Companhia Paranaense de Energia (ELP), also known as COPEL, is a fully integrated electric utility operating in Brazil. The company is engaged in the generation, transmission, and distribution of electricity to more than three million customers in the southern Brazilian state of Parana. The government of the State of Parana controls 58.6% of the shares of COPEL. The company distributes electricity in 392 of the 399 municipalities of the State of Parana, serving 98% of the customers of the state. The company has 4,550 megawatts (MW) of generating capacity, 99% of which is hydroelectric. Roughly 50% of the distributed electricity is produced from 17 hydroelectric plants and 1 thermoelectric plant owned by the company. COPEL also provides telecommunications, natural gas, engineering, water, and sanitation services. During the first half 2007, revenues were divided as follows:
During 2005, 2006 and 2007, COPEL continued to benefit from the increasing demand of electricity in Brazil. We believe this trend will continue in the short term. ANEEL (Brazilian National Agency for Electric Utilities) reports that the demand for electricity in Brazil is expected to increase by 4.5% per year in upcoming years. We consider this estimate to be very conservative. During 2005 and the beginning of 2006, Brazil's economic performance was somewhat disappointing, due to the very tight monetary policy. Nevertheless, demand for electricity remained heated. In 2005, electric power consumption in COPEL's concession area increased 3.6% year-over-year and during 2006 it increased 3.5% year-over-year. However, during the first nine months of 2007 total power consumption billed by COPEL grew 6% (6.8% year-over-year in the residential segment, 9.3% in the commercial segment, 5.1% in the rural segment and 5.5% in the industrial segment).
The improved numbers are a result of a less restrictive Brazilian domestic monetary policy. The Brazilian Central Bank started to cut local interest rates in September 2005, since then domestic interest rates were reduced from over 19% to 11.25% currently. Even though rates are still high, mainly considering the current inflation of 4%, Brazilian Central Bank decided to stop to cut basic interest rates in the very short term. Indeed, after the August Bank meeting an official report was released with strong comments on domestic inflation pressures. In October, it was decided to leave rates unchanged for the first time in two years. Even though those are for sure not encouraging news, we believe it is just a short-term problem, and rates will fall again beginning in 2008. What's more, we believe that the continued improvement in the Brazilian economic environment will make Brazil reach investment grade within the next twelve months, thus leading to a multiple expansion for Brazilian stocks. In the medium term, we expect Brazilian domestic rates to converge to international standards, a fact that will continue to fuel Brazilian domestic demand for energy.
COPEL accounts for 6% of all the electricity produced in Brazil, and Parana is one of the most important states of Brazil in terms of industrial and agricultural production. As a result, COPEL is one of the best positioned companies within the Brazilian electric utility sector. In fact, demand for electricity within COPEL's area was not better during 2006 due to the difficult environment for the agriculture business in the South of Brazil, affected by lower-than-expected rains in the beginning of the year and the continued strength of the Brazilian real, which undermined agriculture exports. We believe the business environment is more positive in 2007. Even though the continued strength of the Brazilian real, international prices for agricultural commodities went up, compensating the adverse effect of the overvalued currency in the commodity export business. Moreover, the hydrology environment in the last months has been better for COPEL if compared to the same period 2006. The good rains during the summer 2006/2007 helped the load the company's reservoirs and the dry season was not that bad. It is important not to forget that 99% of the energy generated by COPEL is from its hydroelectric plants and that the good hydrology is a key factor to keep generating costs under control.
Additionally, we believe there is room for continued growth in energy consumption in Latin America in the medium-to-long term. Per head consumption is between 1.600 KWH (Kilowatt per hour) in countries like Peru and Colombia, while countries like Brazil, Chile, and Argentina have a per head consumption rate of 2000 to 2,500 KWH. These totals lag behind European per head consumption of 5,000 KWH to 8,000 KWH and the U.S., which is above 13,000 KWH, as we can see in the graph below:
We believe COPEL's third quarter 2007 results were better-than-expected. The company posted good revenues, improved cash flow generation, and sound net income. We believe the company results could improve in the medium term due to the continued investments in the generation segment, since in-house generated energy is much cheaper than the energy purchased for resale. In this sense we are pleased to see the continued investments in generation like the Fundao hydroelectric plant with an installed capacity of 120MW, fully operating since August 3, 2006. Additionally, the consortium established between COPEL (51%) and Eletrosul (49%) won the contract for the construction of the Maua Hydroelectric plant, with an estimated capacity of 361 MW starting from January 2011. Additionally, lower interest rates will not only help to increase electricity demand in the very short-term, mainly in the industrial sector, but also will reduce financial expenses in the very short-term. Third quarter results already showed a considerable reduction in financial expenses, a trend that we expect to continue in the short-term.
Natural gas purchases have been increasing quarter-after-quarter, a trend that should continue in the short-term, due to higher expected natural gas prices as a result of the difficult political climate in Bolivia. Recently, it was announced in many Brazilian papers that natural gas prices are expected to increase up to 25% in the following twelve months. Nevertheless, this is not a major issue since around 99% of the company's generation comes from hydroelectric plants. Moreover, the hydrology has been more positive, thus the company will be able to maintain a low level of energy purchases, improving its operating margins.
During the first quarter of 2007 the Brazilian government announced an ambitious four years US$235 billion infrastructure investment plan, named PAC. The plan has the target to increase Brazilian economic growth to something close to 5% per year. The plan has some interesting news for the electric industry. Most of the investments will be directed to energy generation and energy distribution, and the Brazilian domestic electric companies will receive some tax benefits to encourage new investments. We believe COPEL will benefit from this plan in the following years.
We remain concerned over the political influence on COPEL's affairs. The government of the State of Parana owns 58% of the company's outstanding voting shares, which gives it the ability to control the election of a majority of the members on the company's board of directors and appoint senior management. The government typically directs some of COPEL's activities and expenses, which are not necessarily in the best interest of minority shareholders. We have been particularly concerned over the influence of the Governor of the State of Parana, Roberto Requiao in the company.
Finally, we believe the company's third quarter results were solid, and the short-term outlook remains very positive with increasing energy demand and lower generating costs thanks to the positive hydrology, within a growing Brazilian economy. We also believe the business environment in Brazil the short term remains encouraging and that Brazil could be upgraded to investment grade in the short-term. The continued political influence on COPEL's affairs is still a concern, but we believe COPEL is undervalued compared to other Latin American electric utilities. As a result of positive business environment coupled with strong 2007 results, we are increasing 2007 and 2008 earnings estimates. We are keeping our current Buy recommendation on COPEL.