CIO WM Research 22 August 2014

Investing in MexicoBenefiting from Mexico's structuralreforms

• Mexico has begun implementing ground-breaking structuralreforms including a deep liberalization of its energy sectors.This will open the oil and energy sectors to private investmentand could add 1-2 percentage points to the country's long-term GDP growth. We believe Mexican equities are anattractive investment opportunity that will benefit from highercyclical and structural growth.

• We believe this potential is not fully priced in by the marketsand will be realized in coming months as investments from localand foreign corporations into energy-related infrastructureprojects materialize.

• GDP should rebound in 2014 to 2.8% from 1.2% last yearbased on higher government spending, increased employmentand consumption, and manufacturing led by higher activity inthe US.

• The equity market is likely to outperform EM peers as thesedynamics translate into stronger earnings growth. We expect15% earnings per share growth for the Mexican market in thenext 12 months, compared with 7% for EM.

In the last two years, Mexican President Enrique Peña Nieto hasdelivered a comprehensive structural reform agenda. The reforms arewide-ranging and represent the deepest structural transformation inMexican legislation since the latest constitution was drafted in 1917(see Fig.1). As a result, Mexico's structural growth potential has beengreatly enhanced. We highlight the energy and telecommunicationreforms as those are expected to have the deepest impact on growthand Mexican financial markets.

Why is the Energy reform so important?Due to regulatory limitations, the oil sector operates in a system similarto that of Ecuador and Kuwait. Petroleos Mexicanos (PEMEX), theworld's tenth largest oil producer, is the sole operator of upstreamand downstream activities in Mexico. PEMEX decides when and whereto extract and explore, and owns most of the country's geologicalstudies and know-how. Meanwhile, the electricity sector is fullyowned and controlled by the Federal Electricity Commission (CFE).The regulations have allowed some private participation in the past20 years, but only for self-consumption and other limited activities.

Jorge O. Mariscal, Regional CIO Emerging Markets, UBS FSjorge.mariscal@ubs.com, +1 212 821 6350

Adolfo Acebras, analyst, UBS AG

Soledad Lopez, analyst, UBS FSsoledad.lopez@ubs.com, +1 212 821 2142

Source: Getty Images

This report has been prepared by UBS Financial Services Inc. (UBS FS) and UBS AG. Please see important disclaimersand disclosures that begin on page 6.

In our view, both entities are run inefficiently by the state and theirbusiness and financial models are unsustainable due to the hefty roy-alties and taxes imposed on them. Mexico has the sixth-largest shalegas reserves in the world, which increases the potential benefits ofinvesting in and developing the energy sector. Private participation willhelp to fully develop hydrocarbon reserves and increase production.This will position Mexico closer to the US in the shale gas revolution.

PEMEX is a major source of revenue for the government. However,due to financial constraints and lack of investment, the company'soil production has been steadily declining, from 3.5 million barrelsper day (mbpd) in 2004 to 2.5 mbpd currently. As the easily acces-sible oil vanishes, PEMEX faces severe difficulties to replace reserves.However, geological studies indicate that Mexico's natural resourcesare far from depleted, and suggest that production could bounce backto 3.5 mbpd by 2025. PEMEX's capacity to extract natural gas has alsoshrunk in recent years. Investments in natural gas have been far fewerthan in oil extraction owing to cost differentials. Natural gas importsnow account for 33% of supply, up sharply from just 3% in 1997.Challenges go beyond extraction; transportation is also a constraintas the existing pipelines and the planned investments are insufficientbased on future demand. These factors have resulted in expensiveimports and an erratic supply to the industrial sector. Natural gasshortages are estimated to cost the manufacturing industry as muchas USD 150m per day; in the first half of 2013 alone, the total loss isestimated to have been USD 2.25bn.

The new laws will enable the country to offer a competitiveinvestment alternative which is likely to compensate in part for severeunderinvestment in the sector in the past two decades. The recentapprovals (see Fig. 2) enable private investors to participate in theenergy and electricity sectors mainly by partnering with PEMEX andCFE. However, Congress still has to approve a set of environmentallaws for independent private participation, which should happen byyear-end.

Telecom reform is also relevant for marketsOn July 14, President Peña Nieto signed the telecommunications reg-ulatory framework, which details aspects of the constitutional reformapproved last year. Given the high concentration of the sector inMexico (see Fig. 3), the reform aims to increase competition by sanc-tioning dominant players via asymmetric regulation and strength-ening new regulators to oversee the proper implementation of thenew laws.

Fig. 2: Key recent regulatory changes in theenergy sectorPEMEX and CFE• Are now "State Productive Companies" with economic,

administrative, and technological independence andbudgetary autonomy.

• Are free to work with private entities through a tenderprocess managed by SENER.

• Government collection from these companies willslowly migrate from taxes to dividends starting in 2015.

• Land expropriation is replaced with temporary occu-pancy. Land owners will get rent, damage compen-sation, or 3.0% of project earnings.

• The government will assume a percentage of the com-panies' pension liabilities if they agree to modify the col-lective contract with the unions.

Oil sector• CNH will regulate and grant contracts for the sector

through auctions open to private and state companyparticipation.

• SENER will determine the technical conditions while theTreasury will determine the economics of the contractsto be auctioned.

• PEMEX will need to hand CNH any geological and tech-nical information presently in possession.

• Private companies can distribute gasoline with inde-pendent franchises from 2016, and import gasolinefrom 2017.

Foreign investors can:* Participate in gasoline commercialization and petroleumgas distribution.*Own up to 49% of companies dedicated to naval activitiesin exploration of hydrocarbons.* Participate in pipeline construction for transporting oil andderivatives and oil/gas well perforation.

Energy sector• CFE can engage in contracts with private companies for

the operation, improvement, and expansion of distri-bution and transmission networks.

• Private companies will be able to generate electricityfor self-consumption when deemed a "qualified user,"depending on MW usage.

Source: JPM, UBS, August 2014

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CIO WM Research 22 August 2014 2

Fig. 1: Ambitious reform agenda approvedThe reform agenda and our assessment of its short-, medium-, and long-term impact on growth

ReformBelow / Aboveexpectations

2013-2014Short Term

2014-2016Medium Term

2018 and onLong Term

Political

Labour Positive impact

Education

Anti-corruption Slightly positive impact

Gov accountability

Telecom Neutral

Competition

Energy Slightly negative impact

Fiscal

Social Security Negative impact

Source: UBS, as of 11 August 2014

The approval of this reform is a positive step toward increasing com-petition in the sector. We are expecting heavy corporate activity asa result of the new regulation: new entrants, M&A, and asset sales,among others. The largest telecom/media companies have alreadybeen declared dominant in their respective markets. The negativeimpact of anti-monopoly reform on America Movil (18% of MSCIMexico) is priced in. The stock underperformed both MSCI Mexicoand EM in 1Q14 as the details of the reform were known andapproved, then it languished from March to June. However, in earlyJuly the company announced breakup plans to comply with thetelecom reform and AMX posted a 22% rebound. The market wel-comed the company's proactive decision to abide by the new antitrustregulations, and its ability to expand in other market segments andinternationally without regulatory hurdle.

The telecom and broadcast sectors will undergo a deep transfor-mation in the coming years, enhancing Mexico's productivity byimproving voice and data communication and mobility.

Why Mexican equities deserve a premiumThe Mexican equity market has always traded at a premium versusEM as it has a higher exposure to consumer-oriented companiesand less exposure to commodities. The historical valuation spread toEM has increased from a 24% premium, the 14-year average, to a75% premium because of three main factors (see Fig. 4). 1) A solidmacroeconomic framework: low debt to GDP ratios, low inflationand linkages to the US; 2) the country has been the most aggressivereformer across EM; and 3) earnings per share are at a cyclical troughresulting from an effective tax rate increase in the past five years (to31% from 26%).

Fig. 3: Mexican equities: Sector compositionMSCI Mexico

ConsumerDiscretionary

10%

ConsumerStaples25%

Energy0%

Financials18%

Health Care1%

Industrials10%

IT0%

Materials17%

Telecoms(America

Movil)18%

Utilities0%

Source: Bloomberg, UBS, as of 20 August 2014

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We do not expect tax rates to increase further. Therefore, the val-uation premium is expected to continue in the medium term andshould not discourage investors from adding exposure to the Mexicanequity index.

We expect EPS to accelerate; GDP should rebound in 2014 to 2.8%from 1.2% last year based on higher government spending as wellas reactivation of employment and consumption, and manufacturingled by higher industrial activity in the US. This makes Mexico oneof the few countries in EM experiencing growth acceleration. Theequity market is likely to outperform EM peers as the above dynamicstranslate into stronger earnings growth. We expect 15% earnings pershare growth for the Mexican market in the next 12 months, com-pared with 7% for EM.

How will Mexican companies benefit from the reforms?The Mexican equity market should be one of the main beneficiariesof the energy reform and around 22% of the index is made up ofindustrial sectors that could benefit directly from the reforms. Theremaining sectors from MSCI Mexico, being more consumer oriented,will gain from the indirect effects of growth. Structural reforms will bea medium-term game-changer as they should unlock new businessopportunities for Mexican companies, attract foreign direct invest-ments, and change the country's long-term outlook. Higher potentialGDP growth will benefit the Mexican equity market, as revenues areleveraged to the country's GDP growth. The sectors likely to benefitthe most, in our view, are:

• Petrochemical: There have been some partnership announce-ments between sector companies and PEMEX in recent years. Weexpect more joint ventures and projects especially in electricity co-generation, some of which have already been announced.

• Cement: The shale gas industry uses large amounts of cement,and Mexico has the sixth-largest shale gas/oil reserves in theworld. Cement is a main component not only of hydraulic frac-turing or "fracking," but also of the infrastructure that needs tobe built or upgraded to handle all the new projects.

• Finance: Energy projects require large amounts of financing, andlocal financial institutions have solid balance sheets and adequateknowledge to support the sector's transformation.

• Infrastructure: The energy sector will need significantinvestment in constructing new facilities, pipelines, and relatedinfrastructure to transport the new production (such as highwaysand ports). Mexican infrastructure companies have adequateknowledge of the sector and financial capabilities to benefit fromsuch investments.

• Utilities: Though there are few companies in the sector and onlyone listed on the local stock exchange, we think the opportunitiesfor utilities companies will increase substantially. Some auctionsin the pipeline and electricity generation business (valued at USD2.8bn) have already been announced this year, and we continueto expect this sector to be the most active in the short term.

We think mergers, acquisitions and joint ventures will be fundamentalto Mexican companies – creating strong competitors in the short term– and we believe some are already positioned for such events.

Fig. 4: Premium valuations expected to continuePE ratio of the Mexico and Emerging Markets MSCIIndex

-80%

-60%

-40%

-20%

0%

20%

40%

60%

80%

100%

120%

2000 2003 2006 2009 2012Mexico relative to EM

Source: Bloomberg, UBS, August 2014

Fig. 5: Higher growth will lead to higher earningsEstimated EPS and GDP growth

-4.0%

-3.0%

-2.0%

-1.0%

0.0%

1.0%

2.0%

3.0%

4.0%

5.0%

-60.0%

-40.0%

-20.0%

0.0%

20.0%

40.0%

60.0%

80.0%

2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015Earnings Growth GDP Growth

Source: Bloomberg, UBS, August 2014

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What could go wrong?Our benign long-term prospects in Mexico are influenced by the struc-tural reforms. Even if the tedious legislative process is almost over,additional regulatory hurdles in the energy and telecom sectors canfurther delay the implementation process, and therefore weigh onasset classes.

The reforms have been approved and are now being implemented.Extreme regulatory oversight and/or inadequate institutions coulddelay or undermine the implementation.

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Appendix

Investors should be aware that Emerging Market assets are subject to, amongst others, potential risks linked to currency volatility, abruptchanges in the cost of capital and the economic growth outlook, as well as regulatory and socio-political risk, interest rate risk and higher creditrisk. Assets can sometimes be very illiquid and liquidity conditions can abruptly worsen. WMR generally recommends only those securities itbelieves have been registered under Federal U.S. registration rules (Section 12 of the Securities Exchange Act of 1934) and individual Stateregistration rules (commonly known as "Blue Sky" laws). Prospective investors should be aware that to the extent permitted under US law,WMR may from time to time recommend bonds that are not registered under US or State securities laws. These bonds may be issued injurisdictions where the level of required disclosures to be made by issuers is not as frequent or complete as that required by US laws.For more background on emerging markets generally, see the WMR Education Notes, "Emerging Market Bonds: Understanding EmergingMarket Bonds," 12 August 2009 and "Emerging Markets Bonds: Understanding Sovereign Risk," 17 December 2009.Investors interested in holding bonds for a longer period are advised to select the bonds of those sovereigns with the highest credit ratings (inthe investment grade band). Such an approach should decrease the risk that an investor could end up holding bonds on which the sovereignhas defaulted. Sub-investment grade bonds are recommended only for clients with a higher risk tolerance and who seek to hold higher yieldingbonds for shorter periods only.Please note that these bonds may not necessarily be registered with the US Securities and Exchange Commission nor blue-skyed in the US.

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