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Tauron BRE Bank Securities BRE Bank Securities 16 August 2010 Research Report Tauron Power Utilities Poland Buy TPE PW; TPE.WA Offering price PLN 5.10 Target price PLN 8.42 Market cap PLN 8.1bn (New) The Biggest Seller of Electricity in Poland As the second-largest vertically integrated energy producer in Poland, the company offers a way to buy into the power-generation sector, as well as into retail electricity and distribution. The main factors that are Free float PLN 4.8bn expected to drive Tauron's consolidated earnings in the future include an expected increase in energy prices in Poland, combined with Avg. daily trading volume (3M) PLN 52.37m steady mining costs, an expanding capacity (including in renewable energy), growing sales volumes, and a new approach to setting Shareholder Structure distribution tariffs. Based on our forecasts and two valuation methods, State Treasury 36.17% we estimate the value of the Tauron stock at PLN 8.42 per share and KGHM 5.15% we recommend buying it. Others 58.68% Sector Outlook The Polish power utilities sector is expected to correlate increasingly with EU markets, and energy prices are converging to EU averages. The convergence process should be supported by increasing electricity usage accompanied by a hiatus in capacity expansion – a combination which could lead to power shortage during peak demand periods in the future. Company Profile Tauron Polska Energia is the second largest verticallyintegrated power company in Poland, with a generation capacity of 5.6 GW, and annual coal-production capacity of 5MT. The utility is the number-one retailer in the country, supplying over 30.4 TWh of electricity a year, and it sent 30.9 TWh of power in 2009 via its distribution infrastructure. Important dates 31.08 — H1’10 report 15.11 — Q3 2010 report Capacity, Vertical Integration, and Capital Investment Today, Tauron operates power plants with a combined capacity of 5.6 GW, fired mostly with hard coal, 30% of which comes from the company’s own nearby mines. Vertical integration of feedstock supplies means that an increase in energy prices by PLN 10/MWh should entail an increase by at least PLN 55m in the company’s consolidated operating profit (assuming constant mining costs). Tauron has a 10-year capital-investment plan, expected to reach as much as PLN 35 billion, whose objectives include expansion of the power-generation capacity to 7.7 GW, bringing internallysourced coal supplies up to 50%, and greater renewable-power capacity. Industrial Customers Tauron’s power-generation and distribution assets are located in the most densely industrialized areas of northern and south-western Poland, hence, it has more industrial customers than other power utilities, which means that its sales volumes and revenues are more sensitive to economic cycles than, for example, those of PGE or ENEA. At the moment, industrial production is in recovery, which, if continued, will lead to rapid volume growth in Tauron’s trade and distribution businesses, as well as in power generation (allowing the Company to step in once other major baseload power suppliers run out capacity). Distribution – A Reliable Earnings Driver As Poland’s energy regulator (URE) works toward ensuring that Polish utilities are fully compensated for regulatory asset maintenance, Tauron, with its 30+ TWh annual transmission capacity, stands to experience considerable profit growth in its distribution segment in coming years. We predict that the segment’s EBIT may reach PLN 700m in 5-6 years, compared to PLN 95m posted in 2009. Tauron vs. WIG 5.6 PLN 5.5 5.4 5.2 5.1 Tauron 5.0 10-06-30 10-07-09 10-07-18 Kamil Kliszcz (48 22) 697 47 06 [email protected] www.dibre.com.pl 10-07-27 WIG 10-08-05 (PLN m) Revenue EBITDA EBITDA margin EBIT Net profit DPS P/E P/CE P/BV EV/EBITDA DYield 2008 12 448.7 1 615.8 13.0% 347.0 130.8 0.02 60.6 5.7 0.7 6.9 0.4% 2009 13 633.6 2 580.8 18.9% 1 259.7 732.4 0.04 10.8 3.9 0.7 4.2 0.7% 2010F 13 816.5 2 529.9 18.3% 1 144.2 720.3 0.00 11.3 3.8 0.6 4.2 0.0% 2011F 14 320.3 2 675.3 18.7% 1 219.1 747.3 0.09 10.8 3.7 0.6 4.2 1.8% 2012F 15 202.1 2 887.2 19.0% 1 338.2 801.0 0.09 10.1 3.4 0.6 4.3 1.8% BRE Bank Securities 16 August 2010 does not rule out offering brokerage services to an issuer of securities being the subject of a recommendation. Information concerning a conflict of interest arising in connection with issuing a recommendation (should such a conflict exist) is located on the final page of this report. Tauron Polska Energia BRE Securities BREBank Bank Securities About Tauron Organization of Tauron (subsidiaries representing core business areas) TAURON Polska Energia S.A. – Parent company 85.0% PKE Jaworzno PP Łagisza PP Łaziska PP Siersza PP Halemba PP Blachownia PP Katowice PP Bielsko-Biała CHP 85.0% EnergiaPro 85.0% 70.0% Tychy CHP 95.47% ESW 85.0% Katowice HP 95.66% 52.48%* Enion Enion Zarządzanie Aktywami** Polska Energia Pierwsza Kompania Handlowa 10.0% Enion Energia 100.0% 85.0% EnergiaPro Gigawat 100.0% TAURON Ekoenergia 100.0% Hydroelectric power plants Tauron Czech Energy Hydroelectric power plants RoŜnów Hydroel. Power Plants PKW Energomix Servis** 85.0% Holding companies Mining Heat and energy generation Electricity sales 100.0% ZG Janina ZG Sobieski 42.10% 100% Czatkowice Limestone Mine Nowa CHP 41.90% Energy distribution *PKE’s share in PKW’s capitalization is 52.48%, but it has a 68.01% share in votes **In stage one of the consolidation process, to be concluded by mid-2010, Tauron will be merged with Enion ZA and Energomix Servis Source: Tauron, BRE Bank Securities The Tauron Group, which currently comprises 17 core companies, is Poland’s second biggest integrated power utility next to PGE. Through its 5 core segments (Coal Mining, Energy Generation, Renewable Energy, Distribution and Energy Trade) it is present in all areas of the market. Tauron’s power plants, with combined installed capacity of 5.6 GW (concentrated above all in the 85% subsidiary Południowy Koncern Energetyczny, PKE) generated a total of 18.6 TWh of electricity in 2009 (over 30% of which came from coal from its own mines, which operate within PKW, a joint venture of PKE and Kompania Węglowa). Using infrastructure located mostly in southern and south-eastern Poland, Tauron's distribution subsidiaries supply end users with ca. 30.9 TWh of energy per year (2009), i.e. 27% of the country's total volumes, which makes Tauron the nation's biggest distributor. Electricity trade is concentrated in Enion Energia and EnergiaPro Gigawat, wholly owned subsidiaries of two holding companies (Energomix Servis and Enion ZA) in which Tauron owns 85% stakes (the remaining 15% are employee shares). Tauron also has non-core assets in its portfolio, such as real estate and holiday resorts. It is worth stressing here that the holding's parent company does not have full (100%) control over some other important assets, as a result of which minority interest figured to PLN 2.4bn at the end of 2009. At the moment, however, efforts are being undertaken to attain 100% interest in all the Group's core companies. In the first stage of the process, employee shares in PKE, Enion, EnergiaPro and ESW were exchanged for Treasury-owned shares in Tauron (employee shares were to account for 13.42% of Tauron's share capital after these changes). This did not lead to an increase in the number of shares in the parent (13.986bn). The next step was the merger of Tauron with Enion ZA and Energomix Servis, which led to a PLN 318.6m share capital increase, but ensured full control over the trading subsidiaries. Still before the IPO, the Management carried a 9:1 reverse stock split (with nominal value increasing from PLN 1 per share to PLN 9). Thus, after all these moves, the Company’s share capital comprises 1.589bn shares. However, the consolidation process will continue and a new stock offering is likely to take place as soon as in September 2010 (up to 268m shares with total value of PLN 2.4b, although current calculations suggest the offering should figure to 170m shares at PLN 9.0 apiece). The new shares will go to the Treasury in exchange for minority stakes in PKE, Enion, EnergiaPro and ESW (the value of this in-kind contribution will be ca. PLN 1.5bn, and the value of minority interest attributable to these four entities was PLN 1.7bn at the end of 2009). The final stage of the process will be the acquisition of the remaining shares in Południowy 16 August 2010 2 BRE Securities BREBank Bank Securities Tauron Polska Energia Koncern Węglowy in exchange for new shares issued to Kompania Węglowa (most likely, on the same occasion Tauron will take over the Bolesław Śmiały mine from KW). The dilution stemming from this transaction should not exceed 6%. 16 August 2010 3 Tauron Polska Energia BRE Securities BREBank Bank Securities Coal Mining • • • • • • Coal is extracted in two mines with total output of 5 Mt p.a. (7% of total production in Poland) by Południowy Koncern Węglowy (in which Kompania Węglowa holds a minority stake). Most of the coal dust is sold to Tauron's own power plants (70%); the reminder, consisting of lump coal, is sold to external clients. Coal output could increase by 0.9 Mt by 2012, thanks to investment projects at the ZG Janina and ZG Sobieski mines. PKW’s mining costs are below the average for Poland, but above those of LW Bogdanka. Tauron is planning to purchase the Bolesław Śmiały mine, whose annual capacity is 1.6 Mt. The segment’s EBITDA figures to ca. 10% of consolidated earnings; with a high share of fixed costs, it is largely determined by output volumes and the unit price of coal, Tauron’s mining assets are concentrated in Południowy Koncern Węglowy, where the main shareholder is Tauron’s 85% subsidiary Południowy Koncern Energetyczny (52.5% stake and 68% of votes, the reminder belonging to Kompania Węglowa). PKW mines coal in two mining centers, ZG Janina and ZG Sobieski, whose total output is ca. 5 Mt per year (7% of the Polish total). The calorific value of this coal is between 19.1-20.2 MJ/kg (vs. the 21.6 MJ/kg average for Polish mines) and sulfur content of 1.1-1.2% (vs. 0.9%). 75% if the output is coal dust, most of which goes to the nearest power plants from the Group pursuant to a 5-year contract expiring at the end of 2010 (Jaworzno, Siersza, CHP Tychy – in 2009, they purchased nearly 70% of the output). The reminder (mostly lump coal) is sold under general agreements with distributors, in which volumes are determined on a six-month basis. It is worth noting here that given the parameters of this product, the average price in this channel is much higher than in the case of sales to Power Generation (PLN 324/t vs. PLN 204/t in inter-segmental trade in 2009). Coal output in Tauron’s mines (Mt) and sales by buyer 6.0 6.0 5.0 5.0 4.0 3.0 3.4 2.9 3.0 2.0 1.0 1.3 4.0 2.7 2.0 1.8 2.2 2.2 2007 2008 2009 0.0 1.0 0.8 1.2 2.7 3.5 3.4 2008 2009 0.0 ZG Janina ZG Sobieski 2007 Sales w ithin Tauron Group External sales Source: Tauron, BRE Bank Securities Operational reserves as per the JORC code (proved and probable reserves) at PKW’s mines total PLN 56m Mt, including 31.7 Mt at ZG Sobieski and 24.3 Mt at ZG Janina. Given the annual output at these mines, this will allow them to remain operational for 11 more years. In addition, the measured resources at these sites amount to 348 Mt, which means that future investment could extend the life of these mines by 54 and 73 years, respectively. Of these resources, approximately 230 Mt could be reclassified following two projects currently under analysis: deepening the shaft at ZG Janina (with a scheduled completion in 2024) and the construction of a new shaft at ZG Sobieski. Altogether, mining CAPEX in 2010-2010 is planned at ca. PLN 2bn, including PLN 0.5bn in 2010-2012. By 2012, PKW's annual output should reach some 5.9 Mt compared to 4.9 Mt in 2009. As for overground infrastructure (e.g. coal processing plants), the output capacity of these two mines amounts to 8.6 Mt at the moment. One part of the investment plan currently being prepared for the segment might be the purchase of Kompania Węglowa’s Bolesław Śmiały mine, which is the main coal supplier to Tauron’s Łaziska. The mine, with 1.6 Mt annual capacity, would be contributed by KW to PKW in exchange for Tauron shares. Another action currently negotiated with Kompania Węglowa is the purchase of the latter's minority stake in PKW. The agreement could be finalized in late 2010 or early 2011, and this is when we can expect definite information on the number of shares to be issued for Kompania Węglowa. In 2010, the average unit cost of coal extraction at ZG Janina and ZG Sobieski figured to PLN 204/t and PLN 182/t, respectively, putting both of them below the average for the Polish mining industry, which amounted to the staggering PLN 262/t. This is largely a consequence of 16 August 2010 4 Tauron Polska Energia BRE Securities BREBank Bank Securities restructuring carried out after the two mines were separated out of the structures of Kompania Węglowa (ZG Sobieski had been set up back in 1998 on the basis of the assets of the liquidated ZG Sobieski Jaworzno, and ZG Janina in 2004) and employee headcount adjustment to mining capacity (at the moment, there are 1244 employees per 1 Mt of coal extracted, compared to 1600 in the Polish mining industry at large). Another factor of relevance for the cost efficiency of the mines is the fact that they are located in less urbanized areas than other Silesian mines. PKW looks somewhat less impressive compared to Poland's most costeffective coal mine, LW Bogdanka. However, in addition to lower productivity (despite similar volumes, employee headcount at Bogdanka is 36% lower), this is a consequence of earlier underinvestment and a difference in the structure of coal deposits. PKW’s coal reserves and unit mining cost relative to the industry 150 400 130 350 110 300 250 90 250 200 70 200 50 30 10 -10 37.6 17.1 14.7 ZG Sobieski 20.5 3.8 ZG Janina 18.5 Tauron Group 150 100 50 0 300 262 228 199 150 204 188 probable reserves 153 133 138 132 136 100 50 0 2007 proved reserves 182 172 measured resources (right scale) ZG Janina 2008 ZG Sobieski 2009 LWB Bogdanka Polish mining industry Source: Tauron, Ministry of the Economy, LWB Bogdanka, BRE Bank Securities Historical Financial Performance and Our Forecasts for the Segment In 2009, the Coal Mining segment generated ca. 10% of consolidated EBITDA, which is close to the 2008 level. An analysis of the Company’s earnings in 2007-2009 shows that with a relatively high share of fixed costs (D&A and payroll accounts for over 63% of operating expenses), the profitability of the mines is very sensitive to volumes and price. In 2007, both of these parameters were hardly satisfactory. In our opinion, however, the key cause behind the operating loss the segment posted that year were delays in the completion of new long wall panels (due to geological difficulties but also logistic problems involved in the retooling of a longwall system at ZG Sobieski), which was a direct cause of the Company’s failure to attained the volumes planned. In 2008, Tauron was able to achieve the optimal mining output; in addition, unit EBITDA increased from PLN 9/t the year before to PLN 30/t thanks to the increase in coal prices. In 2009, profitability improved further thanks to continued price increases, which more than offset the decline in sales caused by the economic crisis and competition from imported coal. Earnings in Coal Mining, Our Forecasts (PLN m) 2007 2008 2009 2010F 2011F 2012F Revenue EBIT 755 -71 1 004 63 1 167 147 1 122 122 1 264 156 1 490 189 EBIT margin -9% 6% 13% 11% 12% 13% D&A expenses 111 110 106 105 108 111 % share in Tauron Group 9% 9% 8% 8% 7% 7% 40 173 253 228 264 300 EBITDA margin 5% 17% 22% 20% 21% 20% % share in Tauron Group 3% 11% 10% 9% 10% 10% 161.6 182.9 241.6 224.4 229.8 252.6 4.7 5.5 4.8 5.0 5.5 5.9 EBITDA PKW’s average coal price (PLN/t) Output (Mt) Source: Tauron, estimates by BRE Bank Securities In the upcoming years, we expect a systematic increase in production volumes until the current capacity of 5.9 Mt per year is reached. This will be facilitated by preparatory work underground and by the rising demand for coal combined with a reduced pressure from imports and declining output in Poland (as more loss-making mines are closed down while those that have been reducing their investment struggle to sustain their current volumes). In 2010, despite an increase in sales at PKW, we expect a lower EBIT, primarily due to a clear reduction in average prices in the market. In the following year, however, positive trends will reappear. 16 August 2010 5 Tauron Polska Energia BRE Securities BREBank Bank Securities Unit mining cost at PKW coal mines, PLN/t 220 ZG Janina 170 113 116 106 120 70 42 20 14 31 2007 -30 42 35 12 25 17 32 2008 2009 200 180 160 140 120 100 80 60 40 20 0 ZG Sobieski 107 78 79 25 13 16 23 13 16 31 2007 21 22 2008 2009 materials energy external services materials energy external services payroll taxes, other fees other payroll taxes, other fees other Source: Tauron Electricity Generation • • • • • • • • Tauron has electricity generation capacity of 5.4 GW (not including hydroelectric power plants, which are included in another segment) and is Poland’s second-biggest electricity producer (with a 12% share of the market). Approximately 30% of the coal it uses comes from within the group (and the results of the Electricity Generation segment need to be seen in conjunction with the Coal Mining segment). Tauron has ambitious capacity expansion and upgrade plans (PLN 29bn by 2020). The key projects in a short-term perspective include a biomass-fired unit at the Jaworzno power plant, a new unit at the Bielsko-Biała CHP plant and the construction of a CCGT power plant in Stalowa Wola in cooperation with PGNiG. High carbon dioxide emissions at Tauron’s power plant and the risk of additional costs arising upon the implementation of the EU Climate Package will have a negative impact on earnings, but not until several years elapse. Energy costs are likely to increase systematically in the coming years, until they correlate fully with European prices. The ongoing litigation with the energy regulator URE concerning compensation for terminated long-term contracts poses a risk (under the pessimistic scenario, Tauron will need to recognize considerable write-offs in its income statement, in excess of PLN 360m). Tauron should be able to recover a portion of excise tax overpaid in 2006-2008 (the total claim is PLN 909m, of which PLN 85m we consider certain). The segment’s excellent earnings for 2009 will not be replicated due to a decline in long-term contract compensation. In a longer term, we expect profits to go up on a par with capacity expansion and electricity prices. The Tauron Group encompasses power plants and CHP plants with a total installed capacity of 5.4 GW (exclusive of hydroelectric plants) and annual output of 18.2 TWh, which implies a 12% share in Polish energy generation. Most of its generation assets (excluding the Stalowa Wola power plant and CHP plants in Tychy and Nowa) constitute a part of Południowy Koncern Energetyczny, in which Tauron holds an 85% stake. However, sales are managed by the parent company, as confirmed by the high 77% share of intra-group revenue. External revenue accounts for a minor share of total sales in the segment, and most of it comes from long-term contract compensation and transactions with PSE Operator (provision of regulated "systemic" services - four Tauron power plants are centrally controlled by the national network operator). Heat is also sold directly to end users; in 2009, its volumes exceeded 14.7m GJ (ca. 3.4% of the Polish total). 16 August 2010 6 Tauron Polska Energia BRE Securities BREBank Bank Securities Power plants and CHP plants in the Tauron group and their market standing in Poland PP Jaworzno II PP Jaworzno III PP Łagisza PP Łaziska PP Siersza PP Halemba PP Blachownia CHP Bielsko-Biała I CHP Bielsko-Biała II CHP Katowice PP Stalowa Wola CHP Tychy CHO Nowa TOTAL Share of the Polish market Electric power MWe Thermal power MWt 190 1 345 1 060 1 145 677 100 158 77 55 135 341 40 125 5 448 15.6% 321 51 335 196 37 58 174 275 172 459 366 290 466 3 200 5.1% Net electricity output, GWh Net heat output, TJ 6 320 Installed capacity in Poland by holding EdF 3.2 1 310 2 340 4 640 1 700 220 440 1 340 330 80 200 960 410 2 290 710 970 140 310 18 200 11.7% 2 460 1 680 1 830 2 240 14 720 3.4% ENEA 2.8 PAK 2.3 Electrabel 1.8 Tauron 5.4 Vattenfall 1.0 Energa 1.0 Other 5.4 PGE 12.4 Source: Tauron, BRE Bank Securities Tauron’s generation assets are concentrated in southern Poland, in the region of Silesia, which is one of the country's most heavily industrialized areas – a fact that is of relevance for both capacity utilization and coal supplies. One factor to consider is PSE's centralized management of power plants. The operator determines the load for PKE’s biggest units taking into account the current demand in the given area of the system, as well as the need to balance the market at the lowest cost possible. Since the efficiency of Polish transmission assets is still limited (not enough intraregional connections, high network losses), capacity utilization at electricitygenerating units in such regions is very sensitive to the economic situation, as show, for example, by the history of the Company’s sales volumes in 2007 - 2009 (of course, the sharp drop in 2008 was largely the consequence of the introduction of new carbon dioxide limits). In the context of the economic revival we are currently observing and the rising industrial production, Tauron’s power plants should increase their capacity utilization more than installations with less exposure to the heavy industry (KGHM, Arcelor Mittal, Kompania Węglowa). Electricity production growth for Poland, Tauron 25.0 162.0 160.0 159.5 22.1 -13,6% 19.1 20.0 -4,7% 18.2 -2.5% 158.0 155.6 156.0 15.0 -3.0% 154.0 150.9 152.0 150.0 10.0 5.0 148.0 0.0 146.0 2007 2008 2009 electrical energy production in Poland, TWh 2007 2008 2009 conventional energy output, Tauron Group, TWh Source: Tauron, PSE, BRE Bank Securities Tauron’s ownership of a considerable number of hard coal mines is another crucial factor, not only in the context of the regulatory requirement that power utilities sustain 30-day coal stockpiles. Another important factor are transportation costs: at PKP Cargo's standard freight rates, these may add 15-20% to the price of coal on an example distance of 200km. Of course, this transportation advantage is by and large consumed by cost-ineffective coal mines, but the industry's recent problems with surplus output and intensive competition from imports have clearly weakened its negotiating position. Setting prices in contracts by import parity allows PKE to attain more attractive terms than its Polish peers. 16 August 2010 7 Tauron Polska Energia BRE Securities BREBank Bank Securities Average unit cost of steam coal in the Polish market (buyers, coal mines) and the structure of supplies to Tauron's power plants Coal supplies to Tauron's power plants in Mt Price of steam coal in PLN/t 300 274 250 200 150 215 162159156170 145 120 268 241 239 206 204 193185 179 170 138 12.0 10.0 6.0 0.8 1.2 7.0 6.0 1.3 1.1 5.2 4.0 2.0 100 2.8 3.4 3.3 2007 2008 2009 0.0 50 2007 Tauron 0.8 1.3 8.0 Tauron z PKW 2008 PGE ENEA 2009 LWB Bogdanka Steam coal (MG) Intra-group supplies from PKW KompaniaWw ęglow a Katow icki Holding Węglow y Other Source: Tauron, PGE, Ministry of the Economy (MG), estimates by BRE Bank Securities Tauron power plants use some 11 Mt of hard coal per year (at a total cost of PLN 2.4bn), of which over 3 Mt come from internal supplies from PKW (PLN 681m); thus, electricity generation is vertically integrated at ca. 30%. However, given the fact that the holding’s coal mines produce 5 Mt of coal per year (as described at length above, some of the coal mined goes to other buyers due to its parameters), indirect vertical integration amounts to as much as 45% (aggregate earnings of Coal Mining and Electricity Generation), which has a considerable impact on generation margins – with mining costs under tight control, and electricity prices on the rise, the margin can expand more than in the case of competitors (on the chart below, we compare Tauron's EBITDA to that of other producers; the segment's earnings are discussed in detail further down in the report). The Management’s objective is to ensure that 50% of the required coal comes from internal sources, which will be made possible by an increase in PKW’ output and the planned acquisition of the Bolesław Śmiały mine (1.6 Mt). The remaining coal is bought from Polish producers (Kompania Węglowa, Katowicki Holding Węglowy and Jastrzębska Spółka Węglowa). In addition to hard coal, Tauron also produces energy from gas, for which it paid PLN 141m in 2009. Volume and unit price data, as well as the lack of typical gas-fired units in the Group (instead, it is co-burned with coal dust) suggest that the gas used by Tauron is not natural gas, but rather the less calorific process or coking gas. Let us point out that Tauron does not generate “yellow certificates” (cogeneration credits). In the context of certificates of origin, biofuel has become an important fuel for the Company, with its consumption reaching 480 Kt in 2009 (PLN 124m), but this issue is discussed at more length further down in this report. Structure of Tauron’s costs in electricity generation, PLN/MWh and EBITDA margin compared to peers 37 250 200 37 11 25 42 15 28 100 3 39 8 21 50 74 0 22 27 29 2007 2008 2009 53% 46% 50% 40% 26% 30% 25% 137 96 41% 37% 33% 20% 25% 25% 19% 16% 19% 18% 16% 10% Tauron’s margin ENEA PGE CEZ RWE Enel EON 2009 EBITDA margin Tauron* Depreciation Other costs Endesa Coal Other fuels Iberdrola Labor 0% EDF 150 60% Generation EBITDA margin *Tauron's Electricity Generation margin adjusted for Coal Mining earnings to allow for comparison with PGE, which includes these business lines in one segment. Source: Bloomberg, Tauron, ENEA, PGE, estimates by BRE Bank Securities. Given the crucial role of hard coal in costs (55% of the cost of energy generation), changes in the price of coal are of crucial importance for Tauron's profitability. At this point it is worth commenting on the nature of the Polish steam coal market and the current situation in the segment. Until now, domestic mines have been providing most of the coal used by Polish power plants and CHP plants, which purchased over 60% of total output. The combination of rising demand for electricity and declining coal output (12 Mt in 2003-2008) in consequence of industry restructuring and the closure of some of the deposits as well as underinvestment, has finally brought about a seismic shift in steam coal balance, making Poland a net importer. The turning point came in 2008, when our power plants, unable to satisfy the increased demand at home and struggling to keep their reserves at the mandatory 30 days, had to turn towards the more expensive imported coal. Taking advantage of the crisis-driven breakdown in global prices, the utilities also entered into contracts for supplies in 2009, mostly from Russia, forcing Polish coal mines to cut both production and prices. This structural shift means we will be 16 August 2010 8 Tauron Polska Energia BRE Securities BREBank Bank Securities gradually moving away from the quasi-regulated price setting mechanism (which tied coal prices directly with electricity prices) and move on to new mechanisms shaped by Europe-wide tendencies. Naturally, this will be aligned with a similar process in the area of electricity pricing. Meanwhile, in 2010 Polish energy producers will probably take advantage of the tight situation coal mines have found themselves in (high inventory levels) and the competition from imports, increasing their margins through contract renegotiation. Polish steam coal market balance, Mt 25.0 95 84.3 83.0 82.7 79.8 20.0 85 73.8 71.6 75 15.0 64.0 65 10.0 55 5.0 45 0.0 35 2003 2004 2005 Exports 2006 Imports 2007 2008 2009 Steam coal production Source: Ministry of the Economy, Central Statistical Office Our long-term forecasts of coal price are based on their past correlation with crude oil prices. Assuming that the price of Brent crude will return to USD 90/bbl, we can expect the price of ARA coal to go up to EUR 87/t, which, given our EUR/PLN exchange rate forecasts and the additional costs of transportation to Poland could lead to a ca. 27% increase in price, assuming full import parity. There are some uncertainties concerning 2013, when a restrictive Climate Package is set to come into force in the EU, which could distort the correlation between the highly emissive coal and crude oil. However, given the EU’s low share in global coal consumption (ca. 10%), it is uncertain whether power plants are going to be able to transfer some of the cost of CO2 credits onto coal mines. We assume this is not going to be possible and the additional cost of emission credits will be reflected in higher electricity prices in full. Past coal prices in PLN/t, correlation with the price of Brent crude oil 400 350 120 100 300 250 80 200 150 100 60 50 0 20 2013F 2012P 2011P 2009 2008 2007 2006 2005 2009 2004 2008 2003 2007 2002 2006 2001 0 2005 2010P 40 average price of Polish coal average price of LWB Bogdanka coal price of Brent crude oil, EUR/bbl average ARA price of coal ARA steam coal price, EUR/t Source: Bloomberg, Ministry of the Economy, estimates by BRE Bank Securities New unit at the Łagisza power plant launched in 2009 Tauron’s flagship investment product in the recent past has been a new super-critical 460 MW unit at the Łagisza power plant (whose nameplate capacity did not change, however, as three old 120 MW units and two old 50 MW units were switched off upon launch of the new one). Important features of this new coal-fired unit include its high efficiency (nearly 45%) and low emissions of carbon dioxide (under 0.75t/MWh) and other EU-restricted substances, which has a positive impact on both energy generation volumes and generation efficiency. The unique technology used in the new unit (circulating fluidized bed boiler) and in-house general contracting allowed the Company to attain considerable savings. Total CAPEX figured to PLN 1.9bn, which, given the average EUR exchange rate at the beginning of construction (early 2006) implies average construction cost of EUR 1.1m/MW, compared to EUR 1.3-1.5m/MW market average for coal-fired generation units. The experience Tauron gained during the execution of this project should bear fruit in the future, as future projects are likely to follow the same model (with the holding acting not only as the investor, but as the general contractor as well). This could enable Tauron to shorten the preliminary stage of such projects (planning, permits, design), which took over four years in the case of the Łagisza plant (one additional issue here were problems with bank financing due to the then-ongoing dispute over long-term contracts, which constituted a “natural collateral” for bank loans). 16 August 2010 9 Tauron Polska Energia BRE Securities BREBank Bank Securities CAPEX for the 460 MW unit at Łagisza Power Plant (PLN m) Turbine 600 Boilers 400 Network connections 100 Earthwork, engineering work 100 Other 700 TOTAL 1900 Source: Tauron Investment Plans Tauron’s 2010-2020 investment program foresees electricity generation CAPEX of PLN 29.3bn, of which PLN 3.9bn will be spent over the next three years. Most of the new projects under planning are conventional power-generation units which would allow Tauron to increase its capacity from 5.6 GW (inclusive of hydroelectric plants) to 8.5 GW within 10 years (though the latter value needs to be adjusted for capacity attributable to Tauron’s consortium partners). Work is expected to be particularly intensive in 2012-2016. Of course, individual projects are at very different stages of advancement, with some still at the analysis stage, not yet approved by the appropriate corporate bodies. The most advanced project is the construction of a new 50MWe / 182MWt unit at the Bielsko-Biała CHP plant. At the moment, installation work is being performed, and it is set for completion in mid-2013. The new unit will replace an existing one, which was constructed in 1970 and which is not compliant with SOx emission norms. In late 2013 or early 2013, a 50 MW biomass-fired unit will be launched at the Jaworzno power plant. The following year, a 400MW gas-fired unit will be launched at the Stalowa Wola power plant, which is being built as a joint venture with PGNiG (the agreement was signed last year), and which will allow Tauron to generate “yellow” (cogeneration) guarantees of origin. In the following years, Tauron’s generation capacity will expand further to include a new natural-gas fired unit at the Katowice power plant and two big coal-fired unit at Jaworzno and Blachownia (910MW each), though it should be remembered that the latter project will be pursued in cooperation with KGHM (50%). The list of key projects also includes expansion at the Tychy power plant (additional 55MWe and 190MWt) and a new 460MW unit at Łagisza, a twin of the one launched last year (although it may be expanded to include 350MWt heat generation capacity). The Management is also considering three more projects which we ignore in our model due to the remote timeline (910MW units at Łaziska and Siersza) or the high risk of nonexecution (IGCC unit at Kędzierzyn-Koźle, which will not be built without a EU subsidy). New capacity construction plans (excluding wind farms) Bielsko Biała Power plant Biomass unit at Jaworzno PP MWe MWt Cost (PLN m) Launch date Factored into our model? 50 180 409 mid 2013 YES 50 45 351 late 2012 YES Gas-fired unit at Stalowa Wola* PP 200 120 702 mid 2014 YES Katowice PP 135 87 895 2015 YES 55 190 365 early 2016 YES Jaworzno III PP 910 0 5 324 2016 YES Blachownia* PP 455 0 2 662 2016 YES IGCC Kędzierzyn Koźle* 155 69 3 000 2016 NO Łagisza PP 460 350 2 870 late 2017 YES Łaziska PP 910 b/d 5 324 2019 NO Siersza PP 910 b/d 5 324 late 2020 NO Total 4 290 1 041 27 224 - - 13 577 - - Tychy PP Factored into our model 2 315 972 * project to be carried out as 50:50 joint ventures; accordingly, we use this proportion to estimate Tauron’s share of expenses and capacity Source: Tauron, estimates by BRE Bank Securities While Tauron will be launching new units, it cannot be forgotten that a number of existing units will have to be switched off in the near future (nearly 80% of them are 30 years old or older). Therefore, the new investment will partially replace the old capacity. Of course, we should not simply assume that the life of a power generation unit ends after 50 years, because a lot of 16 August 2010 10 Tauron Polska Energia BRE Securities BREBank Bank Securities them, if appropriately maintained and modernized and adjusted to new emission standards, may remain operational for longer (one example is Jaworzno III, which was built in 1970s and which will not be shut down until 2029-2031). Still, the Management expects that by 2020 Tauron will switch off units with total capacity of 1.7GW, i.e. ca. 30% of the Company’s current capacity. Most of these will be units built in the 1950s and 1960s (two at Halemba power plant, two at Łagisza, pulverized fuel boilers at Jaworzno II and several units at the Blachownia power plant, which mostly use coking gas from the Zdzieszowice plant), but some will be units whose NOx and SOx derogation periods will run out (Stalowa Wola CHP, Łagisza, Łaziska). Age of installed capacity, Tauron vs. the Polish market 100% 0% 20% 90% 24% 29% 80% 70% 60% 39% 59% 50% 34% 100% 40% 30% 20% 2% 4% 10% 15% 20% 20% 17% 8% 10% 0% Tauron PGE under 10 years 10-20 years ENEA 20-30 years Other 30-40 years over 40 years Source: Tauron, PGE, ENEA, estimates by BRE Bank Securities Below, we present the schedule of unit launches and closures and the planned net change in Tauron’s power generation capacity. Let us point out, however, that the final level – 7.7GW in 2020 – follows from the Management’s investment plans which have not been fully factored into our model. Our forecasts assume that capacity will expand by 0.6GW, plus an additional 0.44 GW in hydroelectric plants (the latter issue is discussed at more length in the following chapter). Thus, we foresee only an 11% increase in capacity in nominal terms, but we expect that the parameters of the new power plants, combined with higher capacity utilization, will allow production to be increased by over 30%. Changes in Tauron’s installed capacity 2009-2020 (JV projects in proportion of capacity attributable directly to Tauron) as per the Management’s investment program New capacity IGCC Ke dzierzyn Ko z le 309 MW 1 Projects under consideration Jaworzno III 910 MW CHP Bielsko Bia l a 50 MW Wind farm Wicko 40 MW 8 000 Jaworzno biomass 50 MW Stalowa Wola gas unit 400 MW 1 EC Katowice 135 MW 2 Blachownia 910 MW 1 Farma wiatrowa 200 MW EC Tychy 55 MW Siersza 910 MW L agisza 2 460 MW Wind farm 200 MW 7,684 1 110 817 MW 6 000 Laziska 910 MW 30 5 579 60 200 335 2014 2015 267 4 000 Withdrawn capacity 2009 2010 2011 1 To be executed as a JV with industrial partners. Tauron to finance up to 50% of the outlays and to own 50% of the power. 2 Final technical parameters to be determined following an analysis of the local heat market. 2012 2013 Halemba 100 MW Jaworzno 50 MW Blachownia 158 MW 2016 2017 L agisza 2 40 MW 2018 Lagisza 240 MW Siersza 360 MW L aziska 2 50 MW CHP BielskoBiałą la 77 MW Stalowa Wola 120 MW 2019 2020 L agisza 120MW Source: Tauron, BRE Bank Securities An important aspect of the capacity expansion program, in addition to nominal increases capacity itself, is an increase in efficiency. The main cause of the expected reduction operating expenses per MWh will be technological progress the industry has experienced the past several dozen years (recall that most of the units currently in operation were built 16 August 2010 in in in in 11 Tauron Polska Energia BRE Securities BREBank Bank Securities the 1960s and 1970s). New coal-fired units could approach 46% efficiency (e.g. new units at Jaworzno or Blachownia), compared to the current average of 37%, with some older power plants at 33-34%. This factor is of crucial importance not merely for coal consumption, but also for CO2 and other emissions. Further, the new units will be allow for much higher capacity utilization throughout the year than those that require more frequent downtimes; as a result, electricity output per 1 MW of installed capacity should increase. Finally, we believe the new projects will allow for a considerable reduction in employment in the Generation segment. At the moment, the Company is no match for its regional peers in this respect, with over 300 employees per 1 TWh of energy produced, vs. 208 for PGE (excluding lignite mine employees counted in the Mining and Generation segment), 226 at the Kozienice power plant and only 183 in CEZ (excluding nuclear power plants). While these differences may be partially explained by the utilities’ differing approaches to the classification of support employees (e.g. maintenance crews, emergency personnel), they are by and large a consequence of degree of automation (by way of example, the new 460 MW unit at Łagisza requires 0.1 employee per MW, compared to nearly 1.0 employee per MW at the old 50 MW units), the structure and the actual rate of capacity utilization and downsizing efforts undertaken over the past 20 years. We expect Tauron’s parameters to converge with market averages over the next 10 years, thanks both to the launch of new, modern units and to employment optimization at existing plants (the latter process may be delayed until 2014, however, due to existing labor contracts and employment guarantees). Employment at power plants per 1 TWh of electricity produced and the structure of installed capacity at Tauron in 2009 and 2020 (as Management’s plans) Employees per 1 TWh of output 400 Installed capacity, Tauron vs. the market 5% 8% 354 14% 350 300 250 208 51% 226 183 200 87% 150 35% 100 50 2009 0 Tauron PGE ENEA CEZ Old coal-fired pow er plants 2020 Modern coal-fired pow er plants Other Source: Tauron, PGE, ENEA, BRE Bank Securities Capacity Modernization Tauron’s investment plans for 2010-2010 provide for considerable modernization and replacement expenses, whose goal is to allow the current assets to remain operational. Some of these projects are necessary due to emission limits and the expiration of derogation periods some power plants have been granted. By way of example, three Łagisza units and six Stalowa Wola units can take advantage of sulfur dioxide emissions derogation only through 2015, and comparable waivers expire for NOx emissions at Jaworzno, Łaziska, Łagosza and CHP Nowa in 2017. In some cases, the construction of desulfurization or denitrogenation installations is not economically viable given the age of the units, but it will be possible to use a considerable portion of the existing capacity after more tighter ecological norms come into force. The biggest modernization project will be the installation of nitrous oxide catalyzers on six Jaworzno units and four Łaziska units (with total capacity of 2.3 GW), which will make it possible to reduce emissions of this gas to under 200 mg/Nm3. The process is scheduled for 2011-2015, with two units upgraded per year. We estimate its cost at over PLN 300m. Projects Based on Biomass Burning Given the current regulations supporting biomass-based energy generation (as this fuel is considered neutral for carbon dioxide emissions balance), Tauron’s 2010-2020 investment program attaches considerable importance to such projects. At the moment, all units at Jaworzno and Łaziska, five out of six units at Siersza, two units at Stalowa Wola and one unit at the Bielsko-Biała CHP are capable of biomass co-burning. Altogether, these installations use ca. 480 Kt of this fuel and produce ca. 0.55 TWh of “green” energy. The Management hopes to increase this figure to 1.5 TWh by 2020. The key project that will take the Company in this direction will be the construction of a 50 MW unit at Jaworzno II, which will be based entirely on biomass. The launch of this unit, scheduled for 2012, should allow Tauron to double its current biomass-based output. Further increase in biomass-based energy output can be expected in 2014-2016, when several units at Stalowa Wola and the Katowice and Tychy CHP plants will be relaunched as biomass-ready following renovation. Completing all these projects 16 August 2010 12 Tauron Polska Energia BRE Securities BREBank Bank Securities will not only make it possible to reduce carbon dioxide emissions, but also to generate an additional revenue of over PLN 260m from the sale of green certificates. Biomass-based electricity generation at Tauron, biomass consumption in Kt Biomass consum ption, Kt Biom ass-based electricity output, TWh 1 350 1500 2.00 1.54 1.50 900 1000 1.03 1.00 480 0.55 0.50 0.20 0.24 2007 2008 500 133 240 0 0.00 2009 2013F 2007 2020F 2008 2009 2013F 2020F Biomass consumption, Kt Biomass-based electricity output, TWh Source: Tauron, estimates by BRE Bank Securities Compensation for Canceled Long-Term Supply Contracts Following early termination of long-term electricity sales contracts (LTC) between certain suppliers and the Transmission System Operator PSE, the producers that had been covered by these contracts are eligible to receive compensation for so-called “stranded costs” (related to past capacity investments that cannot not be offset by electricity sales in a competitive market – the prices set in LTCs were higher than current market prices), payable in quarterly installments. The total amount of LTC compensation for PKE power plants has been set at PLN 1.48 billion, payable until 2012, the original year of expiration of the longest-running LTC. In 2008, the Company recognized PLN 192m in LTC compensation revenue, i.e. the amount expected under the regulations in force (the total for 2008 was PLN 256m, but the LTC act came into force in Q2 2008). However, the Company only received PLN 128m in 2008 (the remaining PLN 64m was paid in 2009). Than, in its calculations for FY 2009, the energy regulator URE questioned the grounds on which PLN 160m of the total was paid to PKE (URE had doubts concerning intra-group settlements within Tauron, and did not agree to the inclusion of the cost of missing CO2 credits in stranded costs). The regulator demanded that the amount be returned, as it did of the other utilities involved in LTC contracts (ENEA, PGE). Like its competitors, PKE decided to litigate. The court decided that Tauron’s power plants would have to return only half of the questioned amount pending final decision in the dispute (PLN 79.75m). PKE returned PLN 50m by the end of 2009, and the reminder in March 2010. In May 2010, another court decided that Tauron was not required to return the PLN 160m the URE demanded, and awarded the utility additional compensation of PLN 79m. The ruling is not binding pending the regulator’s appeal. In 2009, PE received PLN 273m in LTC compensation payments (three installments for 2009 and a payment delayed from Q4'08), but it recognized PLN 484m in revenue, despite the fact that the maximum amount that can be expected under the law is PLN 268m (plus capitalization rare, because the figures quoted in the law reflect 2007 prices). The main cause of the discrepancy is the fact that Tauron also recognized a part of the so-called "final adjustment", most likely related to LTC which expired in 2008 at Jaworzno (units 3 and 6) and Siersza (desulfurization installations at units 1-6). Due to discrepancies between revenue booked and money actually received from the URE resulted in a PLN 290m increase in receivables in 2009. Following URE's July decision, by the end of September Tauron will receive an additional PLN 138.2m, which will bring the FY 2009 total to PLN 411m. LTC compensation at Tauron’s power plants (PLN m) 2007 2008 2009 2010F 2011F 2012F Compensation for PKU under LTC Act* 583 256 268 141 125 107 Compensation booked n.a. 192 484 Funds received n.a. 128 273 * Compensation figures in the LTC Act are based on 2007 prices, and are therefore capitalized at a rate determined by the URE for each year. Source: Tauron, URE, LTC Act, BRE Bank Securities Excise Tax Refund After the European Court of Justice found that the Polish law was in conflict with EU regulations in 2006-2008, Tauron is demanding a refund of the excise tax it paid (PLN 909m, excluding interest). According to EU regulations, the tax should have been paid by those who sell energy and not those who produce it, which was the case in Poland until 2009. The 16 August 2010 13 Tauron Polska Energia BRE Securities BREBank Bank Securities Finance Ministry’s approach is somewhat different, however – it believes that only the tax calculated on volumes lost in the network must be refunded (indeed, regardless of the legal aspects, it is hard to justify refunding the entire amount, since the cost of the excise tax is borne by the end-user rather than the producer). At present, it is hard to predict the amount Tauron may get (PLN 909m would increase the Company’s value by 7%). It should be pointed out that, in case the full amount is refunded, end users will also be entitled to request refunds from Tauron (the biggest ones, like Mittal and CMC, which buy 10% of energy produced by the Company, are sure to do this as they are likely to have paid material amounts; Kompania Węglowa has already requested a PLN 73m refund). Our model assumes that excise tax imposed on network losses will be refunded, which figures to an estimated PLN 85m. Potential Upshot of the Climate Package The vast majority of Tauron’s generation capacity are coal-fired units (with only 2% in hydroelectric plants), which, of course, has an impact on CO2 emissions. In 2009, the Group emitted 21 Mt of carbon dioxide, and in 2008, 22.7 Mt, compared to its 2008-2012 annual allocation of 21.7 Mt. On average, Tauron emits 1.13 tonnes of carbon dioxide per 1 MWh of electricity produced, i.e. significantly more than the European average and local peers. Of course, given Tauron’s current balance of emission credits (65.5 Mt remaining to be used at the end of 2009, i.e. 21.8 Mt per year), the expected production volumes and the current market prices for emission credits, Tauron need not incur considerable additional costs in 2010-2012. Its expenses for the purchase of allowances could go up afterwards, however, due both to the expected increase in their prices, and to the implementation of the provisions of EU Climate Package in 2013. Output by fuel, CO2 emissions in t/MWh compared to peers** 8% 2% 1.20 1.13 1.07 0.99 0.90 1.00 0.85 0.78 average European power plant 0.8 t/MWh* 0.80 0.66 0.51 0.50 0.48 0.60 0.38 0.40 0.20 EON EDP ENEL Endesa CEZ RWE ENEA wind farms, hydroelectricity Drax gas-fired power plants 0.00 PGE coal fired CHP plants SNET (EON) coal-fired power plants TAURON 90% *estimates by CEZ ** emissions for Polish utilities are calculated for total CO2 emissions, including heat-generation related; if only electric energy is considered, Tauron emits ca. 0.9t/MWh. Source: Tauron, ENEA, PGE, CEZ, PWC, BRE Bank Securities Under the EU Climate Package, energy producers will have to buy all of their emission credits at auctions. The implementation of this scheme will begin in 2013. Poland, as well as several other new EU members will, however, be subject to a period of derogation, and in 2013 our power plants will only have to buy 30% of their emission credits in the market. The pool of free credits will be shrinking gradually, and they will no longer be available in 2020. The impact of the Climate Package on Tauron may be illustrated by a calculation for 2013: with emissions at the current level and credits at the current low prices, the Company would have to buy additional allowances for over PLN 350m. This is of course a remote perspective and it is hard to say at this point what the European energy market will look like after the implementation of the Climate Package (for sure, some of the additional costs will be transferred onto end users, pushing energy prices up, which we have factored into our forecasts). Despite these uncertainties, investors attempt to discount these planned changes in their valuations of power utilities, attaching a premium to those with relatively lower emissions calculated in tCO2/MWh. In this context Tauron, whose emissions are among the highest among Europe’s big producers, does not look very attractive. It should be pointed out, however, that due to the period of derogation and the expected convergence to European pricing levels, Tauron will not feel the full negative impact of the Climate Package until 2015-20. In a longer term, the Company will surely not benefit from the new regulation, as we can expect that increases in energy prices will only cover the higher cost of CO2 emissions in the case of those power plants whose emissions are below the European average of ca. 0.8t/MWh. Even if we take into account the planned launch of wind farms and biomass co-firing installations, Tauron will surely not go below this level (our estimate for 2018 is 0.9 t/MWh vs. the current 1.13 t/MWh, inclusive of emissions related to heat generation). In this context, it will be very hard to justify any premium on Tauron stock vs. CEZ, whose per-MWh CO2 emissions amount to 0.66 tonnes on average, and which will also benefit from the transition period until 2020. 16 August 2010 14 Tauron Polska Energia BRE Securities BREBank Bank Securities Past Financial Performance and Our Forecasts for the Segment The Electricity Generation segment comprises Tauron’s most important power plants, which generated as much as 46% of its consolidated EBITDA last year. The main profitability driver in this area is of course the price of electricity, but it was not the only major determinant of earnings in 2007-2009. Important factors that reduced Tauron’s EBIT in 2008 vs. 2007 included, inter alia, a considerable reduction in production volumes (which was to a certain extent of the economic crisis, but also of more restrictive caps on emissions, with the Group’s allocation shrinking by 26% y/y), the replacement of long-term contracts with a compensation system (which had an impact on the average price and volume) and rising coal prices. Most likely, organizational changes within the Group played a role as well (with sales moved from the generation subsidiaries to Trade, resulting in an increase in intersegment sales from 23% to 66%). In 2009, following a surge in energy prices (by 27% on average in the wholesale market), the segment saw a clear improvement in profitability, but the staggeringly high PLN 667m EBIT was also a consequence of increased "green" energy output (biomass co-firing), the launch of the new, very efficient unit at the Łagisza power plant and the recognition of the whooping PLN 484m in LTC compensation (much more than the LTC act provides for, as discussed above). Adjusted for this item, EBIT increased y/y by PLN 386m rather than PLN 678m. In the following years, we expect the segment to post a lower EBIT largely due to the expected reduction in LTC compensation. The other factors that shape our forecasts are our assumptions for coal and electricity prices, as well as the expected changes in the Group’s generation capacity (with old units shut down and new units launched as discussed above). Earnings in Electricity Generation, Our Forecasts (PLN m) Revenue 2007 3 726 2008 3 782 2009 5 338 2010F 4 933 2011F 5 006 2012F 5 206 71 192 -1 484 677 141 410 125 417 107 402 incl. LTC compensation EBIT EBIT margin 2% 0% 13% 8% 8% 8% D&A expenses 468 479 504 506 498 512 % share in Tauron Group EBITDA 39% 38% 38% 36% 34% 33% 539 478 1 181 915 916 913 EBITDA margin 14% 13% 22% 19% 18% 18% % share in Tauron Group 39% 30% 46% 36% 34% 32% Wholesale price for electricity (PLN/MWh, excl. LTC) 127.2 153.4 195.0 190.0 190.8 200.9 Price of electricity in LTCs (through April 2008, PLN/MWh) 176.6 190.2 - - - - 20.6 23.9 13.8 14.0 17.6 22.3 CO2 allowance prices (EUR/t) Energy output (TWh) Brown coal Hard coal 22.1 0.0 19.1 0.0 18.2 0.0 19.1 0.0 19.4 0.0 19.3 0.0 22.1 19.1 18.2 19.1 19.4 19.3 Natural gas 0.0 0.0 0.0 0.0 0.0 0.0 Wind, hydroelectric* 0.4 0.4 0.4 0.4 0.4 0.5 0.2 0.2 0.5 0.6 0.6 0.6 incl. biomass co-firing * hydroelectric plants are included in the Renewable Energy segment Source: Tauron, estimates by BRE Bank Securities Renewable Energy • • • • Green energy is generated in hydroelectric plants (both run-of-the-river and storage system plants) with total capacity of 131 MW, located in south and south-western Poland. Guarantees of origin offer a high margin. There are plans to build wind farms with total capacity of 440 MW through 2020, with 40 MW to be launched in 2012. We expect stable EBIT determined by the price of green certificates; its increase will not be possible until wind turbines become operational. The Renewable Energy segment comprises 35 hydroelectric plants, including 11 storage system plants and 24 run-of-the-river plants, with combined capacity of 131 MW, located in south and south-western Poland on such rivers as the Oder, Bóbr, Nysa Kłodzka, Dunajec and 16 August 2010 15 Tauron Polska Energia BRE Securities BREBank Bank Securities Vistula). The biggest one is the RoŜnów Hydroelectric Power Plant Complex, with total capacity of 71.5 MW and annual output of 0.19 TWh. All in all, the segment generates ca. 0.4 TWh of the so-called green energy (of which 0.3 TWh comes from storage system plants). It is worth noting at this point that Tauron’s hydroelectric plants are the property of its two subsidiaries, Tauron Ekoenergia and Enion Energia. The ownership structure is an important factor in this case in as much as ZEW RoŜnów, which belongs to the Trade subsidiary Enion Energia, provides its green certificate directly to its parent company, as a result of which this revenue is not shown in Renewable Energy earnings. Installed capacity at Tauron’s wind farms and hydroelectric plants, average PPE prices of green certificates 600 300 500 250 400 440 239 241 2007 2008 256 264 2009 2010YTD 213 200 300 240 240 240 240 150 200 40 40 100 40 100 131 131 131 131 131 131 131 131 131 131 131 131 131 50 hydroelectric plants, MW 2019F 2018F 2017F 2016F 2015F 2014F 2013F 2012F 2011F 2009 2010F 2008 2007 0 0 2006 w ind farms, MW Green certificate, PLN/MWh (right scale) Source: Tauron, Polish Power Exchange, BRE Bank Securities Tauron's investment program for the Renewable Energy segment, in addition to the th modernization and renovation of three hydroelectric plants built in early 20 century (17 MW total capacity) focuses on the construction of new wind farms. The Management expects to add ca. 440 MW of new wind-farm capacity by 2020. In the first move, Tauron is planning to acquire a 40 MW project called Wicko, which is set for launch in 2012. This complex of 20 wind turbines will generate ca. 90 GWh of green energy. Tauron’s capacity in this area will be increased further in 2014, when its own wind farm project should be completed (200 MW). One more project of this kind is coming before 2020. The segment's CAPEX is to total PLN 3.9bn over the next 10 years. Within this timeframe, the value of green certificates originating from Tauron's wind farms and hydroelectric plants will increase by ca. PLN 300m. Earnings in Renewable Energy, Our Forecasts (PLN m) 2007 2008 2009 2010F 2011F 2012F 80 45 105 44 123 55 126 58 126 55 176 89 57% 42% 45% 46% 43% 51% 15 19 21 21 26 36 1% 1% 2% 1% 2% 2% 61 63 76 79 80 125 76% 60% 62% 62% 64% 71% 4% 4% 3% 3% 3% 4% 239.4 241.1 256.4 264.0 264.0 264.0 Hydroelectric plants 0.4 0.4 0.4 0.4 0.4 0.4 0.4 0.4 0.4 0.4 0.5 0.4 Wind farms 0.0 0.0 0.0 0.0 0.0 0.1 Revenue EBIT EBIT margin D&A expenses % share in Tauron Group EBITDA EBITDA margin % share in Tauron Group Green certificate price, PLN/MWh* Renewable energy output (TWh) *spot prices at Polish Power Exchange Source: Tauron, estimates by BRE Bank Securities In 2007-2009, the Renewable Energy generated fairly stable earnings, as can be expected from the nature of this business. The segment comprises the Group's hydroelectric power plants, which in the recent years have not been subject to capacity or output changes. Renewable Energy generates a very high margin, but given the relatively small size of the segment, its share of consolidated EBITDA does not exceed several percent. The increase in revenue observed in the past three years is largely a consequence of the increase in green certificate pricing. Due to the ownership structure of the hydroelectric plants, the segment’s sales figure excludes revenue generated by the sales of 0.4 TWh of Tauron's green energy 16 August 2010 16 Tauron Polska Energia BRE Securities BREBank Bank Securities (revenue from the green certificates of Enion Energa power plants, which figured to PLN 27m, PLN 42m and PLN 60m in 2007-2009, respectively, are "transferred" to the Trade segment, as the parent company uses them directly). In the following years, we do not expect considerable changes in Renewable Energy earnings, until first wind farms are launched (2012). Distribution • • • • • With annual distribution of 30.9 TWh, Tauron has a 27% market share. The distribution business is a regulated one, and its earnings are based on regulatory asset value (RAV) determined by the URE and the relationship between operating expenses incurred and caps set by the regulator. Earnings are set to improve following changes in RAV determination rules, which could bring the EBIT to PLN 700m in 2016. There is potential for a reduction in operating expenses and in network losses (at present, balancing costs incurred on this account figure to ca. PLN 400m per year). Further expansion of the network and interconnector construction is under planning (PLN 1.3bn in growth CAPEX in 2010-2012). Energy distribution is the domain of two subsidiaries, Enion and EnergiaPro, which own lowand high-voltage infrastructure in south and south-western Poland, serving ca. 4.1m clients. In 2009, the two companies delivered 30.9 TWh of electricity to users (27% of the Polish market). Energy distribution is a regulated business, with tariffs set by the URE. Regulatory revenue is calculated as the sum of operating expenses (so as to force distributors to increase their efficiency, the URE does not take into account all of the expenses they report; according to our estimates, for Enion and EnergiaPro the ratio is ca. 83%), depreciation, cost of purchase of transfer services from PSE, network losses (while the level of network losses is adjusted to the distributor's assets, the price limit for energy purchases to compensate for such losses is systematically set too low), tax on network property and return on capital, calculated as the product of the weighted average cost of capital (WACC, 10.4% in 2009) and the so-called regulatory asset value (RAV) In theory, the EBIT of the distribution segment should be equal to that last component. In reality, however, it is lower than that, due to the regulator’s practice of assessing lower costs in the calculation of tariffs, as mentioned above. Another key issue is the regulatory asset value the URE is willing to accept. Key parameters for the determination of the return on RAV (PLN m) Value of the segment’s fixed assets RAV according to URE WACC Proportion of RAV used to calculate return Return on capital EBIT Regulated revenue 2006 2007 2008 2009 2010F no data no data 2005 7 453 7 268 7 767 8 108 3 516 3 641 9 836 3 314 3 296 3 299 11.99% 10.59% 10.04% 50.0% 199 9.85% 10.41% 10.52% 75.0% 100.0% 100.0% 105.1% 51.6% 262 331 346 398 534 no data no data 110 194 95 293 4 096 4 331 4 225 4 346 4 463 4 698 Operating expenses allowed by URE 697 722 737 932 954 994 Actual operating expenses 861 917 1 052 1 165 1 147 - 81% 79% 70% 80% 83% - Percent of operating expenses allowed Source: Tauron, estimates by BRE Bank Securities The URE’s approach to the determination of what percentage of RAV will be used to calculate Tauron’s return has changed quite often over the past few years. In 2004-2007, regulatory asset value was determined on the basis of the fair value of assets of the 10 regional power utilities which had been consolidated into EnergiaPro and Enion in 2004. However, return on capital was not calculated on RAV in its entirety, but on a portion of it (e.g. 50% in 2005, rising to 100% in 2007). In 2008 and 2009, net investment was added to this figure, and in 2009 distributors were allowed to add 0.5% of the 2008 RAV (this is the reason why in the table above the share of RAV used to calculate return on capital exceeds 100%). Meanwhile, power utilities and the regulator launched negotiations aimed at developing a long-term patch towards achieving full return on distribution assets (considerable discrepancy between RAV and the balance-sheet value of the assets). In the end, it was decided that in 2010 and beyond return on capital will be calculated as the sum of the return on capital in the preceding year 16 August 2010 17 Tauron Polska Energia BRE Securities BREBank Bank Securities (ROCt-1),1.5% of regulated revenue in the preceding year (RRt-1) and return on net investment after 2008 (ROIt), i.e. ROCt-1+ 1.5%*RRt-1+WACC*ROIt. The formula will remain in force as long as its result is lower than WACC*RAVt, where RAVt is the regulatory asset value at the end of 2008 calculated on the revenue-loss basis (a staggering PLN 9.8bn for Tauron's distributor subsidiaries), adjusted for net investment in individual periods starting in 2009. According to our estimates, the second formula will come into force in late 2016 or early 2017. By that time, the segment's EBIT should increase to ca. PLN 700-800m. In a shorter perspective, the EBIT may also be boosted by operating savings and reduction in network losses following infrastructural upgrades. Should Tauron succeed in lowering its network loss ratio to CEZ’s or PGE’s level, i.e. by some 1-2pp (from 7% to 5%), the value of energy recovered could reach PLN 120m per year, though it should be remembered that the URE may aim to lower the cap on network losses accepted in the calculation of regulated revenue, and the level of losses is often a consequence of network parameters and the structure of the customer base. Earnings in Distribution, Our Forecasts (PLN m) Revenue EBIT EBIT margin D&A expenses % share in Tauron Group EBITDA EBITDA margin % share in Tauron Group Energy distribution volumes, TWh Distribution assets 2007 4 100 110 3% 576 48% 686 17% 50% 32.2 7 453 2008 4 232 194 5% 619 49% 813 19% 50% 32.3 7 268 2009 4 085 95 2% 631 48% 725 18% 28% 30.9 7 767 2010F 4 439 293 7% 692 50% 985 22% 39% 31.8 8 108 2011F 4 687 349 7% 759 52% 1 108 24% 41% 32.9 8 382 2012F 4 929 411 8% 821 53% 1 232 25% 43% 33.7 8 594 Source: Tauron, estimates by BRE Bank Securities Distribution accounts for 17-19% of Tauron’s consolidated EBITDA, though it is worth pointing out that this is a consequence of its high depreciation charges (nearly half of the Group's total). High depreciation does not, however, entail high cashflows, because distribution assets require considerable replacement CAPEX (the segment’s total CAPEX figure in 2009 was PLN 746m). Of course, the segment’s EBIT is determined by the regulator’s approach to the determination of regulatory revenue, as discussed above. In fact, it was URE’s decision to accept more advantageous parameters in 2008 (higher RAV, higher proportion of operating expenses accepted for use in the calculation) which led to the clear improvement in EBIT that year. In 2009, UE once again increased Tauron’s distributors’ regulatory revenue. Unfortunately, due to the decline in the demand for electricity, volumes were much lower than planned. This has a considerable impact on profitability, as aggregate regulated revenue is the basis for the calculation of tariffs for the given year (based on distribution volumes forecasted ex-ante). In 2009, volumes ended up being much lower than expected; as a result, Tauron generated a revenue much below the level accepted by URE, which depressed earnings (an important factor was also the fact that the price of energy bought to cover network losses was much higher than allowed by URE). We expect 2010 to bring a considerable improvement in earnings, all the more so that URE has raised both the cap on regulatory revenue (by PLN 235m) and the cap on the price of energy purchased to balance the network (by PLN 56/MWh, with prices in the market stable). In the following years, given the new path towards higher RAV, we should see these positive trends continue. Investment projects pursued by Tauron will have an impact as well, which will figure to PLN 3.1bn over the next three years, including ca. PLN 1.8bn in modernization and replacement outlays. They should improve the parameters of Tauron’s energy distribution infrastructure by reducing network losses, making it more fail-proof (for example because surface lines will be replaced with underground lines) and by IT upgrades (improved network management). The reminder of the outlays planned for this period (PLN 1.3bn) will support growth (connections for new customers, the construction of interconnectors with the Czech Republic, Slovakia and Germany). Trade • • 16 August 2010 Electricity sales to end users figure to 30.4 TWh per year, making Tauron the leader of the Polish market. Electricity sales concentrate in south-eastern Poland, i.e. in the country's most industrialized areas, giving the Company considerable exposure to big industrial customers (over 22% of total sales), which makes volumes highly sensitive to the economic situation. 18 Tauron Polska Energia BRE Securities BREBank Bank Securities • • • • • The low share of sales to households relative to competitors (23% vs. 30% at PGE) helps profitability (household prices are regulated and the business brings losses). Seles to end-users are subject to “green” and cogeneration-derived energy quotas, and such costs are not always transferable onto buyers (especially in the case of households). The segment accounted for 12% of consolidated EBITDA in 2009 thanks to the increase in market margins. The profitability of Tauron's energy trade business is lower than its Polish competitors' (ENEA, PGE) due to its “short” position (lower scale of vertical integration). It may be possible to keep margins close to the FY 2009 level and to see profit growth as the price of electricity increases, although there are risk factors to consider, e.g. increased losses on sales to households as the cost of guarantees of origin goes up and increased competition in sales to business customers (TPA). Tauron's electricity trading activities (and trade in emission credits and rights stemming from guarantees of origin) are mostly carried out through two subsidiaries, Enion Energia and EnergiaPro Gigawat, created in the process of the unbundling of distribution and sales. One consequence of the previous structure of the Polish market is that these companies’ area of operations overlaps with the Group's infrastructure (as is the case with the other vertically integrated utilities), although future marketing efforts should make it possible to find clients outside of the “home” regions of south and south-western Poland, including abroad (last year, the Company set up a retail branch in the Czech Republic). At present, Tauron serves some 4m customers, to whom it sold 30.4 TWh of energy in 2009, which made its Poland's biggest electricity seller. To be sure, the runner up PGE did reduce the gap to Tauron, but this was a consequence of a reduced demand on the part of the biggest industrial customers, who account for a greater proportion of Tauron's customer base than in the case of its peers (nearly 22% in 2009 - and probably even more in 2008 - while the market average was under 20%, with PGE at 19.8% and ENEA at just 12%). The higher share of business customers makes volumes more sensitive to the business cycle, but it also boosts profitability, given that sales to households are still regulated in Poland and bring losses. The regulator’s strict polices make it impossible to fully reflect market prices in the amounts charged of this group of customers; as a result, Tauron loses ca. PLN 10-15 per 1 MWh supplied (at 7.1 TWh, this entails an annual loss of PLN 71-106m). If this market is deregulated (which has been promised for years), the segment’s profitability should improve, although these gains are sure to be partially transferred to business customers, who at the moment subsidize sales to households. Quite possibly, once sales to households are deregulated, the Company will have to incur additional marketing expenses as competition intensifies. Diagram of transactions in the Trade segment* Group-wide energy balance Electricity purchases Own electricity production Electricity sales Retail 90% PKE 16.8 TWh Households 55% 7.1 TWh 95% 17.7 TWh Other 1.8 TWh 23% 7.0 TWh Business customers 23.4 TWh 5% 1.8 TWh 77% 27.8 TWh 33.7 TWh Outside purchases Domestic wholesale 40.0 TWh Balancing market 45% 10% Wholesale 3.3 TWh 5.2 TWh 11.3 TWh 0.7 TWh 75% 19.6 TWh 0.2 TWh Imports 0.3 TWh 0.0 TWh 5% Other 2% 2.7 TWh 18% 0.7 TWh * electricity volumes shown in black pertain to 2009, in blue (smaller font) to 2008 Source: Tauron, BRE Bank Securities 16 August 2010 19 Tauron Polska Energia BRE Securities BREBank Bank Securities Guarantees of Origin: Net Effect Statutes and regulations of the Ministry of the Economy force Polish power utilities who sell electricity to end users to sustain a certain share of energy from renewable sources ("green" energy), energy generated in highly efficient cogeneration ("red" energy) and energy generated in natural-gas-based cogeneration ("yellow" energy) in total sales. As a result, trading companies must submit to the URE a specific number of the so-called guarantees of origin they buy in the market, or alternatively pay a special fee. The cost of purchasing these guarantees is partially transferred onto business customers, and partially offset against the revenue the power-generating sister companies earn from the sale of the same certificates (at the moment, internal sources provide 42% of Tauron's green certificates and 29% of its red certificates, but no yellow certificates at all). An increase in the price of the certificates or the introduction of higher quotas (cf. the path of future changes shown below) will have an impact on earnings in the segment and in the Group as a whole. According to our estimates, these costs could increase by ca. PLN 46m in 2010. Mandatory quotas of “colored energy" in total sales and PPE prices of the individual classes of guarantees of origin, PLN/MWh 25.0% 20.0% 23.2% 22.2% 21.3% 20.6% 300 19.0% 250 15.0% 264 256 241 239 200 10.4% 10.4% 10.4% 150 8.7% 10.0% 7.0% 119 125 123 116 100 5.0% 2.7% 3.1% 2.9% 3.5% 3.3% 50 0.0% 18 17 20 19 0 2008 2009 Green energy 2010 Red energy 2011 2012 2007 Yellow energy 2008 Green certificate 2009 2010YTD Yellow certificate Red certificate Source: URE, Ministry of Economy, PPE The trade business brings s low margin, but with rising turnover (due to mounting energy prices), the segment accounted for 12% of consolidated EBITDA in 2009. Most of the margin comes from sales to business customers, who buy ca. 77% of the total volume. Because of the regulator’s strict policies, the regulated sales to households continue to generate losses (the URE approves tariffs which consistently underplay the cost of buying electricity incurred by its sellers). The past financial performance of the segment illustrates the same trends as the data for other Polish utilities, which also saw a considerable improvement in the margin on electricity sales in 2009. We expect this higher level will be sustained in the coming years, or go down only slightly (due to pressure from business customers and rising popularity of thirdparty access), which, given the expected increase in electricity prices, will translate into higher profits, though the segment’s earnings will still be weighed down by household tariffs, due in particular to the rising cost of "colored" energy. Deregulation would mark a breakthrough, but it is impossible to say at the moment when this might happen. It should be pointed out, however, that Tauron’s EBITDA margin in Trade (2.7%) is below ENEA's (4.8%) or PGE's (5.3%). This, however, is a consequence of the lower scale of vertical integration at Tauron rather than differences in efficiency or pricing strategies. Tauron has a “short position” in the market (it sells much more energy than it generates), which means that it gives up a considerable portion of its wholesale market to, for example, PGE. The share of internally-generated energy in sales to end users is only 61% at Tauron, vs. 73% at ENEA and 179% at PGE. Earnings in Trade, Our Forecasts (PLN m) 2007 2008 2009 2010F 2011F 2012F Revenue 6 863 19 9 947 90 11 522 302 11 726 272 12 150 266 12 792 265 0% 1% 3% 2% 2% 2% 1 3 4 6 9 12 0% 0% 0% 0% 1% 1% 20 93 306 278 275 277 0% 1% 3% 2% 2% 2% 1% 6% 12% 11% 10% 10% 33.9 34.7 30.4 31.3 32.4 33.2 EBIT EBIT margin D&A expenses % share in Tauron Group EBITDA EBITDA margin % share in Tauron Group Energy sales volumes, TWh Source: Tauron, estimates by BRE Bank Securities 16 August 2010 20 Tauron Polska Energia BRE Securities BREBank Bank Securities Other • • The focus of this segment is the regulated low-margin business of heat distribution (10,000 TJ) and it has a marginal impact on consolidated earnings. In addition, the segment encompasses KW Czatkowice, a limestone mine whose output is used in the desulfurization process. The most important element of this segment is the distribution of heat by PEC Katowice, in which Tauron owns a 95.7% stake and which it has been consolidating since May 2008 following acquisition from the Treasury (this is the source of the notable increase in the segment’s revenue), PEC Dąbrowa Górnicza (85%) and SEC Jaworzno (which is currently owned by PKE in 64.5%, and as such is not consolidated under the full method). The former two entities have their own heat generating plants (22 MWt and 174 MWt, respectively), while 98% of the heat distributed by SEC Jaworzno comes from a CHP plant which constitutes a part of the Jaworzno II complex (and partially also Jaworzno III). PEC Katowice operates in five cities (Katowice, Chorzów, Świętochłowice, Siemianowice Śląskie and Mysłowice), and PEC Dąbrowa Górnicza two, Dąbrowa Górnicza itself and Sosnowiec. Both companies sell similar amounts of heat per year, ca. 5,000 TJ. Heat distribution is fully regulated by the URE (as a natural monopoly) and is not very profitable, as can be seen in the earnings table below. We do not expect this situation to change considerably in the near future. In addition, the “Other” segment includes the Czatkowice limestone mine, which manufactures sorbents used in the wet desulfurization process at Tauron’s power plants. Earnings in “Other” segment, Our Forecasts (PLN m) 2007 2008 2009 2010F 2011F 2012F Revenue EBIT 251 -15 363 -25 518 7 505 3 507 1 534 9 EBIT margin -6% -7% 1% 1% 0% 2% 27 39 55 55 56 57 2% 3% 4% 4% 4% 4% 12 15 62 58 57 65 EBITDA margin 5% 4% 12% 12% 11% 12% % share in Tauron Group 1% 1% 2% 2% 2% 2% D&A expenses % share in Tauron Group EBITDA Source: Tauron, estimates by BRE Bank Securities Financing of Operations: Net Debt At the end of last year, Tauron’s net debt figured to PLN 868m, i.e. it was very low relative to both equity and EBITDA, as confirmed by the high rating assigned to Tauron by Fitch. Tauron’s total financial debt of PLN 1.9bn included, inter alia, liabilities stemming from bonds issued to finance the construction of a 460 MW unit at Łagisza (PLN 597m), preferential loans for the same project from BOŚ and the National Environmental fund (PLN 322m), a PLN 243m loan for modernization work at the Siersza power plant (denominated in the USD, which makes it the Company's only material exposure to foreign-exchange risk) and a PLN 115m loan taken to finance the construction of a desulfurization installation at Łaziska. In the past calendar year, thanks to high cash flows from operations (nearly PLN 2m) and reduced CAPEX, the Company was able to attain a considerable debt reduction. In our opinion Tauron will be able to keep leverage this low (0.3xEBITDA) this year, but the Management’s investment program will entail a higher consolidated debt. According to our estimates, the Company will incur the highest expenses in 2013-2015 (with a peak in 2014), which will push the net debt / EBITDA ratio above 3.0 within five years. However, given the nature of Tauron’s business, we consider the use of debt realistic and safe. In the near future, the Management will attempt to prepare the Group for these developments, by centralizing liquidity management (cash pooling, intra-group bonds), which should facilitate a reduction in the cost of financing, improve cash flow management efficiency and boost the concern's credit capacity. 16 August 2010 21 Tauron Polska Energia BRE Securities BREBank Bank Securities Net debt (PLN m) Loans long-term short-term Bonds long-term short-term Leases Financial debt Cash Net debt Net debt / equity Net debt / EBITDA 2007 1 576 1 190 386 420 345 75 182 2 178 974 1 204 0.11 0.87 2008 1 358 871 487 718 555 162 155 2 231 950 1 281 0.12 0.79 2009 1 179 664 515 597 516 81 124 1 900 1 032 868 0.07 0.34 Source: Tauron Dividends In 2008 and 2009, the parent Company paid PLN 20m and PLN 51m as dividends to shareholders, i.e. 13% of FY07 net profit and 39% of FY2008 profit, respectively. The profit for FY 2009 was retained in the Company in its entirety except for PLN 8.3m paid to the Treasury due to legal requirements. For FY 2010-2012, the Management is going to recommend that dividend not exceed 30% of consolidated net profit attributable to shareholders of the parent, with the caveat that the current stage in the Company’s development, investment projects, liquidity, debt and market situation (i.e. cost of debt) all be taken into account. In a longer term, Tauron could pay as much as 40-50% of its consolidated net profit to shareholders. Since the Company's IPO does not involve new share issues and that the investment program is ambitious, we should assume that in the upcoming years the Company will accumulate funds to finance expenses set to peak in 2013-2015. Therefore, in our forecasts we assume a payout rate of 20% in the medium term. It should be noted here that an additional obstacle to dividend payments is the current structure of the Group, with most cash flows generated by subsidiaries. Structure of Costs: Potential Savings As is the case with other Polish power utilities, the biggest component of Tauron's costs are payroll expenses, which amounted to PLN 2.3bn in 2009. At first sight, such overemployment, whose roots lie in the past, offers considerable potential for future cost cutting (which, as discussed above, is even greater for Tauron than for ENEA or PGE). It is worth noting at this point, however, that social contracts binding the Company provide employment guarantees through at least 2014, extend the protection of elderly workers to six years before retirement and force annual salary hikes. The very strong unions are unlikely to allow the Management to pursue such cost cuts. The only hope for expense reduction and profitability improvement lies in the process of capital integration of the Group, which is expected to be concluded by 2011 (centralization of some cost groups and reduction in G&A expenses through mergers of some of the subsidiaries which will be wholly owned by then). Costs by category (2009) Other 1% Employee benef its 26% Materials and energy 29% Taxes and fees 6% Other 4% Maintenance services 2% Depreciation 15% Transmission services 17% Source: Tauron 16 August 2010 22 Tauron Polska Energia BRE Securities BREBank Bank Securities We can hardly expect cuts in the other expense categories, including the most important category, variable expenses, i.e. the cost of materials and energy. Approximately 85% of costs in this category are fuel purchases (coal, gas, biomass), and no reduction will be possible here until efficiency-increasing investment projects have been completed (this topic is discussed in greater detail above). As for the cost of transmission services (17% of the total), it should be noted that expenses incurred in this category are transferred onto customers in full, as Tauron is a mere intermediary which charges these fees on behalf of PSE. Taxes and fees, which figured to PLN 488m in 2009, are shaped by administrative decisions (property taxes, environmental fees) and there is little hope they will be reduced in the near future. Q1 2010 Consolidated Financial Results Tauron generated an operating profit of PLN 476m in the first quarter of 2010, marking a 42% increase over the Q1 2009 figure. The strong growth was owed primarily to Distribution, which achieved an EBIT of PLN 117m (in spite of additional expenses incurred on grid repairs necessitated by freezing temperatures and snowfall damage), in a substantial improvement from an PLN 18m EBIT loss reported a year earlier. The improvement was owed to an over-PLN 100m increase in revenues, fueled by a more favorable price tariff set by the regulator, and by slightly higher power-transmission volumes. These factors will continue to support the segment’s profitability going forward, however, the future profit figures will not be as strong because of seasonal variations. The first-quarter EBIT of the Generation segment also displayed a year-on-year increase, but this was owed mainly to higher LTC compensation (PLN 74m vs. PLN 30m in Q109). The adjusted EBIT is weaker as a result of slightly lower power prices realized on 11% higher generation volumes. Tauron points out that the financial performance of the Generation segment is subject to considerable seasonal variations, as exemplified by the results of 2009, when the bulk (PLN 145m out of a total PLN 193m) of the LTC-adjusted profits were generated in the first quarter. The results of the following quarters were built primarily on stranded-cost recoveries (which reached a Q209-Q4 total of PLN 450m). In the Trade segment, EBIT dropped 25% as a result of additional costs of green certificates related to household electricity, paired with increasing competition for industrial consumers – a combination of factors which is factored in our full-year financial forecasts for Tauron. The Mining segment maintained its first-quarter EBIT at the year-ago level in spite of a drop in unit coal prices, by increasing output from 1.1MT to 1.4MT. The deteriorated Q1’10 earnings of the Renewable Energy line was probably due to seasonally low capacity usage by Tauron’s hydroelectric power stations. "Other" operations, most notably heat generation and sales, improved their profits thanks to seasonally low temperatures. Consolidated Q1 2010 results vs. our full-year forecast (PLN m) Revenues of which LTC compensation EBIT, incl.: Mining Power Generation Renewable Energy Power Distribution Trade Other Unattributed EBITDA D&A expenses Financial operations Pre-tax income Tax Minority interests Net income 1Q 2010 3 794.3 73.6 476.0 43.0 184.9 13.9 117.0 84.4 26.3 6.6 822.7 346.6 -26.3 449.7 1Q 2009 3 549.5 29.7 334.7 44.7 175.0 17.1 -18.4 112.9 14.7 -11.2 659.3 324.6 -28.8 305.9 change 7% 148% 42% -4% 6% -19% -25% 79% 25% 7% -9% 47% 90.1 67.8 291.8 84.8 35.0 186.0 6% 94% 57% 2010FQ1/FY2010F (pct.) 13 816.5 27.5% 141.0 52.2% 1 144.2 41.6% 122.3 35.2% 409.9 45.1% 57.9 24.1% 292.6 40.0% 272.2 31.0% 12.2 -22.9 2 529.9 32.5% 1 385.8 25.0% -113.5 23.2% 1 030.7 43.6% 195.8 114.6 720.3 46.0% 59.1% 40.5% 2009Q1/FY2009 (pct.) 13 633.6 26.0% 484.0 6.1% 1 259.7 26.6% 147.0 30.4% 677.1 25.8% 55.1 31.0% 94.6 301.8 37.4% 6.6 -22.6 49.7% 2 581.0 25.5% 1 321.2 24.6% -94.7 30.4% 1 165.0 26.3% 266.3 166.3 732.4 31.9% 21.1% 25.4% Source: Tauron, F – forecasts by BRE Bank Securities Tauron generated high operating cash flows in Q1 2010 (PLN 210m vs. PLN 14 in Q109), but, because of high capital expenses totaling PLN 318m, its net debt as compared to the preceding quarter increased by PLN 228m to PLN 971m. The first-quarter CAPEX accounted for just 17% of what we expect Tauron to spend this year, but this might have been related to unfavorable weather conditions, and capital investment should increase in the following 16 August 2010 23 Tauron Polska Energia BRE Securities BREBank Bank Securities quarters. Overall, Tauron had a very successful first quarter. The achievement of 42% of our full-year EBIT estimate was owed to seasonal patterns, and is not a case for upward revisions in our 2010 forecasts. Our prediction is that this year’s EBITDA will be close to the 2009 figure. Q2 2010 Outlook Tauron’s 2010 second-quarter results are expected to reflect a seasonal slowdown, with EBITDA falling 30% relative to Q1. By business segment, Mining's profits will decrease on a lower coal output (1.2MT vs. 1.4MT in Q1), and Generation will be impacted by lower LTC compensation (PLN 50m vs. PLN 74m) and lower volumes (Tauron power plants are not typical baseload units, and they do not receive many requests from the grid operator PSE during periods of lower demand), resulting in a drop in the combined EBIT of the two segments by ca. PLN 100m. A seasonal decrease in power supply will also negatively impact the operating profit of the Distribution segment, expected to drop to PLN 29m from PLN 117m in Q1’10. The downturn will be additionally underpinned by higher costs of maintenance postponed from the first quarter due to bad weather (the Q1’10 maintenance costs were about PLN 85m lower than in the same period a year ago). Without any major one-time gains or losses from financial operations, and after minority interests, Tauron’s 2010 second-quarter bottom-line profit is expected to approximate PLN 145m. Q2 2010 Consolidated Earnings Forecast (PLN m) Revenues EBITDA EBITDA margin EBIT Pre-tax income Net income 2Q2010F 2Q2008 change 3 180.3 578.5 18.2% 239.9 220.4 145.3 - - Q1-Q2 2010F 6 974.6 1 401.2 20.1% 715.9 670.1 437.1 Q1-Q2 2009 - change 2010F - 13 816.5 2 675.3 19.4% 1 144.2 1 030.7 720.3 as pct. of 2010F 50% 52% 63% 65% 61% 2009 13 633.6 2 580.8 18.9% 1 259.7 1 165.0 732.4 Source: Tauron, F – forecasts by BRE Bank Securities CEE Energy Market • • • Energy demand is slowly picking up after a 2008 slump led by a downturn in industrial production; recent consumption data show year-on-year rise. Falling demand sent European energy prices tumbling, but the real effects of this will be felt in 2010 and 2011 due to hedging mechanisms; prices in Poland are steady after a 2009 rebound. Prices are poised to recover on rising costs of fuel (coal, Russian gas). The onset of the European energy crisis late 2008 was a direct consequence of falling industrial production. Sinking volumes were quickly followed by a downturn in EEX prices, accompanied by a downward momentum in the prices of basic fuels: coal and natural gas. In Q2 2009, reductions in electricity usage at times exceeded 10%, though the 2009 full-year drop vs. 2008 for the CEE region amounted to 6%-7%. Demand in the region’s largest market, Germany, shrunk by a staggering 7.4% during the first three quarters of 2009, but the pace of the downward slide decelerated to 1.6% in December thanks to base effects, in line with the trends observed in industrial production. Demand is likely to continue its recovery in coming months, however, considering the sluggish pace of capacity rebuilding by manufacturers (February 2010 was the first month to witness better-than-expected production data), electricity usage levels as forecasted for the German benchmark will display flat year-on-year growth in 2010. 16 August 2010 24 Tauron Polska Energia BRE Securities BREBank Bank Securities Electricity consumption in Germany & Czech Republic vs. industrial production Germ any Czech Republic Industrial production (right scale) 10% 20% 10% 5% 10% 5% 0% 0% 0% Industrial production Energy usage 2009Q03 2009Q01 2008Q03 2008Q01 2007Q03 2007Q01 2006Q03 2006Q01 -15% 2005Q03 -30% 2005Q01 -10% -15% 2004Q03 -20% 2004Q01 -5% -10% 2003Q03 -10% 2003Q01 -5% 2009Q03 2009Q01 2008Q03 2008Q01 2007Q03 2007Q01 2006Q03 2006Q01 2005Q03 2005Q01 2004Q03 2004Q01 2003Q03 2003Q01 10% 5% 0% -5% -10% -15% -20% -25% Energy usage (right scale) Source: Eurostat The outlook for electricity markets in Poland and the Czech Republic is somewhat better, with demand expected to edge up this year on the back of stronger economic growth. According to data compiled by the Polish transmission system operator PSE-Operator, electricity usage in Poland was 2.3% higher in December 2010 than in the same month a year earlier, and the first-quarter year-on-year growth amounted to 3.4%. In the Czech Republic, January consumption was 0.8% higher than a year ago after a slowdown from the 3.2% growth rate recorded in December 2009, which, however, can be attributed to base effects. Based on reports of 7% production growth in January and February, we believe it is safe to assume that the country’s energy demand is set for a rebound this year. Electricity consumption in Poland vs. production growth Industrial Production Index Energy consum ption 2008 2010 Jan-10 Oct-09 Jul-09 Apr-09 Jan-09 Oct-08 Jul-08 Apr-08 December November October August July 2009 September 2007 June May April March February January 5 000 Jan-08 7 000 Oct-07 9 000 Jul-07 11 000 Jan-07 20% 15% 10% 5% 0% -5% -10% -15% +3.7% +3.7% 13 000 Apr-07 15 000 +3.0% Industrial production Source: GUS, PSE Falling demand and a deteriorated economic outlook had an immediate impact on electricity prices quoted by major European exchanges. Prices of power futures on the European Energy Exchange (EEX) reached their low in March 2009, and the same trends were observed in Poland, where the price of 1 megawatt hour was down to PLN 140 from a 2008 average of PLN 194. As the global economy picked up, so did sentiment among energy traders, and prices rebounded to their start-of-year levels. Eventually, however, the optimism was proven premature by slower-than-expected growth in capacity usage by the manufacturing industry, and by monthly power consumption which continued to show year-on-year declines. EEX prices took a downward turn again, and the slump was further reinforced by questions raised earlier this year about whether the economy has entered a new recovery phase, or is just on a rebound from recession. It is important to remember that, due to the extensive hedging policies of power producers, there is a time lag between market-price movements and their manifestation in company earnings. Accordingly, the 2009 downturn affected mainly generation volumes and spot sales, while the impact on producer earnings in countries like the Czech Republic or Germany has started to be noticeable in 2010, and is expected to linger through 2011. RWE is an example of an electricity supplier which made arrangements to sell 60% of its 2010 output and 20% of its 2011 output back in 2008, when prices were still relatively high. Hedging effects should be taken into account when comparing current wholesale electricity prices in Western Europe and Poland (market prices are not a good benchmark precisely because of these effects). The trends affecting electricity prices also affected confidence in the markets for fuels used in electricity generation, more specifically natural gas and coal (the costs of these fuels have a 50% and 70% share respectively in power-pant operating expenses after adjustment for CO2 allowances). Prices of steam coal in the ARA area are 58% lower at the moment than in 2008, and natural gas prices are down 57%. If we take into account this and the reduction in carbon emission credit prices from EUR 31 to EUR 13 a ton, the 46% drop in electricity prices between July 2008 and now seems to be counterbalanced by the reduced European power16 August 2010 25 Tauron Polska Energia BRE Securities BREBank Bank Securities plant costs. According to our estimates based on RWE data, forward electricity prices in 2011 are lower than the theoretical marginal costs of a new coal-fired power plant. The difference is about 10%, or even 11% for a CCGT plant, but this is too little (in particular given that estimates of power plant costs involve a large number of variables) to inform accurate predictions about the future balance between prices and costs. That said, these estimates indicate that the downside potential of EEX prices is nearly exhausted, and this conclusion is further supported by the fact that fossil fuels, in particular natural gas, have performed much worse over the past year than other raw materials such as copper or oil. The weakening of the correlation to oil prices was probably a consequence of a strong global supply of LNG combined with limited storage capacities. We expect European gas prices to increase in coming months, fueled by more expensive Russian supplies stemming from the pricing formulas used by Gazprom. Electricity vs. coal- and natural-gas prices (January 2008=100); gas prices in Russia vs. at Zeebrugge 230.0 210.0 190.0 170.0 150.0 130.0 110.0 90.0 70.0 50.0 30.0 600 500 400 300 200 EEX electricity EEX natural gas May-10 ARA steam coal Russian gas prices (USD/1000 m3) 3Q 10F 3Q 09 1Q 10F 1Q 09 3Q 08 1Q 08 3Q 07 1Q 07 3Q 06 1Q 06 3Q 05 0 1Q 05 Jan-10 Mar-10 Nov-09 Jul-09 Sep-09 May-09 Jan-09 Mar-09 Nov-08 Jul-08 Sep-08 May-08 Jan-08 Mar-08 100 1M Zeebrugge contracts (USD/1000 m3 Source: Eurostat We based our long-term forecasts of electricity prices on their correlation with crude oil prices. In view of the scheduled implementation of the EU climate package in 2013, our estimates take into account the effects of the resulting increase in CO2 emission credit costs. We assume that these costs (the European Commission set the target carbon-credit prices at EUR 40/T) will become fully reflected in electricity prices by 2020, after discontinuation of free emissions allocations. Our estimates are close to the current prices of contracts for delivery in 2011 and 2012, but remain higher than the current EEX quotes on contracts with delivery dates in 2013 through 2015. This can be largely attributed to the expected trends in CO2 emission credits which are traded at about EUR 15/T, and which we expect to increase to EUR 30/T after the implementation of the EU climate package in 2013 (note that the allowances can be saved for use in future years, and some producers are probably buying them up now while they are still cheap). Electricity price forecasts, current EEX quotes* 2014F 2013F 2012F 2011F 90 80 70 60 50 40 30 20 10 0 2010F 2017F 2015F 2013F 2011F 2009 2007 2005 2003 80 70 60 50 40 30 20 10 0 2001 90 80 70 60 50 40 30 20 10 0 CO2 emission credits estimated 1Y forw ard electricity prices electricity price forecast current quotes current quotes adj. for CO2 credits oil prices (EUR/Bbl) (right scale) *price quotes and forecasts for 1Y futures contracts (e.g. a 2010 price estimate is for a contract for delivery in 2011) Source: Bloomberg, estimates by BRE Bank Securities 2009 saw an unprecedented, 26% jump in electricity prices in Poland, which followed a period of a coal shortage paired with record power demand in 2008. In spite of this jump, local average wholesale prices remained well below those charged by producers in Germany and the Czech Republic. This gap is expected to narrow this year, though mainly thanks to a downturn in EEX quotes caused by weak economic momentum, and lower EUR/PLN exchange rates. When comparing different markets, keep in mind that international producers can hedge prices in liquid exchanges – a mechanism not yet available to Polish energy companies (next year’s deliveries are largely contracted during the final months of the preceding year). This is illustrated by the following diagram, showing current EEX quotes and 16 August 2010 26 Tauron Polska Energia BRE Securities BREBank Bank Securities the selling prices charged by CEZ. Polish vs. EEX electricity prices, CEZ selling prices 350 300 250 200 150 100 50 Polish w holesale prices (PLN/MWh) EEX prices (PLN/MWh) 2014F 2013F 2012F 2011F 2010F 2009 2008 0 CEZ's selling prices (PLN/MWh) Source: Source: Bloomberg, URE, PGE, CEZ, estimates by BRE Bank Securities The diagram indicates that there is still potential for convergence of Polish prices toward EU levels. Because of limitations in transmission capacity which are not likely to be remedied in the near future, price convergence will not be achieved through cross-border arbitrage, but through rising prices of fuels, in particular hard coal. Until recently, a considerable spread between Polish and German electricity prices was maintained thanks to relatively constant price spreads between Polish and ARA coal. With the recent narrowing of the domestic-ARA price gap, however, aggressive coal imports into Poland should strengthen the correlation of the prices charged by Polish mines with global price trends. This prediction is further supported by the fact that the profit margins earned by leading Polish coal producers have been considerably squeezed by high production costs, which means that these mines will probably take advantage of any recovery in demand from neighboring countries, and the resulting drop in competitive pressure, to increase their selling prices. This suggests (and this is the assumption on which our forecasts are based) that domestic electricity prices in the years ahead are going to follow the same trends as leading European markets. Poland vs. ARA coal prices and production costs 300.0 400 350 250.0 300 200.0 250 150.0 200 150 100.0 100 50.0 50 0.0 0 2003 2004 2005 NWE coal (PLN/T) 2006 2007 2008 2009 Polish steam coal prices (PLN/T) 2010F 2003 2004 2005 2006 avg. coal production costs (PLN/T) 2007 2008 2009 Polish coal prices (PLN/T) Source: Bloomberg, Ministry of the Economy 16 August 2010 27 Tauron Polska Energia BRE Securities BREBank Bank Securities Polish Electricity Market • • • • • Coal-fired power plants dominate (58% hard coal, 36% lignite). Coal is expected to remain the main source of power in the foreseeable future (45% of output in 2015). Electricity usage is correlated with GDP. Demand is expected to continue increasing at an average annual rate of 1.8% between 2010 and 2020. Power consumption dropped 4.0% amid the 2009 crisis, but Q1 2010 saw a 3.4% rebound. Low power reserve margins, especially during peak-load periods. About 40% of installed capacity is over 30 years old and needs to be replaced. The costs of such replacements are estimated at EUR 15-20 billion. Growing demand requires an additional 6000 MW of capacity. Prices of residential electricity (24% of the market total) are to remain regulated and cross-subsidized from business tariffs for the next 3-4 years. Polish and EU electricity prices have converged as a result of 2009 hikes at home and 2010 drops elsewhere in Europe. Electricity prices are expected to continue growing in the long term, fueled by the expansion of the interconnection infrastructure, tightening emission standards, and rising demand. Most of the electricity produced in Poland comes from coal, which occurs in great abundance here. As much as 56% of the total output is generated from hard coal and 36% is produced from lignite. An analysis of the future investment plans of Polish power producers indicates that coal is going to continue its domination as the main source of energy even in spite of EU pressure on CO2 emission reductions, which affects coal’s competitiveness as low-cost feedstock (costs of emission credits, environmental fees). A shift in energy sources is not likely to occur within the next decade, during which Polish power plants will have to comply with new environmental regulations, existing plants will become obsolete, and nuclear energy projects will come into play. Electricity production by source Poland EU27 Hy dro 10% Other 12% Natural gas 20% Brown coal 10% Nuclear 29% Hard coal 18% Brown coal 36% Czech Rep Natural Other 4% gas Hy dro 2% 2% Natural gas 4% Other 3% Hy dro 4% Nuclear 31% Hard coal 56% Brown coal 52% Hard coal 7% Germ any Other 16% Natural gas 11% Brown coal 22% Hy dro 4% Nuclear 26% Hard coal 20% Source: Eurostat, BRE Bank Securities An environmentally-driven shift in the distribution of domestic power sources, although noticeable, has so far not undermined coal’s domination in any significant way. The fastestgrowing source of alternative energy is biomass, which is eligible for green certification. Over the last four years, the volume of energy produced from biomass co-burning increased over 2.6-fold (including contributions from captive combined-cycle plants), and its share in the total domestic power output rose from 1.1% to 3.2% in 2009. Wind power is also gaining momentum, having reached a total maximum capacity of 720 MW since the first turbines were installed in 2006. That said, wind had a fractional, 0.5% share in the total 2009 power output. One indicator of the future prospects of wind power in Poland is the large number of planned wind-farm projects and preliminary approvals issued by URE, which represent a total capacity of 2.5 GW. However, since the motivation behind such project submissions is often to capture the most viable wind-farm sites, which are not very numerous in Poland, before others, these plans should be regarded with a grain of salt. The third type of alternative fuel with potential to increase its share in Poland’s energy mix is natural gas. The output of gas-fired power plants increased by 19% between 2006 and 2009, making up 3.3% of the total electricity output. According to announcements by leading power producers and the national gas monopoly PGNiG, the gas-fired capacity will increase by 1800 MW in the next five years. 16 August 2010 28 Tauron Polska Energia BRE Securities BREBank Bank Securities Gross electricity generation in Poland in 2002-2009 (by fuel type) (GWh) Power Utilities 2002 135 123 2003 142 494 2004 145 613 2005 148 359 2006 152 498 2007 150 866 2008 147 469 2009 143 509 Thermal plants, fired by: hard coal lignite natural gas biomass Hydroelectric plants Captive Power Plants coal-fired gas-fired biomass-fired Other Total 131 401 82 659 48 742 0 0 3 722 8 110 n/a n/a n/a n/a 143 233 139 348 87 821 51 527 0 0 3 146 8 257 n/a n/a n/a n/a 150 751 142 151 86 477 52 159 3 263 252 3 462 8 099 7 329 228 542 447 154 159 144 832 86 246 54 865 2 944 777 3 527 8 090 7 226 231 633 489 156 938 149 676 90 961 53 518 4 046 1 151 2 822 8 280 7 408 195 677 69 160 847 148 184 91 498 51 142 3 908 1 636 2 682 8 216 6 954 539 723 446 159 528 144 997 84 347 53 384 4 581 2 685 2 465 6 459 5 356 440 663 1 646 155 574 140 816 81 640 50 353 4 664 4 159 2 683 6 589 5 465 392 732 1 599 151 697 Source: PSE Over the past 15-odd years, electricity usage in Poland was correlated with GDP growth, increasing by an average 1% per year. The rising demand was fully satisfied by higher capacity usage by domestic power plants. In 2008, power consumption approximated 155 TWh, while production totaled 159 TWh. In the first nine months of the year, we observed a significant increase in demand (by an average 2.5%), which spurred warnings about possible reductions in power supply during the summer. With the onset of the financial crisis, however, demand contracted, lifting the pressure felt by producers. Toward the end of the year, when a slump in global demand forced production cutbacks, consumption displayed a year-on-year decline, which was the strongest in November and December (-6.2% and -5.9% respectively). All in all, electricity consumption in Poland rose by just 0.5% in 2008. Consumption continued its decline in 2009, falling 10.8% in April, and the downward pressure came primarily from industrial buyers, which led to differences in the sales volumes generated by producers with different customer mixes as sales to residential consumers remained steady. A shift in energy trends occurred toward the end of 2009, and it was spurred by a pickup in industrial production. Power usage started to display an upward momentum (+2.3% y/y) in December of last year, and continued to rise at 3.0-3.7% rates in the first months of 2010. Although freezing winter temperatures no doubt played a large part in this growth, they were not the only usage driver, as demonstrated by the continued growth seen in March. Per-capita electricity usage, Poland vs. EU 200 180 160 170 7000 165 6000 160 5000 155 4000 150 169 Cumulative GDP (1995=100) Turkey Lithuania 2020F 2015F 2009 2010F 2008 2007 2006 2005 2004 2003 2002 2001 2000 1999 1998 1997 1996 1995 electricity usage (TWh) 0 Romania 125 80 1000 Poland 130 Bulgaria 135 Hungary 145 146 Slovakia 141 EU-27 137 139 139 137 2000 140 153 Czech Rep. 140 141 139 149 150 Spain 136 154 155 EU-25 100 151 3000 France 120 145 Germany 140 total per-capita consumption (kWh) Source: Eurostat, ARE, URE, GUS, UCTE A few months ago, PSE-Operator issued a forecast proclaiming that Polish power consumption will increase by about 1% this year. First-quarter usage data showed that these forecasts might have been too pessimistic, and undermined the Polish government’s projections of a continued downtrend in 2010. While it would be unreasonable to expect a consumption rebound to the record 2008 levels, it seems likely that a sustained upward trend will continue in coming years, possibly at the annual rate of 1.8% projected by UCTE (the Polish Energy Market Agency, ARE, puts the power-usage CAGR at 1.6% in the years 2010 to 2015, and 2.1% in 2015 to 2020). These long-term projections are based on the assumption that percapita usage in Poland will be converging to Western European levels, since the variations between our and EU ratios range from 11% (Hungary) to as much as 55% (France, Germany). These differences are not much smaller after adjustment for residential consumption; to achieve the per-capita usage levels of Slovakia, Poland should increase power consumption by 6.1 TWh, or 4.1%. 16 August 2010 29 Tauron Polska Energia BRE Securities BREBank Bank Securities Monthly electricity usage in Poland* Energy cons um ption +3.0% 15 000 +3.7% +3.7% 13 000 11 000 9 000 7 000 2009 December November October August July 2008 September 2007 June May April January February March 5 000 2010 *year-on-year consumption trends for 2010 Source: PSE When analyzing the Polish electricity market, it is also important to consider its structure, dominated by vertically integrated utilities (PGE, Tauron, ENEA, ENERGA). With the top three producers holding 55% of the total installed capacity, the bulk (over 58%) of the trading volumes are generated between their respective power plants and sales units. Utilities sell only 0.3% of their output through the energy exchange, and, as a result, the total trading volumes achieved on the TGE hover around 3.1 TWh (2.1% of total electricity consumption). That is why TGE quotes are not a reliable benchmark for the industry. The alternative trading platform POEE (owned by PGE) attracted volumes of 4.4 TWh in 2009, but most of the trades were based on bilateral agreements. The exchange-traded energy volumes are expected to increase after the entry into force this August of the requirement that power utilities are to sell at least 15% of their output through the market (the requirement for producers receiving LTC compensation can be as high as 100%). The enforceability of this requirement has recently been put into question by an announcement by one of the leading utilities that it had entered into long-term sales arrangements with its own trading units, but the new rules are a major step toward making TGE a benchmark that will accurately reflect the actual trends in Polish energy. Meanwhile, the most reliable source of wholesale price information is the URE, whose latest annual reports have indicated that electricity prices increased considerably in 2008 and 2009, following deregulation of the market for industrial power buyers (residential energy is still fully regulated), and owing to higher demand and fuel costs. Wholesale electricity prices by sales channel (PLN/MWh), utility sales channels channel shares in total sales avg. prices by sales channel 250.0 230.0 210.0 190.0 160 170.0 150.0 130.0 113 110.0 90.0 2004 100% 184 190 171 194 177 60% 148 111 117 80% 40% 125 20% 0% 2005 2006 2007 2008 2009 2004 2005 2006 LTC to trading companies LTC on energy exchange on energy balancing market on energy exchange 2007 2008 2009 to trading companies on energy balancing market Source: BRE Bank Securities based on URE data The Polish power industry requires huge investment in order to meet growing demand and replace outdated capacity. The need for new capacity is best illustrated by peak-load reserve margins observed in 2007 and 2008, when power plant failures significantly shrunk the reserve (increasing demand paired with insufficient existing capacity increases the likelihood of failures). About 40% of the capacity installed in Poland is more than 30 years old, and will have to be retired within the next 15-20 years. This implies a need to replace ca. 14 GW of capacity (incl. 12 GW of coal-fired power), at costs which are expected to range between EUR 15bn and EUR 20bn, depending on type of fuel. Investment at this scale is impossible without support from banks and international industry investors. 16 August 2010 30 Tauron Polska Energia BRE Securities BREBank Bank Securities Polish power plants: available capacities and reserve margins (left), age (right) 16 000 35 000 33 000 31 000 29 000 27 000 25 000 23 000 21 000 19 000 17 000 15 000 6 000 14 000 5 000 4 000 10 000 8 000 2 000 6 000 1 000 4 000 0 2 000 2009 2008 2007 2006 2005 2004 2003 2002 2001 2000 1999 1998 3 000 12 000 0 0-5 years nameplate capacity available capacity margin reserve (right scale) 5-10 years 10-20 years 20-30 years 30+ years Installed capacity (MW) by age Source: BRE Bank Securities based on PSE, ARE, ENEA, PGE, Tauron data In addition to money, a key factor that will determine capacity expansion in the Polish energy industry will be the CO2 emission requirements of the EU climate package. SOx and NOx emission quotas will also play a role in investment decisions (some Polish power producers have been grated temporary derogation from the EU emission targets). As far as carbon emissions are concerned, the EU has obligated Polish power plants to purchase emission credits covering 30% of their emissions by 2013, increasing to 100% by 2020. Free credits will be available only to existing plants, or plants which started to be built before the end of 2008. Others will have to buy allowances on the market, which puts into question the profitability of building new capacity given the projected increase in CO2 allowance prices. Therefore, the only solution for producers of coal-fueled electricity is to put in place carbon capture and storage (CCS) facilities which are eligible for 15% subsidies financed from carbon credit auction revenues. It is too early to predict how the EU climate package will impact the capacity expansion plans of the Polish energy industry. Producers are still waiting for a detailed definition of what it means that a project must have “physically started” before the end of 2008 to be eligible for free emission credits in 2013 through 2020 (what is more, these projects will be required to obtain CO2 emission permits by 2011, which are tantamount to emission trading permits under the Polish law). The Ministry of the Economy has received applications for 32.4 GW-worth of projects, from which it selected fourteen most advanced ones totaling 16.7 GW of new capacity to be installed by 2020, including 10 GW by 2015. These projects are still pending approval by the European Commission, expected in late 2010 / early 2011, after which power producers can start looking for financing for the green-lighted capacity additions. 16 August 2010 31 Tauron Polska Energia BRE Securities BREBank Bank Securities Macroeconomic Assumptions The table below outlines the macroeconomic assumptions underlying DCF valuation. Prices of Brent crude (USD/Bbl) EEX energy prices (EUR/MWh) Polish energy prices (PLN/MWh) Prices of CO2 certificates, EUR/T PKW coal prices (PLN/T) PLN/USD exchange rate (avg. for the year) EUR/PLN exchange rate (avg. for the year) TAURON’s power output (TWh) lignite hard coal natural gas wind water 2007 72.8 54.9 142.8 20.6 161.6 2008 98.0 54.9 154.3 23.9 182.9 2009 62.0 69.1 195.0 13.8 241.6 2010F 75.0 49.3 190.0 14.0 224.4 2011F 80.0 50.2 190.8 17.6 229.8 2012F 90.0 55.8 200.9 22.3 252.6 2013F 90.0 63.3 221.5 30.0 245.4 2014F 90.0 66.6 233.1 31.5 245.4 2015F 90.0 67.3 235.7 33.0 245.4 2.77 2.42 3.12 3.00 2.90 2.80 2.70 2.70 2.70 3.79 3.48 4.33 4.05 3.80 3.60 3.50 3.50 3.50 22.5 0.0 22.1 0.0 0.0 0.4 19.5 0.0 19.1 0.0 0.0 0.4 18.6 0.0 18.2 0.0 0.0 0.4 19.5 0.0 19.1 0.0 0.0 0.4 19.8 0.0 19.4 0.0 0.0 0.4 19.8 0.0 19.3 0.0 0.1 0.4 19.0 0.0 18.4 0.0 0.1 0.4 20.1 0.0 18.7 0.9 0.1 0.4 21.5 0.0 19.0 1.5 0.6 0.4 Source: Bloomberg, Tauron, F – forecasts by BRE Bank Securities 16 August 2010 32 Tauron Polska Energia BRE Securities BREBank Bank Securities Earnings Forecast and Valuation Our DCF analysis produced a per-share price for Tauron of PLN 8.27, and relative valuation yielded PLN 7.35/share. We set our nine-month price target on the stock at PLN 8.42 a share. Weight Relative Valuation DCF Valuation 50% 50% Price 7.35 8.27 price 9M target price 7.81 8.42 DCF Valuation Assumptions: 1. 2. 3. 4. 5. 6. 16 August 2010 Cash flows are discounted to their value as at 31 May 2010. Equity value estimates include minority interests and net debt as at year-end 2009. The macroeconomic assumptions are as laid out above. We added an expected excise-tax PLN 85m refund related to network losses to the valuation. We adjusted the free cash flows projected for the forecast years for disputed LTC compensation, by increasing accounts payable. For the purposes of terminal value calculations, we adjusted the amount of D&A expenses to PLN 2.05bn, to match the amount of capital expenses. We assume that FCF after FY2019 will grow at a rate of 2%. The risk-free rate is 5.82%, and beta is 0.9. 33 Tauron Polska Energia BRE Securities BREBank Bank Securities DCF model for Tauron (PLN m) 2010F 2011F 2012F 2013F 2014F 2015F 2016F 2017F 2018F 2019F 2019+ Revenues 13 816 14 320 15 202 16 464 17 438 17 996 18 544 19 145 19 736 19 936 20 138 1.3% 3.6% 6.2% 8.3% 5.9% 3.2% 3.0% 3.2% 3.1% 1.0% 1.0% 2 529.9 2 675.3 2 887.2 2 911.9 3 312.3 change EBITDA EBITDA margin 18.3% 18.7% 3 676.5 4 130.8 4 542.5 4 724.2 5 206.3 5 259.0 19.0% 17.7% 19.0% Amortization and depreciation 1 385.8 1 456.2 1 549.0 1 670.7 1 796.3 1 952.9 2 250.6 2 341.2 2 424.4 2 551.0 2 054.1 EBIT 1 723.6 1 880.2 2 201.3 2 299.9 2 655.2 3 204.9 22.3% 23.7% 23.9% 26.1% 26.1% 1 241.2 1 516.0 EBITDA margin 8.3% 8.5% 8.8% 7.5% 8.7% 9.6% 10.1% 11.5% 11.7% 13.3% 15.9% Tax rate on EBIT 217.4 231.6 254.3 235.8 288.0 327.5 357.2 418.2 437.0 504.5 608.9 NOPLAT 926.8 987.5 1 083.9 1 005.4 1 228.0 CAPEX Working capital Capital investments FCF 1 144.2 1 219.1 1 338.2 20.4% 1 396.1 1 523.0 1 783.0 1 862.9 2 150.7 2 595.9 -1 901 -2 549 -3 168 -4 606 -6 248 -5 314 -4 109 -2 645 -2 210 -2 054 -2 054 -8.5 -93.8 -103.3 -111.8 -45.1 -25.8 -25.4 -27.8 -27.3 -9.2 -9.2 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 402.8 -198.7 WACC 10.1% 9.9% 9.6% 8.8% 7.6% 6.9% 6.6% 6.9% 7.4% 8.0% 8.6% discount factor 94.5% 86.0% 78.5% 72.1% 67.0% 62.7% 58.8% 55.0% 51.2% 47.5% 47.5% PV FCF 380.8 -170.9 -501.2 -1 473.2 -2 191.4 -1 249.1 -212.5 WACC 10.1% 9.9% 9.6% 8.8% 7.6% 6.9% 6.6% 6.9% 7.4% 8.0% 8.6% 6.8% 6.8% 6.8% 6.8% 6.8% 6.8% 6.8% 6.8% 6.8% 6.8% 6.8% Risk-free rate 5.82% 5.82% 5.82% 5.82% 5.82% 5.82% 5.82% 5.82% 5.82% 5.82% 5.82% Risk premium 1.0% 1.0% 1.0% 1.0% 1.0% 1.0% 1.0% 1.0% 1.0% 1.0% 1.0% 19.0% 19.0% 19.0% 19.0% 19.0% 19.0% 19.0% 19.0% 19.0% 19.0% 19.0% Net debt / EV 4.4% 8.2% 15.1% 32.1% 56.5% 72.2% 77.3% 70.7% 61.2% 48.4% 35.0% Cost of Equity 10.3% 10.3% 10.3% 10.3% 10.3% 10.3% 10.3% 10.3% 10.3% 10.3% 10.3% Risk premium 5.0% 5.0% 5.0% 5.0% 5.0% 5.0% 5.0% 5.0% 5.0% 5.0% 5.0% 0.9 0.9 0.9 0.9 0.9 0.9 0.9 0.9 0.9 0.9 0.9 Cost of debt Effective tax rate Beta FCF growth after the forecast horizon -638.7 -2 042.1 -3 268.9 -1 991.0 -361.1 1 451.1 2 050.1 2 638.4 2 586.7 798.6 1 050.6 1 252.0 2.0% Sensitivity Analysis Terminal value 38 948 Present value of the terminal value (PV TV) 18 481 FCF growth in perpetuity 0.0% 1.0% 2.0% 3.0% 4.0% Present value of FCF in the forecast horizon -2 316 WACC +1.0ppt 5.00 6.00 7.26 8.90 11.12 Equity value (EV) 16 165 WACC +0.5ppt 5.47 6.59 8.02 9.92 12.55 FY2009 net debt Minority interests Network loss excise receivable 744 WACC 2 368 WACC -0.5ppt 85 WACC -01.0ppt Equity value 13 138 Number of shares (millions) 1 589.4 Equity value per share (PLN) Cost of equity (9M) Target price EV/EBITDA('10) based on DCF P/E('10) based on DCF TV to EV 16 August 2010 6.00 7.26 8.90 11.12 14.29 6.59 8.02 9.92 12.55 16.45 7.26 8.90 11.12 14.29 19.21 8.27 7.6% 8.90 6.4 18.2 114% 34 Tauron Polska Energia BRE Securities BREBank Bank Securities Relative Valuation We compared Tauron’s P/E and EV/EBITDA multiples with the multiples of its peers estimated for FY2009 through FY2011. The peer group includes power producers and distributors. It also includes PGNiG, which is the closest to meeting the definition of a public utility among Polish companies. Price EDF E.ON AG IBERDROLA SA ENEL SPA RWE AG ENDESA SA FORTUM OYJ PGE PGNiG CEZ ENEA 33.37 22.79 5.44 3.82 53.32 18.80 18.54 22.04 3.47 860.6 18.94 Maximum Minimum Median Tauron (premium / discount) to median Implied price Median Multiple weight Year weight TAURON – implied value per share (PLN) 2009 P/CE 2010F 2011F 2012F 2009 EV/EBITDA* 2010F 2011F 2012F 5.6 4.6 6.0 3.8 5.5 4.2 9.1 6.3 6.5 6.2 7.1 5.3 4.7 5.6 3.6 4.9 4.5 8.5 6.5 4.9 6.5 6.3 5.1 5.0 5.3 3.6 5.1 4.7 8.7 6.0 5.1 6.4 6.3 4.7 4.8 4.9 3.4 4.8 4.5 8.2 5.6 4.9 6.3 6.1 6.4 6.1 8.7 6.0 6.4 5.7 9.7 5.0 6.5 6.6 5.1 6.0 6.1 8.1 5.7 5.6 5.8 9.3 5.4 4.5 6.8 4.4 5.7 6.2 7.7 5.7 5.7 5.8 9.5 5.0 4.7 6.8 4.3 5,3 6,1 7,1 5,5 5,4 5,5 8,9 4,5 4,5 6,5 4,0 9.1 3.8 6.0 8.5 3.6 5.3 8.7 3.6 5.1 8.2 3.4 4.9 9.7 5.0 6.4 9.3 4.4 5.8 9.5 4.3 5.7 8,9 4,0 5,5 3.9 -33.8% 3.8 -27.0% 3.7 -27.8% 3.4 -29.4% 4.3 -31.8% 4.4 -22.9% 4.2 -26.5% 3,9 -29,0% 6.0 5.3 4.9 6.4 5.8 33.3% 0.0% 0.0% 7.35 5.1 50.0% 33.3% 33.3% 5.7 50.0% 33.3% 33.3% 5,5 33,3% *EV/EBITDA based on FY2009 net debt TAURON, CEZ, ENEA, PGE- a comparison Valuation Multiples CEZ ENEA PGE PGE adj. for LTC TAURON sector median CEZ vs. median ENEA vs. median PGE vs. median PGE adj. vs. median TAURON vs median P/E P/CE EV/EBITDA Price 2009 2010F 2011F 2012F 2009 2010F 2011F 2012F 2009 2010F 2011F 2012F 860.60 8.7 10.0 10.1 9.9 6.2 6.5 6.4 6.3 6.6 6.8 6.8 6.5 18.94 16.3 12.8 12.8 12.3 7.1 6.3 6.3 6.1 5.1 4.4 4.3 4.0 22.04 11.3 12.2 11.5 10.7 6.3 6.5 6.0 5.6 5.0 5.4 5.0 4.5 22.04 9.8 11.1 11.0 10.2 5.8 6.2 5.8 5.4 4.6 5.2 4.9 4.4 5.10 11.1 11.3 10.8 10.1 3.9 3.8 3.7 3.4 4.3 4.4 4.2 3.9 - 11.0 10.0 10.3 9.9 6.0 5.3 5.1 4.9 6.4 5.8 5.7 5.5 - -21% 0% -1% 0% 4% 23% 26% 28% 3% 19% 19% 19% - 48% 28% 24% 24% 19% 20% 23% 25% -20% -24% -24% -27% 3% 21% 12% 8% 6% 23% 18% 14% -21% -6% -12% -17% - -11% 11% 7% 3% -2% 18% 15% 11% -27% -10% -14% -19% 1% 12% 6% 2% -34% -27% -28% -29% -32% -23% -26% -29% Source: Bloomberg, F –forecasts by BRE Bank Securities While helpful, valuation multiples alone are not the most accurate measure of a power utility’s attractiveness as an investment. Other important factors that account for the potential benefits of rising electricity prices are the scale and degree of vertical integration of production. Considered from this angle, CEZ and PGE offer the most growth potential because price hikes on 68%-69% of the electricity output produced by vertically integrated operations translate directly onto their profit margins. However, with 30% of coal fuel supplied by own mines, Tauron also benefits from this correlation. Further, the company offers more lucrative exposure to power distribution considering the favorable changes introduced in the regulatory tariff- 16 August 2010 35 Tauron Polska Energia BRE Securities BREBank Bank Securities calculation methodology. With the 2010 returns on distribution-network assets expected to be the lowest in the sector, Tauron offers a stronger future growth potential when it comes to returns on assets than, for example, ENEA and PGE. Key operational data for publicly traded power utilities Power output (TWh) nuclear power vertically integrated production Coal output (MMT) as pct. of vertically integrated production 2010 distribution volumes (TWh) Distribution assets (value as per regulatory criteria) 2010 F distribution EBIT ROA Cumulative 2010-15 CAPEX Cumulative 2010-15 EBITDA CAPEX / EBITDA D&A / EBIT CEZ 71.3 28.8 19.8 23.0 68% 54.7 PGE 53.1 0.0 38.1 40.7 72% 31.4 ENEA 12.1 0.0 0.0 0.0 0% 16.5 TAURON 18.6 0.0 5.6 4.8 30% 31.8 114 453 9 259 8.1% 398 104 569 040 70% 34% 13 427 488 3.6% 45 909 54 262 85% 49% 5 484 268 4.9% 18 196 9 730 187% 131% 9 836 293 3.0% 23 787 17 996 132% 123% Source: Tauron, CEZ, PGE, ENEA, estimates by BRE Bank Securities When comparing EV/EBITDA multiples, it is also important to look at a company’s future capital investment plans in relation to the EBITDA levels projected for the same period. This indicator looks best for PGE, but Tauron, as well as ENEA, have announced capital investment projects that exceed their current operating cash flows, which means that investors should expect the two report high debt levels, and retain most of annual earnings, in the next few years. In turn, the price-to-earnings multiples of the different companies should be considered taking into account their respective depreciation and amortization expenses; Polish utilities incur high depreciation charges on their power transmission infrastructures, and, since they are not compensated for the full value of these assets, D&A charges put a considerable weight on their EBIT results. In light of these considerations, we believe that P/CE is the most reliable valuation multiple for Polish power utilities. Forecast and Valuation Risks Below is an outline of the key risks that might undermine our financial forecasts and valuation of Tauron Polska Energia: • • • • • • 16 August 2010 prices of electricity, CO2 emission credits, and base materials – we based our forecasts of the future trends in these factors on historical data, and on the assumption that they will be increasing their correlation with the European market. Any variations may necessitate revisions on our part. regulatory policy – Tauron’s distribution and heat-generation lines, as well as residential sales and LTC compensation receipts, are subject to the regime of the Energy Regulatory Office (URE), aimed at aligning the interests of electricity consumers, producers, and distributors. This regime, which includes pricing revisions, has a direct influence on Tauron’s earnings, hence, any policy tightening by the URE will affect our financial forecasts for the company. environmental regulation – the power industry is required to adhere to a number of stringent environmental regulations, including with respect to greenhouse emissions and renewable energy. The introduction of any new requirements can have an impact on Tauron’s earnings. Moreover, it is impossible to accurately predict at this time the actual impact of the EU energy-climate package on the Polish power industry. mine disasters – as operator of a number of coal mines, Tauron is exposed to a wide range of disaster risks (methane gas explosions, bumps, mining accidents) that can potentially affect production volumes. capital investment – Tauron’s capital investment plan includes a number of highcost projects that extend over long periods of time. Any variations from the CAPEX budget and the project schedules can affect the company’s earnings and our valuation. trade unions – nearly 75% of Tauron’s employees belong to trade unions which have the power to influence the company’s operating expenses through salary pressures or by contesting downsizing and restructuring measures. 36 Tauron Polska Energia BRE Securities BREBank Bank Securities Income Statement (PLN m) Revenues change 2007 12 264.0 n/a 0.0 2008 12 448.7 1.5% 192.2 2009 13 633.6 9.5% 484.0 2010F 13 816.5 1.3% 141.0 2011F 14 320.3 3.6% 125.0 2012F 15 202.1 6.2% 107.0 2013F 16 463.5 8.3% 0.0 EBIT change EBITDA margin 186.9 -71.5 70.8 45.5 109.5 18.7 -15.2 29.0 186.9 n/a 1.5% 347.0 62.9 -0.7 44.0 193.9 90.1 -24.6 -24.6 347.0 85.7% 2.8% 1 259.7 147.0 677.1 55.1 94.6 301.8 6.6 -22.6 1 259.7 263.0% 9.2% 1 144.2 122.3 409.9 57.9 292.6 272.2 12.2 -22.9 1 144.2 -9.2% 8.3% 1 219.1 155.8 417.3 54.5 349.1 266.1 0.1 -23.7 1 219.1 6.6% 8.5% 1 338.2 188.7 401.6 89.3 411.0 264.8 8.1 -25.2 1 338.2 9.8% 8.8% 1 241.2 161.1 227.2 100.4 473.2 280.0 26.5 -27.3 1 241.2 -7.2% 7.5% Profit on financing activity Extraordinary gains/losses Other -37.3 0.0 0.0 -96.8 0.0 0.0 -94.7 0.0 0.0 -113.5 0.0 0.0 -132.1 0.0 0.0 -167.0 0.0 0.0 -287.4 0.0 0.0 Pre-tax income Tax Minority interests* Discontinued operations 149.6 -0.2 -3.7 0.0 250.3 68.0 51.4 0.0 1 165.0 266.3 166.3 0.0 1 030.7 195.8 114.6 0.0 1 087.0 206.5 133.2 0.0 1 171.2 222.5 147.7 0.0 953.8 181.2 110.9 0.0 Net income change Net margin 153.5 n/a 1.3% 130.8 -14.8% 1.1% 732.4 459.7% 5.4% 720.3 -1.7% 5.2% 747.3 3.8% 5.2% 801.0 7.2% 5.3% 661.7 -17.4% 4.0% Amortization and depreciation EBITDA change EBITDA margin 1 197.7 1 384.6 n/a 11.3% 1 268.7 1 615.8 16.7% 13.0% 1 321.0 2 580.8 59.7% 18.9% 1 385.8 2 529.9 -2.0% 18.3% 1 456.2 2 675.3 5.7% 18.7% 1 549.0 2 887.2 7.9% 19.0% 1 670.7 2 911.9 0.9% 17.7% Shares at year-end (millions) EPS CEPS 1 554.0 0.1 0.9 1 554.0 0.1 0.9 1 554.0 0.5 1.3 1 589.4 0.5 1.3 1 589.4 0.5 1.4 1 589.4 0.5 1.5 1 589.4 0.4 1.5 2.8% 1.5% 1.2% 0.6% 6.4% 3.4% 5.8% 3.2% 5.7% 3.2% 5.8% 3.3% 4.6% 2.5% incl. LTC EBIT, incl. Mining Power Generation Renewable Energy Distribution: Trade Other Unattributed ROAE ROAA *as of 2010, minority interests include Tauron’s fully-controlled trade operations 16 August 2010 37 Tauron Polska Energia BRE Securities BREBank Bank Securities Balance Sheet (PLN m) ASSETS Fixed assets Property, plant and equipment Intangible assets Other financial assets Other non-financial assets Deferred tax assets 2007 20 247.7 17 387.0 16 469.7 285.2 537.1 84.6 10.4 2008 20 823.1 17 984.2 17 098.8 533.3 176.9 61.5 113.6 2009 22 160.2 18 480.5 17 260.6 824.8 179.7 58.5 156.9 2010F 22 882.0 18 996.0 17 785.8 815.0 179.7 58.5 156.9 2011F 23 581.8 20 088.4 18 882.6 810.6 179.7 58.5 156.9 2012F 25 400.9 21 707.8 20 498.9 813.6 179.7 58.5 156.9 2013F 28 586.3 24 643.4 23 407.3 840.9 179.7 58.5 156.9 2 860.7 267.3 1 230.0 387.5 1.7 974.2 2 839.0 395.2 1 275.3 217.1 1.7 949.7 3 679.7 536.2 1 875.0 230.4 6.0 1 032.1 3 885.9 543.4 1 896.3 230.4 6.0 1 209.9 3 493.4 563.2 1 954.8 230.4 6.0 668.5 3 693.1 597.9 2 057.3 230.4 6.0 668.5 3 942.9 647.5 2 204.0 230.4 6.0 668.5 2007 20 247.7 11 026.8 13 698.6 -2 671.9 2008 20 823.1 11 125.9 13 698.6 -2 572.7 2009 22 160.2 11 816.5 13 986.3 -2 169.8 2010F 22 882.0 12 855.4 14 304.9 -1 449.5 2011F 23 581.8 13 458.7 14 304.9 -846.2 2012F 25 400.9 14 110.2 14 304.9 -194.7 2013F 28 586.3 14 611.7 14 304.9 306.8 Minority shares 2 179.3 2 219.5 2 367.7 2 030.6 2 072.1 2 113.3 2 106.0 Long-term liabilities Loans Other 4 042.7 1 535.1 2 507.6 4 098.3 1 426.2 2 672.2 4 078.7 1 179.4 2 899.3 4 078.7 1 179.4 2 899.3 4 078.7 1 179.4 2 899.3 4 762.8 1 863.5 2 899.3 6 458.7 3 559.3 2 899.3 Short-term liabilities Loans Trade creditors Other 2 999.0 460.9 1 373.4 1 164.6 3 379.4 649.7 1 240.1 1 489.5 3 897.2 596.3 1 490.7 1 810.2 3 917.2 596.3 1 510.7 1 810.2 3 972.3 596.3 1 565.8 1 810.2 4 414.6 942.2 1 662.2 1 810.2 5 409.9 1 799.6 1 800.2 1 810.2 Debt Net debt (Net debt / Equity) (Net debt / EBITDA) 1 996.1 1 021.8 9.3% 0.7 2 075.9 1 126.2 10.1% 0.7 1 775.7 743.6 6.3% 0.3 1 775.7 565.8 4.4% 0.2 1 775.7 1 107.2 8.2% 0.4 2 805.7 2 137.2 15.1% 0.7 5 359.0 4 690.4 32.1% 1.6 7.1 7.2 7.6 8.1 8.5 8.9 9.2 Current assets Inventories Trade debtors Other current assets Assets held for sale Cash and cash equivalents* (PLN m) LIABILITIES EQUITY Share capital Other equity BVPS *there is a difference between the cash shown on the balance sheet and in the cash flow statement which stems from Tauron’s overdraft facility balances 16 August 2010 38 Tauron Polska Energia BRE Securities BREBank Bank Securities Cash Flows (PLN m) Cash flows from operating activities Net income 2007 2008 2009 2010F 2011F 2012F 2013F 1 471.3 1 615.5 1 963.2 2 325.6 2 375.0 2 561.3 2 618.9 153.5 130.8 732.4 720.3 747.3 801.0 661.7 1 197.7 1 268.7 1 321.0 1 385.8 1 456.2 1 549.0 1 670.7 -130.1 -222.0 -462.7 -8.5 -93.8 -103.3 -111.8 250.2 437.9 372.5 228.1 265.3 314.7 398.3 -1 755.6 -1 514.2 -1 354.0 -1 862.9 -2 501.8 -3 125.6 -4 557.5 -1 819.4 -1 792.2 -1 440.3 -1 901.3 -2 548.5 -3 168.3 -4 606.4 63.8 278.0 86.2 38.4 46.8 42.7 48.9 118.4 -95.7 -543.5 -284.9 -414.6 564.2 1 938.6 0.0 0.0 0.0 0.0 0.0 0.0 0.0 Debt 338.2 92.0 -329.3 0.0 0.0 1 030.0 2 553.3 Dividend (buy-back) -32.3 -33.9 -58.2 0.0 -144.1 -149.5 -160.2 -187.5 -153.9 -155.9 -284.9 -270.6 -316.3 -454.4 Amortization and depreciation Working capital Other Cash flows from investing activities CAPEX Other Cash flows from financing activities Stock offering Other Change in cash Cash at the end of period DPS (PLN) -166.0 5.6 65.7 177.8 -541.4 0.0 0.0 901.4 906.9 972.7 1 150.5 609.1 609.1 609.1 0.02 0.02 0.04 0.00 0.09 0.09 0.10 FCF -564.7 -466.4 411.5 424.4 -173.6 -607.0 -1 987.5 (CAPEX / Sales) 14.8% 14.4% 10.6% 13.8% 17.8% 20.8% 28.0% 2007 2008 2009 2010F 2011F 2012F 2013F 51.6 60.6 10.8 11.3 10.8 10.1 12.3 P/CE 5.9 5.7 3.9 3.8 3.7 3.4 3.5 P/BV 0.7 0.7 0.7 0.6 0.6 0.6 0.6 P/S 0.6 0.6 0.6 0.6 0.6 0.5 0.5 -5.1% -4.2% 3.8% 4.0% -1.5% -4.9% -13.4% 8.0 6.9 4.2 4.2 4.2 4.3 5.1 59.1 32.2 8.7 9.3 9.2 9.2 11.9 0.9 0.9 0.8 0.8 0.8 0.8 0.9 0.4% 0.4% 0.7% 0.0% 1.8% 1.8% 2.0% Market multiples P/E FCF/EV EV/EBITDA EV/EBIT EV/S DYield Price per share (PLN) 5.10 Shares at year-end (millions) 1554.0 1554.0 1554.0 1589.4 1589.4 1589.4 1589.4 MC (PLN m) Equity attributable to minority shareholders (PLN m) 7 925.4 7 925.4 7 925.4 8 106.1 8 106.1 8 106.1 8 106.1 2179.3 2219.5 2367.7 2030.6 2072.1 2113.3 2106.0 11 041.9 11 186.6 10 952.1 10 618.0 11 200.9 12 272.0 14 818.0 EV (PLN m) 16 August 2010 39 Tauron Polska Energia BRE Securities BREBank Bank Securities Michał Marczak tel. (+48 22) 697 47 38 Managing Director Head of Research [email protected] Strategy, Telco, Mining, Metals, Media Research Department: Kamil Kliszcz tel. (+48 22) 697 47 06 [email protected] Fuels, Chemicals, Energy, Retail Piotr Grzybowski tel. (+48 22) 697 47 17 [email protected] IT, Media Maciej Stokłosa tel. (+48 22) 697 47 41 [email protected] Construction, Real-Estate Developers Jakub Szkopek tel. (+48 22) 697 47 40 [email protected] Manufacturers Iza Rokicka tel. (+48 22) 697 47 37 [email protected] Banks Sales and Trading: Piotr Dudziński tel. (+48 22) 697 48 22 Director [email protected] Marzena Łempicka-Wilim tel. (+48 22) 697 48 95 Deputy Director [email protected] Traders: Emil Onyszczuk tel. (+48 22) 697 49 63 [email protected] Grzegorz Stępien tel. (+48 22) 697 48 62 [email protected] Tomasz Dudź tel. (+48 22) 697 49 68 [email protected] Michał Jakubowski tel. (+48 22) 697 47 44 [email protected] Tomasz Jakubiec tel. (+48 22) 697 47 31 [email protected] Grzegorz Strublewski tel. (+48 22) 697 48 76 [email protected] Foreign Markets Unit: Adam Prokop tel. (+48 22) 697 48 46 Foreign Markets Manager [email protected] Michał RoŜmiej tel. (+48 22) 697 48 64 [email protected] Jakub Słotkowicz tel. (+48 22) 697 48 64 [email protected] Jacek Wrześniewski tel. (+48 22) 697 49 85 [email protected] "Private Broker" Jarosław Banasiak tel. (+48 22) 697 48 70 Manager, "Private Broker" Team [email protected] Jacek Szczepański tel. (+48 22) 697 48 26 Director, Active Sales [email protected] Dom Inwestycyjny BRE Banku S.A. ul. Wspólna 47/49 00-950 Warszawa www.dibre.com.pl 16 August 2010 40 BRE Securities BREBank Bank Securities Tauron Polska Energia List of abbreviations and ratios contained in the report: EV – net debt + market value EBIT – Earnings Before Interest and Taxes EBITDA – EBIT + Depreciation and Amortisation P/CE – price to earnings with amortisation MC/S – market capitalisation to sales EBIT/EV – operating profit to economic value P/E – (Price/Earnings) – price divided by annual net profit per share ROE – (Return on Equity) – annual net profit divided by average equity P/BV – (Price/Book Value) – price divided by book value per share Net debt – credits + debt papers + interest bearing loans – cash and cash equivalents EBITDA margin – EBITDA/Sales Recommendations of BRE Bank Securities A recommendation is valid for a period of 6-9 months, unless a subsequent recommendation is issued within this period. Expected returns from individual recommendations are as follows: BUY – we expect that the rate of return from an investment will be at least 15% ACCUMULATE – we expect that the rate of return from an investment will range from 5% to 15% HOLD – we expect that the rate of return from an investment will range from –5% to +5% REDUCE – we expect that the rate of return from an investment will range from -5% to -15% SELL – we expect that an investment will bear a loss greater than 15% Recommendations are updated at least once every nine months. This document has been created and published by BRE Bank Securities S.A. The present report expresses the knowledge as well as opinions of the authors on day the report was prepared. The opinions and estimates contained herein constitute our best judgement at this date and time, and are subject to change without notice. The present report was prepared with due care and attention, observing principles of methodological correctness and objectivity, on the basis of sources available to the public, which BRE Bank Securities S.A. considers reliable, including information published by issuers, shares of which are subject to recommendations. However, BRE Bank Securities S.A., in no case, guarantees the accuracy and completeness of the report, in particular should sources on the basis of which the report was prepared prove to be inaccurate, incomplete or not fully consistent with the facts. BRE Bank Securities S.A. bears no responsibility for investment decisions taken on the basis of the present report or for any damages incurred as a result of investment decisions taken on the basis of the present report. 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Strong and weak points of valuation methods used in recommendations: DCF – acknowledged as the most methodologically correct method of valuation; it is based in discounting financial flows generated by a company; its weak point is the significant susceptibility to a change of forecast assumptions in the model. Comparative – based on a comparison of valuation multipliers of companies from a given sector; simple in construction, reflects the current state of the market; weak points include substantial variability (fluctuations together with market indices) as well as difficulty in the selection of the group of comparable companies. BRE Bank Securities did not issue any investment ratings for Tauron in the last nine months. 16 August 2010 41
