Policy Certainty For TNB, Attractive Dividend Yield Of 5%

We believe the government is committed to carrying out energy reforms and this bodes well for TNB. We expect TNB to recover higher fuel cost in the upcoming 2H18 ICPT review via the KWEI funds. In addition, the stabilisation fund may include existing funds from TNB generators and IPP contributors and provide a future tariff buffer while upholding the IBR and ICPT frameworks. Re-iterate our positive stance with a BUY on the stock and a DCF-based target price of RM17.70.

WHAT’S NEW

• Energy reforms promote efficiency… A regulatory meeting reaffirms our view that the government is committed to carrying out energy reforms including the gas subsidy rationalisation programme. As such, we believe the government will continue to subscribe to the Incentive Based Regulation (IBR), which promotes asset efficiency. In addition, we believe the market has underestimated the potential size of stabilisation funds (which include existing funds from TNB generator and IPP contributors) to be made available to the government to maintain ICPT surcharges in the next three years (assuming coal and gas prices continue to rise). This bodes well for TNB.

STOCK IMPACT

• ...and this bodes well for TNB, lifting regulatory overhang on the stock. More importantly, 2H18 electricity tariff is slated to be announced in the next few days. We expect TNB to recover higher coal costs incurred in 1H18 via the imbalance-cost pass through (ICPT) mechanism. TNB is likely to benefit from policy clarity as regulatory risk dissipates thereon. To recap, the ICPT mandates that TNB returns/clawback uncontrollable fuel price fluctuations (coal, gas, LNG), and anchors TNB’s future earnings sustainability and predictability. This paves the way for active capital management. The stock offers attractive 5% dividend yield.
• 2H18 electricity tariff likely to be maintained… We believe the government will maintain current electricity tariff and utilise funds from the Electricity Industry Fund (or more commonly known as Kumpulan Wang Industri Elektrik, KWEI) to offset rising coal cost incurred by TNB in the past six months (Jan-Jun 18).
• …as stabilisation funds are sufficient to cover 1H18 surcharges. We estimate a RM910m (or 3.7% of base tariff) cost under recovery for 1H18. This reflects: a) rising coal prices vs reference price of US$75/MT, and b) a bi-annual gas price hike of RM1.50/mmbtu. We believe there are adequate funds in the KWEI should the government decide to maintain the current electricity tariff.
• Half of TNB customers will not be affected by ICPT, even if the government decides to increase the tariff beyond 2H18. We see Gas Malaysia’s ability to pass on higher gas cost to industrial users as a clear indication that the IBR and ICPT will remain relevant to TNB. Arguably, the higher gas prices accorded to Gas Malaysia only affect the industrial sector whilst an electricity hike will affect domestic, commercial and industrial users. Having said that, 52% of TNB’s 8.4m customers will not be affected by ICPT as domestic consumers with monthly consumption of 300kWh (or RM77/month) or below are spared from the higher costs.
• More funding from IPPs and TNB generators. We understand that the Ministry of Energy, Green Technology and Water is in charge of the Malaysian Electricity Supply Industries Trust Account (MESITA, see RHS description) and this fund is likely to be transferred to Energy Commission, the regulator. While the fund’s mandate is to promote rural electrification and R&D, we do not discount a wider scope for the fund including tariff stabilisation, once it is transferred to the regulator. We estimate the fund at RM3.5b.

EARNINGS REVISION/RISK

• We project full-year 2018 net profit of RM6,971m on the back of a 2% electricity demand growth in Peninsular Malaysia as well as minimal reinvestment tax allowance for the rest of 2018.
• Key risk is widening losses from overseas investments. We note that TNB experienced a net loss of RM77m from its Turkey and India investments in 1Q18.

VALUATION/RECOMMENDATION

• Re-iterate BUY with DCF-based target price of RM17.70. Following the change in the government, share price had dropped >10%. This reflects concerns over the validity of both the IBR and ICPT under the new administration. Our recent meeting suggests the government remains committed to energy reforms. The stock is attractive at 11.5x forward earnings and offers a sustainable dividend yield of 5%. At our DCF-based target price, the stock would trade at 15x 2019F PE and 8x EV/EBTIDA – a fair valuation, given good earnings visibility, sustainable dividend yields and market liquidity.
• Trough valuation. In the event the new government decides to unwind the current regulatory framework, we believe the stock would trade closer to its trough valuation – estimated at RM8.60, due to earnings and cashflow (dividend) uncertainties. Our trough valuation is based on a two-year average earnings (FY12-13) record, prior to the implementation of IBR (of RM4,880m) and a PE multiple of 10x.
• Foreign shareholding stable at 24% as at end-Mar 18.

Source: UOB Kay Hian Research - 27 Jun 2018