CSS Umeme Initiation of Coverage 2012

Crested Stocks & Securities CSS

Umeme Limited

Initiation of Coverage

Crested Stocks & Securities Ltd.

Impala House 6th Floor, Plot 13/15 Kimathi Avenue

P.O. Box 31736, Kampala (Uganda)

Tel: +256 312 230900, Hotline: +256 713 230900

E: [email protected], W: www.crestedsecurities.com

1

1 October 2012

Umeme Holding Limited Uganda is 100% owned by

Actis Infrastructure 2 LP. Actis is a pan-emerging

private equity firm investing exclusively in Africa, Asia,

and Latin America with US$5 billion managed. For its

East Africa portfolio, Actis has invested in DFCU

(Development Finance Company of Uganda) and

TSAVO Power Company East Africa in Kenya among

others. The company’s core business activities are

electricity distribution and electricity supply and

service after sales. According to World Bank data,

only 9% of the Ugandan population had access to

electricity in 2009. Umeme is regulated by the

Electricity Regulatory Authority (ERA) and

incorporated in the Republic of Uganda.

Date Event

6 May 2004 Umeme Limited is incorporated as a joint venture between Globeleq Holdings

(Conco) Limited and Eskom Enterprises (Pty) Limited with 56% and 44% shares

respectively.

1 March 2005 Umeme takes over the distribution and license to distribute and supply power

in Uganda from Uganda Electricity Distribution Company Limited (UEDCL) for a

period of 20 years.

28 November 2006 Eskom sells its 44% investment in Umeme to Globeleq, thus making Globeleq

the sole shareholder with 100% ownership by the year ended 31 December

2006.

15 October 2009 Ownership of Globeleq is transferred to CDC Group Plc. and Globeleq is

renamed Umeme Holding Limited.

3 December 2009 Ownership of Umeme Holding Limited is transferred from CDC to Actis

Infrastructure 2 LP.

Table 2 Company timeline (Source: Umeme 2010, 2011 annual reports)

Umeme Limited

Sector Utilities

Financial year end 31 December

Shareholder Actis Infrastructure 2 LP

(CDC Group Plc) 100%

FY2011 (UGX’ 000)

Revenue 457,062,608

Net Profit 23,009,339

ROA 4.11%

ROE 21.47%

Table 1 Key facts (Source: Umeme 2011 annual report)

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Umeme Limited





Tel: +256 312 230900, Hotline: +256 713 230900


2

Economic Overview - Uganda

In the latter half of 2012, drought has been replaced by rainfall and power shortages are being resolved

with hydropower dams coming online. Uganda’s GDP growth for the third quarter of the year is

estimated to increase by 2.4%, compared to a decline of 2.6% in the previous quarter. Overall annual

GDP growth in 2012 is projected to be 3.2%, down from 6.7% in 2011. Growth rates for 2013 and 2014

are expected to return to 6% and higher.

Annual headline inflation rates for July and August 2012 were 14.3% and 11.9%, down from highs of

25.6% and 25.7% in January and February. Inflation is expected to move into single digits before the end

of 2012 and the Bank of Uganda’s (BOU) inflation target of 5% should be achieved early 2013. The high

inflation rates in the beginning of 2012 were mainly due to high prices for food, fuel and utilities in

previous periods.

BOU has aggressively set its Central Bank Rate (CBR) to curb inflation during the first 9 months of 2012

and it is expected to continue this policy for the rest of the year. In September the CBR reduced to 15%

from a high of 21% in May 2012. With the easing of the monetary policy by the central bank it is

expected that commercial bank rates (ranging from 24% to 26% in September 2012) shall come down.

Lower rates make credit more available to the private sector and enhances economic growth.

A lower CBR rate also results in falling interest rates on Ugandan treasuries. The benchmark 91-day T-bill

yield dropped to 10.017% in mid-September, from a 2012 high of 23.4%. The drop in yields makes

Ugandan treasuries less attractive for international investors, who had been investing in Uganda’s

government notes since mid-2011. Lower yields mean lower foreign exchange inflow and shilling

depreciation against the dollar. Previously, the official mid-rate in the Inter-bank foreign exchange

market (IFEM) appreciated 7.8 percent from UGX 2,611.5 per US dollar in the second quarter of 2011 to

an average of UGX 2,409.1 per US dollar in the second quarter 2012. These gains for the shilling have

been reversed with the USD trading at UGX 2537.50 at the end of September.

Uganda’s demographics are also driving economic growth. The population is projected reach over 32

million in 2012 and is growing at a rate of 3.2 percent per year. Over 88% of the population is living in

rural areas. At the same time, urbanization is increasing rapidly. Uganda’s capital city is Kampala with an

estimated 1.7 million people. The challenge for Umeme is to extend the power grid to the rural

population while guaranteeing sufficient power supply for the high consumption urban areas.




Umeme Limited





Tel: +256 312 230900, Hotline: +256 713 230900


3

PEST Analysis (Political, Economic, Social, Technological); understanding the potential and the direction

of the company

Political; government interventions and regulations regarding Umeme’s operations

Umeme operates under a concession arrangement with the Government of Uganda (GoU). The

concession is a negotiated contract between the company and the government. Umeme signed a 20

year concessional agreement taking effect on 1st March 2005. The concession involved Umeme entering

into a Lease and Assignment Agreement (LAA) with Uganda Electricity Distribution Company Limited

(UEDCL). Under the LAA, the company received possession of the electricity distribution infrastructure

assets, but not ownership. The distribution network assets shall be returned to UEDCL after 20 years,

unless the contract is terminated before that date.

Umeme’s concession attracted Foreign Direct Investment, improved the quality of the service,

rehabilitated, upgraded and expanded the network, and increased electricity access to customers in the

countryside. The LAA requires Umeme to maintain and operate the electricity network, to collect

revenues, to make minimum investments in system rehabilitation and reinforcement, to pay lease fees

to UEDCL, and to return control of assets – including all new investments – to UEDCL at the end of the

lease.

The Electricity Regulatory Authority (ERA) monitors performance targets regarding maintenance,

upgrade, and expansion of the network by Umeme. One of the targets was to reduce commercial and

technical power loss from a level of 35.7% in 2005 to 28% by 2011. Currently, the power loss stands at

27% (2012).

Electricity is purchased from Uganda Electricity Transmission Company Limited (UETCL), who owns and

operates the high voltage transmission network. Several companies including Eskom Uganda Limited

(EUL), Jacobsen Uganda Power Plant Co Ltd (JUPPCL), Aggreko Plc. operate power generation stations all

over Uganda. As with Umeme, the generation companies have their own concessions with Uganda

Electricity Generation Company Limited (UEGCL) who owns the power generating equipment.

Umeme’s operations are subject to a number of rules and regulations. First, the company has to comply

with Statutory Codes on power quality, reliability, standards, and safety. Secondly, although it is a

private company, Umeme’s financial statements must be prepared in accordance with IFRS as issued by

IASB. In 2011, a change in accounting policy required Umeme to recognize part of the concession asset

as a financial asset rather than an intangible asset. Whereas an intangible asset is only amortized, a

financial asset is also taxed.




Umeme Limited





Tel: +256 312 230900, Hotline: +256 713 230900


4

Power Sector Overview

Power generation

equipment owned by

UEGCL and operated by

Eskom, Aggreko,

Jacobsen, etc.

Consumers

Main Power Grid

High voltage

transmission network

owned and operated by

UETCL

Distribution and

transmission equipment

owned by UEDCL and

operated by Umeme

Figure 1 Relationship between the players in the Ugandan electricity sector (Sources: UEGCL, UETCL, UEDCL, Umeme)




Umeme Limited





Tel: +256 312 230900, Hotline: +256 713 230900


5

Economic; the economic cost of Umeme’s strategy

The most important cost of Umeme’s operations is the purchase of electricity from UETCL. In 2011, cost

of sales was UGX 270.6billion at 59.21% of revenue (2010: 65.53%).

Government of Uganda previously intervened in the sector by subsidizing electricity end users. In 2011,

the subsidy from GoU had reached UGX 600 billion; too big a dent in Uganda’s national budget. On 15

January 2012 GoU removed subsidies with the objective of letting end user tariffs more closely reflect

actual costs. The subsidies from government (GoU) became unsustainable due to a number of external

factors. Hydropower supply was low in 2011, caused by a prolonged drought. At the same time, thermal

power was becoming more expensive due to increases in world fuel prices. The tariffs Umeme currently

charges per kWh are among the highest in the East African region.

Figure 2 Power tariffs in East Africa (Sources: Umeme, Kenya Power & Lighting, Tanesco)

The second major cost is repair and maintenance of the distribution network at UGX 16.77billion in 2011

(2010: UGX 14.87billion). Under the concession, Umeme is responsible for repairs, expansion, and

upgrading the distribution system. Under the Lease and Assignment Agreement (LAA) the company

must fulfill minimum investment requirements every year up to 2010. By March 2010, the company was

required to have invested a minimum of US$ 65million. As at 31 December 2011, Umeme had more

than achieved this target by investing US$ 134 million in the distribution system.

0.00

0.05

0.10

0.15

0.20

0.25

USD

pe

r kW

h

Umeme ($1=UGX2,536.50)

Kenya Power ($1=KES85.3150)

Tanesco ($1=TZS1,574.50)




Umeme Limited





Tel: +256 312 230900, Hotline: +256 713 230900


6

Figure 3 Minimum investment requirements (Source: Umeme annual reports 2010, 2011)

In addition to repair and maintenance expenses, Umeme incurs foreign exchange losses (or gains). The

company’s main income from the sale of power is billed in Uganda shillings while purchase of

equipment and debt servicing is done in foreign currencies – mostly US$. When the shilling appreciated

against the dollar in 2009, Umeme made a foreign exchange gain of UGX 1.9billion. However, when the

shilling depreciated against the dollar in 2010 and 2011, the company made a foreign exchange loss of

UGX 18.9billion and UGX 5.9billion respectively.

Figure 4 US Dollar/Uganda Shilling currency pair from 2009 to 2011 (Source: Citibank)

10 20

40

65

6.9 11.9

29.6

52.5

80.7

104.9

134

0

20

40

60

80

100

120

140

160

2005 2006 2007 2008 2009 2010 2011

US

$m

Year

Investment requirement

Amount invested

1,500

1,700

1,900

2,100

2,300

2,500

2,700

2,900

3,100

$U

S1 =

UG

X




Umeme Limited





Tel: +256 312 230900, Hotline: +256 713 230900


7

Finance costs are also a large part of Umeme’s expenses. The company is highly leveraged, which means

debt is used to finance its operations. The three major loans are an IFC loan, a shareholder’s loan, and

the concession obligation. The borrowing agreement with IFC was signed in 2009 and worth US$ 25

million. The loan attracts an interest rate of 6 months LIBOR+5%. LIBOR (London Interbank Offered Rate)

is a rate of interest at which banks offer to lend money to one another. LIBOR is recognized worldwide

as a benchmark for setting the cost of variable-rate loans. On 1 October 2012, the USD 6 months LIBOR

was 0.63065% (source: Thomson Reuters). Umeme’s IFC loan principal is repayable in 20 semi-annual

installments of US$ 1.25 million each, starting 28 February 2011.

In addition to the IFC loan, Umeme has a loan with its shareholder Actis Infrastructure 2 LP. Umeme’s

loan with Actis is unsecured and attracts an interest rate of 12% per annum (interest of US$ 6 million

was paid in 2011). The shareholder’s loan is subordinated to the IFC loan and the shareholder allows for

flexibility in repayment.

The third major liability is the concession obligation with a present value of rental payments for the

distribution estimated at US$ 119 million on 1 March 2005 (the start of the concession).

Finally, Umeme incurs costs of vandalism and power theft, and technical and commercial power loss. As

at December 2011, total energy losses were 27.3% of energy generated. This is slightly higher than

Umeme’s peers in the region: 26% loss by Tanesco in Tanzania and 16% loss by Kenya Power & Lighting,

Globally, the sector’s losses are an average of 10%.

Figure 5 Energy losses in Uganda (Source: Umeme 2011 annual report, media reports)

38%

34% 35% 34% 35%

30% 27%

0%

5%

10%

15%

20%

25%

30%

35%

40%

2005 2006 2007 2008 2009 2010 2011

% L

oss

Year




Umeme Limited





Tel: +256 312 230900, Hotline: +256 713 230900


8

Social; determining the appetite for Umeme’s strategy among the general population

Umeme’s reputation as a reliable power distributor has been badly shaken by the phenomenon of load

shedding i.e., an intentional power shutdown where electricity delivery is stopped in one or more

predetermined geographical regions or areas. Load shedding is used when demand for electricity

exceeds supply and very common in developing countries. The cause is either insufficient power

generation or inadequate transmission infrastructure. In Uganda, power supply issues are being

remedied through commissioning of new hydropower dams and improvements to transmission

infrastructure by Umeme. However, load shedding still occurs and causes dissatisfaction among power

consumers and the general population.

The price of electricity also poses challenges for Umeme. Earlier this year, subsidies on end user

electricity prices were removed and prices for different groups (domestic, commercial, industrial, etc.)

went up by an average of 42.6%. Additionally, the feeling among some Umeme customers is that the

company is either unwilling or unable to stop people who are stealing power. Power theft is a big

problem in Uganda and paying customers feel like they are paying not only for themselves, but also for

the power thieves.




Umeme Limited





Tel: +256 312 230900, Hotline: +256 713 230900


9

Technological; the time and cost of technology involved of the strategy of Umeme

In Uganda electricity is mainly generated through

hydropower and thermal generation. Hydro

electricity is generated by exploiting the power of

moving water. Flowing water is used to spin a

turbine connected to a generator. The major power

generator in Uganda is EUL with power stations on

The River Nile at Kiira and Nalubaale (concessioned

by UEGCL). The new Bujagali dam, commissioned in

July 2012, is expected to ease Uganda’s power

shortages in Uganda.

In thermal power generation, petroleum based

fuels such as heavy fuel oil or diesel are burned

to heat water for steam turbines. For example,

Jacobsen Electricity Company Uganda Limited

owns and operates the Namanve power station

in Namanve, central Uganda. The downside of

thermal generation is that petroleum products

are expensive, making it more costly than

hydropower generation. This drives up

electricity prices for end-users. UETCL is the

single buyer of bulk power from all independent

power generators (like EUL and Jacobsen).

Umeme in turn purchases electricity from

UETCL.

Billing and revenue collection is another challenge for Umeme. Unlike in other countries the postal

system in Uganda is not functioning properly. Often, energy usage cannot be billed by sending paper

bills to postal addresses. Therefore collection teams must visit each electricity user. This poses

challenges on several levels and potential conflicts of interest between bill collection teams, the

consumer and Umeme. As a solution, Umeme is implementing pre-payment metering where customers

pay upfront at an Umeme branch for the power they consume. This system guarantees 100% revenue

collection and helps to prevent waste of energy (a household is disconnected whenever there is no

upfront payment).

Figure 6 Hydropower plant (Source: ERA)

Figure 7 Thermal power plant (Source: BBC)




Umeme Limited





Tel: +256 312 230900, Hotline: +256 713 230900


10

SWOT Analysis; Strengths, Weaknesses (internal), Opportunities, and Threats (external) in the strategy

of Umeme

Helpful

Harmful

Internal

Strengths:

- Strong shareholder (ACTIS) - Monopolist - Access to overseas resources

Weaknesses:

- Poor reputation - Undependable employees

External

Opportunities:

- New hydropower dams - Oil industry spurs growth - Pre-payment metering

Threats:

- Losing concession - Vandalism/power theft - Forex, inflation, and oil price

risk Table 3 SWOT matrix for Umeme

The main conclusions from the SWOT analysis are the following.

Strengths: the Commonwealth Development Corporation (CDC) owns 100% of the shares of Umeme

through fund manager Actis Infrastructure 2 LP. The shareholder Actis is a major strength for Umeme

because it not only gives access to financing (shareholder loan), but also to human resources and high

quality equipment for the distribution network. Actis also manages CDC’s 60.02% shareholding in DFCU

(Development Finance Company Uganda) which is listed on the Uganda Securities Exchange (USE).

Opportunities: with more hydropower dams being taken into operation (Bujagali dam in the short-term

and Karuma dam in the long term), power shortages can be expected to decrease. Costly thermal power

generation facilities can be deemphasized resulting in lower costs for generating power. Opportunities

in the oil industry for Umeme are twofold. Firstly, petroleum products produced in Uganda will be

cheaper compared to imported oil and this will make thermal oil generation less costly. Secondly, the oil

industry will itself consume a lot of power and as well spur local industries – both new sources of

revenue for Umeme. The third opportunity for Umeme is the pre-payment metering system which is

currently being implemented. The system guarantees 100% revenue collection and offers Umeme the

flexibility to link the price per kWh to fluctuations in inflation, foreign exchange, and oil price.




Umeme Limited





Tel: +256 312 230900, Hotline: +256 713 230900


11

Weaknesses: Umeme’s major weakness is the public perception of the company. Load shedding as well

as high power tariffs are blamed on Umeme even though the first is caused by low levels of power

generation and the latter by high fuel prices, inflation, and local currency depreciation (all are beyond

Umeme’s control). Another weakness is fraudulent employees who steal equipment or facilitate the

theft of power by consumers. It is up to the company to communicate these issues clearly and

effectively to the Ugandan population to improve its image in society.

Threats: the biggest threat to Umeme’s strategy is the expiration of the concession on 1 March 2025 or

early termination of the concession. The second major threat is commercial power loss due to illegal

connections and meter bypassing, which makes Umeme’s losses the highest in the region (27% of power

generated is lost; compared to 26% in Tanzania and 16% in Kenya). Other threats include Umeme’s

exposure to foreign exchange risk, inflation, and oil price fluctuation. These aspects are beyond

Umeme’s control and therefore external threats.




Umeme Limited





Tel: +256 312 230900, Hotline: +256 713 230900


12

Business outlook

This year, we expect revenue growth to jump to around 40%, compared to a 2007-2011 CAGR of 9.90%.

The peak in revenue will be due to increased power supply after the commissioning of the 250Mw

Bujagali hydropower dam, and the prepayment metering system through which Umeme will pass costs

of inflation, currency depreciation, and high oil prices to customers. After 2012 we expect revenue

growth to return to normal levels, but more jumps in revenue growth can be expected when other

hydropower dams are commissioned (e.g., the 600Mw Karuma dam). Operating costs should go up

significantly in 2012 to around 86% (2011: 80.66%) because of heavy investments in the power

distribution network and the removal of GoU subsidies for Umeme in January 2012. From 2013

onwards, Umeme should be able to push down operating costs steadily due to increased efficiency after

the implementation of electronic revenue collection and an upgraded power distribution system with

reduced power losses.

Regardless of the heavy investments and system upgrades, we still see challenges for Umeme to meet

requirements of network expansion, power loss reduction, and revenue collection as set by ERA. Not

meeting requirements may cause Umeme to lose the concession early (UEDCL must always be in

position to take over and resume operations of electricity distribution and supply business). In any case,

Umeme has a definite life span, because when the concession ends on 1 March 2025 it has the

obligation to return control of the assets, including all new investments, to UEDCL.

We expect Umeme to remain profitable for many years to come. The company was underperforming in

2010 with a high operating margin (operating costs at 86.14% of revenues) and earnings margins being

lower than 2009. But the 2010 loss was only due to a change in accounting rules that made Umeme

recognize part of the concession as financial asset as opposed to intangible assets. Whereas intangible

assets are only amortized, financial assets are taxed, and the additional tax charge in 2010 caused the

loss (in 2010, tax stood at 144.81% of earnings before tax).




Umeme Limited





Tel: +256 312 230900, Hotline: +256 713 230900


13

Income statement (UGX' 000) 2009A 2010A 2011A 2012E 2013F

Revenue 476,596,000 513,676,000 535,567,000 749,793,800 824,023,386

Operating costs (409,582,532) (442,460,000) (431,996,000) (641,073,699) (697,494,595)

EBITDA 67,013,468 71,216,000 103,571,000 107,970,307 121,032,555

D&A (14,144,112) (19,692,253) (21,539,527) (27,067,556) (28,563,947)

EBIT 52,869,356 51,523,747 82,031,473 80,902,751 92,468,608

Finance (costs)/income (27,239,608) (45,172,747) (37,412,473) (29,166,979) (33,109,260)

Earnings before tax 25,629,748 6,351,000 44,619,000 51,735,772 59,359,349

Income tax (charge)/credit (15,220,000) (9,196,928) (21,607,188) (15,520,732) (17,807,805)

Net profit 10,409,748 (2,845,928) 23,011,812 36,215,041 41,551,544 Table 4 Income statement (Source: Umeme annual reports 2010 & 2011, Crested estimates)

Balance sheet (UGX' 000) 2009A 2010A 2011A 2012E 2013F

Non current assets 281,844,121 319,794,606 356,824,531 409,160,664 459,937,503

Non current liabilities 203,925,204 253,724,982 255,631,076 229,204,598 298,595,113

Current assets 159,980,860 193,583,552 202,424,626 289,900,782 325,877,469

Current liabilities 150,895,576 175,494,837 196,450,403 319,908,168 336,544,091

Net current assets/(liabilities) 9,085,284 18,088,715 5,974,223 (30,007,386) (10,666,623)

Total assets 441,824,981 513,378,158 559,249,157 699,061,446 785,814,972

Total liabilities 354,820,780 429,219,819 452,081,479 549,112,766 635,139,205

Shareholder equity 87,004,202 84,158,339 107,167,678 149,948,680 150,675,767

Total equity and liabilities 441,824,982 513,378,158 559,249,157 699,061,446 785,814,972 Table 5 Balance sheet (Source: Umeme annual reports 2010 & 2011, Crested estimates)

Cash flow (UGX' 000) 2009A 2010A 2011A 2012E 2013F

Cash flow from operations 55,462,000 59,262,000 70,395,000 91,846,000 100,051,826

Change in net working capital (16,411,854) (13,060,586) (19,508,000) 453,617 (10,185,817)

Net cash from operations 39,050,146 46,201,414 50,887,000 92,299,617 89,866,009

Net cash from investing (38,408,000) (38,355,000) (50,942,000) (77,543,154) (89,168,735)

Free cash flow 642,146 7,846,414 (55,000) 14,756,462 697,273

Net cash from financing (6,104,000) 8,779,000 (9,692,000) (5,860,000) (3,219,250)

Net change in cash (5,461,854) 16,625,414 (9,747,000) 8,896,462 (2,521,977)

Cash & cash equivalents at end 38,185,146 54,810,560 45,063,560 53,960,022 51,438,045 Table 6 Cash flow statement (Source: Umeme annual reports 2010 & 2011, Crested estimates)




Umeme Limited





Tel: +256 312 230900, Hotline: +256 713 230900


14

Margins 2009A 2010A 2011A 2012E 2013F

Sales growth 12.34% 7.78% 4.26% 40.00% 9.90%

Operating margin 85.94% 86.14% 80.66% 85.50% 84.65%

EBITDA margin 14.06% 13.86% 19.34% 14.40% 14.69%

EBIT margin 11.09% 10.03% 15.32% 10.79% 11.22%

EBT margin 5.38% 1.24% 8.33% 6.90% 7.20%

EBIT-EBT margin 5.72% 8.79% 6.99% 3.89% 4.02% Table 7 Growth rates & margins (Source: Umeme annual reports 2010 & 2011, Crested estimates)

Ratios 2009A 2010A 2011A 2012E 2013F

Current ratio 1.06 1.10 1.03 0.91 0.97

Debt ratio 0.80 0.84 0.81 0.79 0.81

Debt to equity ratio 4.08 5.10 4.22 3.66 4.22

OCF to sales ratio 8.19% 8.99% 9.50% 12.31% 10.91%

Capex coverage ratio 101.67% 120.46% 99.89% 119.03% 100.78%

FCF to OCF ratio 1.64% 16.98% -0.11% 15.99% 0.78%

ROA 2.36% -0.55% 4.11% 5.18% 5.29%

ROE 11.96% -3.38% 21.47% 24.15% 27.58% Table 8 Key ratios (Source: Umeme annual reports 2010 & 2011, Crested estimates)




Umeme Limited





Tel: +256 312 230900, Hotline: +256 713 230900


15

CSS Research Department

Joseph Kibuuka Business Development Manager [email protected] +256 782 474 929 Henry Kakande Research Analyst [email protected] +256 782 026 176 Christiaan Gordijn Research Analyst, Marketing [email protected] +256 777 050 132

DISCLAIMER: The information contained herein is obtained from sources which to the best of our knowledge are reliable. As such we are not responsible or liable for any factual errors arising thereof and anyone acting on the information or opinion does so at his/her own risk. This report was not issued on behalf of the company covered. The opinions expressed herein are ours and are subject to change anytime without notice.






CSS Umeme Initiation of Coverage 2012

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