Investment Highlights

• We downgrade our recommendation from HOLD to SELL for Petronas Gas (PGas) as the share price has risen above our slightly higher sum-of-parts-based (SOP) fair value of RM16.65/share (from an earlier RM16.60/share), which implies an FY18F PE of 18x, a 20% discount to the 2- year average of 23x.

• Our revised SOP stems from the 3% increase in FY18F earnings, as we have removed the assumption for a 2ppts reduction from our estimated FY16 return on depreciated replacement cost or regulated asset base (RAB) for the gas transportation segment of 17% under the Gas Supply (Amendment) Act 2016’s Third Party Access (TPA) implementation, which commences today.

• Management has previously affirmed that the computation for the return on RAB or weighted average cost of capital may be based on its fair value, potentially on a depreciated replacement cost (RC) basis vs. its 2013 market capitalisation used to compute its WACC of 9% under the current tariff.

• Recall that based on management's guidance that its gas transportation segment’s depreciated replacement cost is 3x its current historical book value, our FY18F-FY19F return on regulated asset base (RAB) translates to 9% for the gas transportation segment vs. Tenaga Nasional’s 5.4% ROA in FY17.

• However, PGas has confirmed yesterday that the Energy Commission has maintained the current tariff for the utilisation of the Peninsular Gas Utilisation system, Regasification Terminal Sungai Udang and Regasification Terminal Pengerang until the end of 2018.

• Nevertheless, PGas is still in continuous discussion with the Energy Commission on the framework and quantum of the tariff beyond 2018.

• Hence, our FY19F earnings onwards are unchanged as we have assumed that the gas transportation tariff will be reduced by 9%.

• In our view, the stock price has recovered given that the impact for the TPA has been deferred. However, the impending value erosion from the implementation of the government’s incentive-based regulatory mechanism will only defer the impact by a year.

• Hence, the stock currently trades at an unjustified FY18F PE of 20x with its earnings likely to erode over the longer term under the new TPA terms.

Source: AmInvest Research - 16 Jan 2018