators in Europe. To compute the debt premium, the majority of the companies refer to comparable companies, although only a few consider comparable’ CDS. The UK regulator is one of them and considers credit spreads for companies with credit ratings of A and BBB. However, the obtained value is much lower than the one considered by ERSE (1,25% against 4,3%). We believe that this difference reflects also some country risk that derive from the macroeconomic differences amongst countries. Being the European average of 1,5%, we believe that this premium might decrease in a future regulatory revision in the case of a more stable macroeconomic environment.

The Market Premium considered by the regulator was obtained from a recent study which assesses analysts, academics and company’s opinions about the market risk in different countries. The result obtained was of 6,5%. Using this method, ERSE distinguishes from the common European regulators methodology. The majority of them such as the UK, Netherlands and Luxembourg regulators base its market premiums in publications from Dimson, Marsh and Staunton. ERSE beliefs are that these studies are based on mature and stable markets which do not represent the current Portuguese reality. In fact, with the method used by ERSE, there is a higher premium for investing in equity rather in risk free assets when compared with the premiums considered by other regulators (which remain in the range 3%-5,9%). With this, ERSE tries to incorporate the systematic country risk.

Despite a similar methodology, ERSE considers a higher Debt Premium than the European average.

Overestimation of REN’s cost of debt…

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Minimum Maximum Risk free

Debt premium Cost of Debt (before taxes)

Cost of Debt (after taxes) Gearing Market Premium

Equity Beta 0,51 0,60

Cost of Equity (before taxes) 9,81% 10,69%

Cost of Equity (after taxes) 6,72% 7,32%

Tax Rate

Cost of Capital (before taxes) 8,76% 9,20%

Spread over Rf Cost of Capital for assets at real

costs

Premium for assets at reference costs

Cost of Capital for assets at reference costs 9% 1,50% 10,50% 6,50% 50,00% 31,50% 5,60% 5,28% 7,71% 4,30% 3,41%

Parameters for Cost of Capital

Table 1 – Electricity Regulated Cost of Capital

Source: ERSE

As it did in previous premiums, ERSE apprehends an increased systematic risk (β=0,6) for REN than the other regulators for the correspondent TSOs (0,26-0,48). However, in this case we do believe that ERSE has done a better assessment of the TSO risk than other countries. Since we have been seeing a strong relation of REN’s value with the macroeconomic conditions in which it operates. In fact, we do believe this value to be almost double as the one considered by ERSE and it is presented in the WACC chapter.

With the discussed parameters, ERSE achieved a 7,32% after tax cost of equity.

To compute WACC, the regulator assumed a 50% gearing to compound the cost of debt and Equity. Such as other European regulators, ERSE considers a theoretical debt level. The Netherlands and Luxembourg regulators for instance, consider an optimum theoretical value of 55% and 50% respectively while UK’s regulator considers a 60% Debt level by market analysis and credit rating agencies assessments. Having this, we believe that ERSE will continue to consider a theoretical level for future regulatory periods, going in line with its “peers”.

By table 1, one can see that ERSE has presented an interval for most of the parameters and achieved a final cost of capital of 9% for the year 2012. This RoR will be for the assets put into operation before 2009. For the assets put into operations after 2009 at standard costs the regulator kept the 1,5% premium which results in a 10,5% remuneration rate for these assets.

An important aspect of the new regulation framework, is that now the

spread of the cost of capital over the risk free rate is not anymore

indexed to the average of the daily 10Y Portuguese Treasury Bonds from September of year t-2 to August, year t-1. For the next regulatory period, the spread will be indexed to the daily average of 5 year Portuguese Republic CDS from October from year t-1 until September year t. From this average it will be excluded the higher and lower 1/12 quotations.

The starting point for the indexation of the CDS is 7,80%. In this methodology it was also considered a step up and a step down of the indexation: If the Portuguese Republic CDS increases (decreases) amid 0% and 3%, the RoR will face a step up (step down) between 0% and 0,75%. In the case that the CDS increases (decreases) among 3% and 7%, the RoR will increase (decrease) by 0,75% more (less) with a total variation limit of ±1,5 p.p.. By figure 12 one can have a better and more intuitive understanding of the Figure 12 – Spread Indexation

Source: ERSE

Better Equity Beta assessment than the remaining European regulators…

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(SEE DISCLOSURES AND DISCLAIMERS AT END OF DOCUMENT) indexation mechanism. With this system, the RAB remuneration will try to compensate the increases and decreases in future cash flows that result from an increase/decrease in the company’s risk.

From all this analysis, we conclude that the regulator has overestimated the company’s risk and therefore provided REN with higher remuneration rates. The increases in the RoR might be due to the fact that with the approximation of the sale of the 40% Government stake, the Portuguese Government may want the company to be more attractive in order to achieve a better price for the deal.

In fact, by figure 13, one can see that REN presents an attractive rate of return when compared to other European companies, “competing” only against the Spanish REE which presents a higher rate. Opposite to these companies, REN faces a short regulatory period (3 years). This consents a higher uncertainty in its cash flows but at the same time allows for a faster adaptation to structural changes of the economy. This was the case now, with the changes in the indexing methodology to better respond to the recent changes in risk. Another difference in Portugal is that its RAB is not adjusted to inflation, being therefore the rate applied on the assets at the acquired value, not being updated to inflation as it is in Spain. This comes as a big disadvantage as the asset base devaluates through time.

Regarding the OPEX recovery, the regulator have analysed the performance of the company’s costs so far and its relation to the limits imposed. By figure 14, it is straightforward to see that the company has not been able to meet the accepted costs throughout the years except to the year 2010. Analysing this by regulatory period we can say that the decrease in costs from the regulatory period of 2006-2008 to 2009-2011 was only about 1,6%. Considering the fact that 1% is due to technologic progress (assumed by ERSE), then, there was only a 0,6% decrease from efficiency gains. We do not believe that this was the decrease ERSE expected from the implementation of this methodology. As predicted, ERSE increased the efficiency factor for 2012-2014 for 3,5% starting from a base value in 2012 that corresponds to the average of allowed costs from 2009 to 2011.

Considering the CPI value for 2013 and 2014 of 1,5% and 2,5% respectively, this will require the company to actually reduce its operational costs by 2% and 1% in these years. Analysing the historical performance of the company we do not believe that this will come true. The consequence of this is that, 7,70% 4,40% 6,23% 6,90% REE National Grid Terna REN Electricity

RAB RoR

(nominal, after tax)

Figure 13 – RoR Comparable Companies

Source: Companies’ data

Figure 14 – OPEX growth Source: ERSE

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(SEE DISCLOSURES AND DISCLAIMERS AT END OF DOCUMENT) not meeting ERSE requirements, the company will face extra costs, this is, the difference between the realized expenditure and its recovery. Regarding the incentive for the fully depreciated assets, the framework will remain the same except for the efficiency factor that will go from 0,75% to 1,5%. Concerning the incentive to the availability of the network, there will be no changes for the next regulatory period.

Regarding the Interests on Tariff Deviations, there has been a significant decrease on its amount in the latest years and changes in the spreads will have limited impact on our valuation.

Valuation

For the period 2010-2016, REN plans to spend as capital expenditures a total of €3,2B in which €2,29B will go directly to the electricity concession segment. As RAB’s remuneration is one of the major value drivers, we assume that the capital expenditures will go to the company’s RAB. Historically, the return on RAB has accounted for 30% of total revenues, being therefore, one of the most important items when valuing this sector. In fact, changes in RAB have been accompanying the amount registered as capital expenditure and we expect this to continue in the future. However, we believe this capex plan to be highly ambitious for many reasons. Firstly, Portugal is facing difficult economic conditions which can seriously harm the financing ability to support the plan execution. Additionally, REN argues that it believes in a future increase in the electricity consumption that justifies an expansion of the network. The reasons for this increase in demand are mainly due to:

 Convergence with the lifestyle and European comfort;

 Economic growth;

 Specific projects such as: High speed train lines and the new International Lisbon Airport.

Nonetheless, we do not believe that these conditions will go as imagined. Although there is still space for the electricity networks to grow and we believe they will do so, we reject the first two bullets, for the reasons highlighted in the macroeconomic overview. Regarding the specific projects argument, due to the recession and troika mandate, it is not expected that the new airport project will go ahead in the short term and, in what concerns the high speed train, either the construction will be postponed or the scope of 14% 13% 4% 28% 7% 34%

Electricty investment

Internal grid reinforcement

Environmental improvement

Integration of thermal generation

Integration of Renewables

Interconnection reinforcement

reinforcement to distribution grid & EHV consumers

Figure 15 - Electricity's investment breakdown

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(SEE DISCLOSURES AND DISCLAIMERS AT END OF DOCUMENT) the project will be shortened, demanding less electricity than was previously estimated.

Additionally, EDP has already publicly said that it will decrease its investment plan in the following two years. This has direct influence in REN’s investment plan since 28% of this will be for the integration of renewable energies. In fact, a few days later, Rui Cartaxo, REN’s CEO, also stated that there should be a highly rigorous management of its debt and investments thus, verifying a slowdown in its capex.

For these reasons, we do not believe that REN will be able to fully execute its capex plan as we strongly believe that this is overestimated and will most likely be revised at the end of 2011. This information will only be disclosed in the next shareholders meeting that is expected to take place in April 2012. For valuation purposes, we assumed a base execution rate of 70%. This leads us to an annual spending of €230.922k, much lower than the €293.638k spent in 2010.

This will significantly decrease estimated revenues as the return on RAB is the major revenue streaming. As it can be seen from Figure 16, the opex recovery amount has been decreasing throughout time. This is expected to continue in the near future coming mostly from the more demanding efficiency factors which represent a tough challenge for REN to cope with. As a result, we can see the values explicit in table 2 where we predict an increasing EBITDA margin in the next few years that derive mainly from the increase in revenues.

Figure 16 – Electricity Revenues Source: Company data, Analyst Estimates

(Non Land RAB concerns all RAB excluding Hydro land)

50.000 100.000 150.000 200.000 250.000 300.000 350.000 400.000 2009 2010 2011E 2012E k€ Regulated Revenues Others Recovery of depreciation Opex Recovery

Return Non Land RAB

Table 2 – EBIT Break down

Source: Company data; Analyst estimates

Thousands € 2009 2010 2011E 2012E 2013E 2014E 2015E 2016E Return on non-land RAB 111.200 126.463 137.489 186.963 206.188 224.684 242.475 259.585

Recovery of OPEX 66.400 68.800 64.276 120.000 117.240 114.895 112.712 110.571

Recovery of depreciation 102.000 109.200 120.431 129.259 139.298 148.938 158.199 167.090

Others 76.600 33.500 31.665 18.586 18.147 17.714 17.292 16.876

Construction revenues - regulated assets 355.000 293.000 255.593 223.815 223.815 223.815 223.815 223.815

Total Revenues 711.200 630.963 609.454 678.622 704.688 730.047 754.493 777.938

OPEX 99.400 69.000 72.200 120.000 121.440 123.262 125.234 127.238

ConstructionCosts - regulated assets 333.500 271.900 225.306 223.815 223.815 223.815 223.815 223.815

EBITDA 278.300 290.063 311.948 334.807 359.433 382.970 405.445 426.885

EBITDA margin 39% 46% 51% 49% 51% 52% 54% 55%

Depreciations 94.105 95.487 134.619 146.548 157.931 168.860 179.360 189.440

Financial Income 2.589 2.684 4.272 996 1.083 979 877 1.018

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(SEE DISCLOSURES AND DISCLAIMERS AT END OF DOCUMENT) For the Electricity segment valuation, we consider a nominal growth rate of 2,5% (translating in a 0,5% real growth rate) as we consider the possibility of internationalisation due to the recent negotiations with Electricidade de Moçambique, the electric company in Mozambique. Mozambique is a country with a considerably lack of infrastructures that are expected to be developed in the future (for more information about the Mozambican market refer to section “Still place for growth?”). Furthermore, the investors interested in REN’s second privatization are mainly international companies with energy interests. We believe them to intend to play an active role as shareholders, contributing with their know how for possible synergies and incentive for international expansion. The WACC used was of 7,51% and is explained in the WACC chapter.

With this, we achieved the results presented in table 3.

Sensitivity Analysis

Changes in the regulation can have significant impacts in the value of the company. In table 4 is presented a sensitivity analysis of REN’s share price target (weighted average price) to the rates of return values in the new regulatory period for our Base Case. Coloured in blue, we can see the cases where we would change to a BUY recommendation. Nonetheless, there is no case where we would drastically change our recommendation to SELL due to the step down of the indexation in the new RoR methodology. This sensitivity analysis considers the limit values of the indexation factor and a mean point between the current value and the limit.

Table 3 – Electricity DCF Breakdown Source: Company data; Analyst estimates

Thousands € 2012E 2013E 2014E 2015E 2016E EBIT 189.255 202.586 215.089 226.962 238.463

Taxes 59.615 63.815 67.753 71.493 75.116

After taxes result 129.640 138.771 147.336 155.469 163.347 Depreciations 146.548 157.931 168.860 179.360 189.440 Changes in NWC 3.219 11.993 21.823 11.866 16.217 Capex 230.922 230.922 230.922 230.922 230.922 Other Investments - 692 4.756 5.706 5.724 895 Other Liabilities - 30.994 4.393 11.606 8.681 36.371 FCF 11.745 53.424 69.352 94.998 3.257.607 Discounted FCF 11.745 49.690 59.996 76.439 2.437.998 EV 2.635.869

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Another critical value driver concerns the ability of the company to fully execute its investment plan. Since RAB is remunerated at a rate of return higher than the rate at it is discounted (WACC), this represents a significant value driver for the company. By executing just more 5% of the planned investment, we would change our recommendation to SELL.

 NATURAL GAS

The Natural Gas System is divided into seven major activities: reception, storage and regasification of liquefied natural gas (“LNG”), underground storage, transportation, supply, operation of the natural gas market and logistic operation for the witching of supplier of natural gas.

Portugal imports most of its Natural Gas through long-term supply contracts with Algeria (one of the main suppliers).

REN operates in the natural gas sector with State concessions through three companies: REN Gasodutos (holds the national gas transmission network and other related assets and is responsible for the reception, transmission and delivery of natural gas), REN Armazenagem (responsible for the underground storage, extraction, treatment and delivery of natural gas to the national gas transmission network) and

REN Atlântico (reception terminal, storage and LNG regasification).

In 2006, REN acquired the LNG terminal in Sines. This has been through notable expansion projects and has still a big importance in the capex plan.

Table 4 – RoR sensitivity analysis Source: Analyst estimates

2,22 9,00% 9,75% 10,50% 11,25% 12,00% 7,50% 1,65 1,78 1,90 2,03 2,15 8,25% 1,81 1,94 2,06 2,19 2,31 9,00% 1,97 2,10 2,22 2,35 2,47 9,75% 2,13 2,26 2,38 2,51 2,63 10,50% 2,29 2,42 2,54 2,67 2,79

ROR Assets With Premium

R O R A s s e ts W it hout P re m ium

Table 5 – Capex execution rate sensitivity analysis Source: Analyst estimates

Execution Rate 60% 65% 70% 75% 80% 90% 100%

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Natural Gas Regulation Analysis

Such as in electricity, these sector revenues also face a strong regulation framework. Figure 17 illustrates the allowed revenues for the gas sector for the regulatory period of 2010-2013.

Although the next regulation parameters will only be disclosed next year, we expect the regulatory framework to remain with a similar structure. We forecast a future trend from the natural gas RoR to the electricity RoR. The gas rate has been higher than the Electricity one (base rate with no premium) as ERSE considered it riskier. Whereas in electricity no one expects technological substitutes, Natural Gas is a resource that can be exchanged for other alternatives. However, as we exposed in the Energy overview chapter, we expect a growing demand supporting the thesis that this risk might not be incorporated in the rates of return for the next regulatory period.

Looking at table 6, one can see that, in what concerns systematic risk there is no evidence of any significant difference in between these sectors’ systematic risk.

Therefore, in our base scenario, we assume a 9% RoR for the regulatory period after 2013, increasing the investment incentives. In figure 18 we can

(1) Smoothing effect only applies to LNG Terminal for a 7 year period

(2) Equivalent X=1,1% for REN Gasodutos and X=1% for REN Atlântico for the regulatory period. X applies both to revenue cap and price cap

Return on Capital +Rate of Return ●Regulatory Assets Base (RAB) +Depreciation (net of subsidy recognition) +/- Smoothing effect(1) Recovery of Net Operating Costs +Regulated Operational Costs +Other Regulated

Non-tariff revenues

●Revenue cap for OPEX growth is limited to (1+IPC-X)(2)

• OPEX induced by network expansion is subjected to a price cap with growth limited to (1+IPC-X)(2)

Tariff Deviations from previous years

+Tariff Deviations in n-2*(1+Euribor 3M +

1%)(2)

Figure 17 - Natural Gas Remuneration Source: Company data

Figure 18 – Regulated Revenues

Source: Company data; Analyst estimates Table 6 – Electricity vs Gas Risk

Source: Bloomberg Electricity Companies Beta

Gas

Companies Beta Terna 0,49 Rete Gas 0,48

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(SEE DISCLOSURES AND DISCLAIMERS AT END OF DOCUMENT) see that this will have a big impact in the Gas valuation as the return on RAB accounts for half of the allowed revenues. Additionaly, as we consider that the natural gas sector ccounts for the same risk as the electricity sector, we will use the same discount rate.

Valuation

For the gas sector, REN projects a CAPEX of €860Millions going directly to RAB increases and maintenance. The expenditure plan will be mainly for the following projects:

 LNG Terminal expansion (Sines);

 Underground storage infrastructure expansion;

This plan entails 5 new caverns. Regarding this aspect we are highly optimistic as REN won the right to explore the two caverns that GALP Energias was fighting for.

 Third interconnection;

 Pipeline network development.

Although the capital expenditures plan for this sector is not as dependent on Government projects as the electricity plan is, we keep our beliefs that the company will not be able to fully pursue its capex plan due to the macroeconomic climate.

Once again we assume for our base case a 70% execution rate. This shortening has a negative impact on the revenues that are derived from the remuneration on RAB that is partially compensated for in the assumed increase in the remuneration rate.

Although in the first nine months of 2011 the company have significantly decreased its operating costs in 58% when compared to the same period in 2010, we do not expect this increased efficiency to keep in the same pace. So far, the company has not been able to achieve the opex cap imposed by the regulator (1+ IPC - X). In the present regulatory period, the efficiency factor is of X=1,1% for REN Gasodutos and X=1% for REN Atlântico. As in electricity, we expect this factor to increase in the next regulatory period, converging to the 3,5% electricity efficiency factor. The forecasts for the natural gas revenues and costs (together with the company estimates) are as shown in table 7. 850.000 900.000 950.000 1.000.000 1.050.000

k €

Natural Gas RAB

Figure 19 - Natural Gas RAB Source: Company data

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Although there is a decrease in EBITDA until 2013, we foresee a notable recovery. This happens mainly in 2014 where we can perceive the strong impact of the assumed 9% ROR. As it can be seen from the results, there are positive prospects for the natural gas sector despite the assumed reduction in the capex plan.

For the valuation of the Gas sector, we assumed a 3% nominal growth rate for the period after 2016 which translates in a 1% real growth rate (considering a 2% inflation rate for the future). For the reasons previously presented concerning the risk levels of both electricity and natural gas, we assume the same discount rate for this sector’s valuation.

In table 8 we present our forecasts for the Natural Gas sector. Table 7 – Natural gas EBIT Breakdown

Source: Company data; Analyst Estimates

Thousands of € 2009 2010 2011E 2012E 2013E 2014E 2015E 2016E

Return on non-land RAB 75.660 79.700 82.145 85.637 88.781 103.416 106.954 110.491 Opex Recovery 33.400 36.500 28.700 29.016 28.348 27.781 27.254 26.736 Recovery of Depreciation 39.800 43.700 43.264 40.974 42.614 42.614 42.614 42.614 Others 40.700 39.600 - 553 1.007 - 2.895 - 430 3.705 7.341 Construction revenues - regulated assets 103.000 126.600 79.924 94.233 83.131 83.131 83.131 83.131

Total Revenues 292.560 326.100 233.481 250.867 239.979 256.512 263.657 270.311

OPEX 51.100 51.400 29.200 29.521 29.875 30.234 30.597 30.964 Construction costs - regulated assets 100.600 122.600 79.924 94.233 83.131 83.131 83.131 83.131

Non recurring items 12.400 4.200 - - -

-EBITDA 128.460 147.900 146.069 138.215 126.973 143.148 149.929 156.217

EBITDA margin 44% 45% 63% 55% 53% 56% 57% 58%

Depreciations 46.028 49.991 45.889 47.389 49.286 49.286 49.286 49.286 Financial Income 3.793 2.697 2.347 481 418 429 390 458

EBIT 86.225 100.606 102.526 91.307 78.105 94.291 101.034 107.390

Table 8 – Natural Gas DCF breakdown Source: Company data; Analyst estimates

Thousands € 2012E 2013E 2014E 2015E 2016E

EBIT 91.307 78.105 94.291 101.034 107.390

Taxes 28.762 24.603 29.702 31.826 33.828

After taxes result 62.545 53.502 64.589 69.208 73.562

Depreciations 47.389 49.286 49.286 49.286 49.286 Changes in NWC 2.513 7.916 8.406 5.281 7.364 Capex 88.588 88.588 88.588 88.588 88.588 Other Investments - 334 1.834 2.501 2.548 403 Other Liabilities - 14.953 1.694 5.088 3.864 16.379 FCF 4.213 6.144 19.468 25.941 1.629.523 Discounted FCF 4.213 5.714 16.842 20.873 1.219.537 EV 1.267.179

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Sensitivity Analysis

As the Natural Gas sector accounts for around 30% of the company’s value, changes in the RoR of its asset base for the future have a significant impact. If, for instance, the RoR increases to 9,50% in the future we expect the price to increase from our price target by 4% to €2,31, changing our recommendation to SELL. This can be seen in table 9 where there is a sensitivity analysis for the impact of changes in the Gas RAB rate of return from our base case on the price of a REN’s share. Regarding the capex plan, this has a more limited impact than in electricity, only changing our recommendation with a 20% increase. As we do not consider this a likely situation, changes in the capex execution plan until 2016 for the gas sector are not a crucial point in this valuation although it is still a value driver due to the fact that its current RoR is still higher than the WACC.

Weighted Average Cost of Capital

Cost of Equity

Regarding the cost of equity, it is relevant to consider important aspects: REN operations are solely in the Portuguese territory and it’s controlled mainly by the Portuguese State. This, together with the fact that its revenues depend on a state owned regulator, lead us to recognise a strong relationship with the Portuguese Republic.

Given the today macroeconomic conditions, we are forced to highlight the importance of the country risk in REN’s valuation.

To assess it, we considered not only the beta for the company but also another one that would mirror the risk implicit in the Portuguese index PSI20. For this we computed the ratio between the volatility of PSI20 and S&P Global and multiplied by its correlation. As we believe the current Portuguese macroeconomic scenario to be seriously contagious to the remaining economy (due to Euro sustainability concerns), we assumed a correlation equal to one. This implies the assumption of a direct contagious risk.

Table 9 – RoR Sensitivity Analysis

Source: Analyst estimates RoR Price (€) 8,00% 2,05 8,50% 2,13 9,00% 2,22 9,50% 2,31 10,00% 2,40

Table 10 – Natural Gas Capex Execution rate Source: Company data; Analyst estimates

Execution Rate 60% 65% 70% 75% 80% 90% 100%

Price (€) 2,19 2,21 2,22 2,23 2,25 2,28 2,30

Table 12 – Cost of equity

Source: Bloomberg; Company data

Risk Free 3,8%

Joint Beta 1,46 Equity Market Premium 6,07%

Cost of Equity 12,69%

Table 11 - Beta inputs

Source: Bloomberg; Company data

Sample Aug 2007 - Oct 2011

Beta 0,83

REN D/E 2

Beta REN 1,22

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Figure 20 - Yield Curve Portugal as of 29th December 2011

Source: Banco de Portugal

Regarding REN’s beta, we considered the beta for the utilities industry by gathering the returns of the utilities from Eurostoxx and leveraged it for REN. For the risk free, we considered the 10 year German Government Bond yield and for the Equity risk premium we considered 6%1. We present the inputs and results in table 11 and 12.

Cost of Debt

Due to the absence of traded long term bonds for REN we attached REN’s yield curve to the Portuguese Republic one. During 2011 we saw a strong relationship between both institutions’ ratings and we believe that this is likely to continue. Once again it is important to stress the business exposure to the Portuguese market as the company has no international diversification. Additionally, the challenging financial conditions REN will face in the near future to fund its capex plan come as a strong constraint for the company. The current traded yield for a short term REN’s bond (2 years) is of 13,19% while a bond with the same maturity of the Portuguese Republic is traded at 14,80%. We extrapolated this relationship for the long term and subtracted from the Portuguese Republic 10year yield the same differential as in the short term. This led to a 10 year yield for REN of 11,72%.

Regarding the recovery rate, we take Moody’s methodology that can be seen in figure 21. We considered the historical average recovery rates and then multiplied them by our expected proportions (40% for long term unsecured debt and 60% for the 1st lien loan). This resulted in a recovery rate of 75%. Concerning the default rate, we considered Moody’s publication where it considers a 11,12% default rate for a Ba1 rated company. Having this, we achieved a 7,64% cost of debt.

Having these values calculated we are able to compute the Weighted Average Cost of Capital (WACC). In table 13 one can find the inputs and the discount rates for REN’s cost of capital.

1

Elroy Dimson, Paul Marsh, and Mike Staunton 87% 40% 68% 33% 63% 25% 52% 15%

1st Lien Loan Sr. Unsec. Bond Historical average

Current LGD Assessment Average Downturn Stress Downturn Figure 21 – Recovery rates

Source: Moody’s: Corporate Default and Recovery Rates, 1920-2008. February 2009

Table 13 – WACC

Source: Company data, analyst estimates Cost of Equity 12,69% Cost of Debt 7,64% Debt 2.341.805 Equity 1.032.220 Tax rate 31,5% WACC 7,51%

Imagem

Figure 7 – Organizational Chart  Source: Company data
Figure 10 - Allowed Revenues  Source: Company data
Table 1 – Electricity Regulated Cost  of Capital
Figure 16 – Electricity Revenues  Source: Company data, Analyst  Estimates
+7

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