We are upgrading the Water Sector to OVERWEIGHT from NEUTRAL premised on the following investment merits: (i) we have seen strong commitment from all parties, including the Federal Government (through PAAB), Selangor State Government (SSG) and water concessionaires to resolve the Selangor's water restructuring deadlock, (ii) the restructuring of Selangor’s water assets provide opportunities to downstream players following the Langat 2 WTP construction, and (iii) anticipation of special dividend from these water concessionaires after asset sale. On the other hand, we continue to OVERWEIGHT the Power Sector with TENAGA as our TOP PICK given that a tariff review is imminent in view of the expected higher gas and fuel costs arising from the Government’s intention to reduce subsidies. Eventually, the fuel pass-through mechanism will reduce the fuel cost risk to TENAGA. In all, the upcoming Budget 2014 should be a non-event to the sector while the implementation of GST would likely have minimal sector impact.

A mix set of 2QCY13 results. In the recently just-concluded reporting season, Tenaga Nasional Bhd’s (“TENAGA”’ OP; TP: RM10.48) 3Q13 results came in above our as well as market consensus powered by a RM200m capacity payment saving, strong-than-expected electricity demand in the commercial segment and lower coal price of USD84.5/mt in 9M13 vs. our assumption of USD92/mt for full-year FY13. Meanwhile, Puncak Niaga Holdings Bhd’s (PUNCAK”, OP; TP: RM4.05) 2Q13 results came in below expectations no thanks largely to the delay in the Petronas oil & gas project. On the other hand, YTL Power International Bhd’s (“YTLPOWR”, MP; TP: RM1.58) 4Q13 results and MMC Corp Bhd’s (“MMCCORP”, MP; TP: RM2.67) 2Q13 results came in within both our as well as the market expectations.

WATER: higher conviction on the resolution of restructuring issues. All parties, including SSG, PAAB, and water concessionaires have nodded to resolve the deadlock of the Selangor's water restructuring. This is based on: (i) increasing news flow suggesting cooperation from both federal and state governments to resolve the issues to address the expected water crisis in the near future and (ii) our channel checks with water players revealed that they are getting more confident that the last offer by SSG will go through. It is expected that SSG will again announce a takeover of the water concessionaire, but the price will be the same as per the fourth offer (i.e. RM9.65b). Theoretically, Kumpulan Darul Ehsan Bhd (KDEB) will fork out RM2.0b to buy over the concessionaires' equity while PAAB will have to pay the remainder RM7.7b to fund the assets plus surplus value (if any after performing the due diligence on the assets valuation).

Langat 2 WTP awards will follow suit after the water restructuring. The new RM1.2b Langat 2 water treatment plant (WTP) will add another 1,130 MLD in Selangor and the Klang Valley. It will be sourced from Pahang (i.e. Kelau Dam). This is one of the efforts to address the worrying water supply issues in Selangor and the Klang Valley in the near future. We expect Langat 2 WTP to be awarded in 1Q14 soon after the restructuring of the assets.

POWER: Project 3A confirmed; 3B on the way. Not unexpectedly, TENAGA won the fast track Project 3A in early Aug-13 to build another 1,000MW coal-fired plant in its existing Manjung facility, to be called Manjung 5. Once the Project 3A is ready in Oct-17, the facility will be the largest power plant in Southeast Asia with total installed capacity of 4,100MW. The process bidding for Project 3B is still on going and TENAGA and YTLPOWR are two of the shortlisted contenders. With regard to statements that TENAGA has unfair advantage over IPPs in new power plant tenders, we maintain our view that TENAGA should continue bidding for new projects to ensure a competitive bidding environment which ultimately benefit the consumers from more efficient power generation.

Upgrade Water to OVERWEIGHT and TENAGA remains the TOP PICK. All in, we decided to upgrade the Water Sector to OVERWEIGHT from NEUTRAL as (i) we have seen strong commitment from all parties including the Federal government, SSG and water concessionaires to resolve Selangor's water restructuring deadlock, (ii) the restructuring of Selangor’s water assets provide opportunities to downstream players following the Langat 2 WTP construction, and (iii) anticipation of special dividend from these water concessionaires after the asset sale. Hence, we maintain OUTPERFORM on PUNCAK with higher Target Price of RM4.05. The revised TP is after switching our valuation methodology for its Selangor water operation from DCF valuation to the equity value offered by SSG in our SOP-derived valuation. On the other hand, TENAGA is still our TOP PICK for the Power Utilities for the rerating story coupled with compelling valuation. We also have MARKET PERFORM calls on MMCCORP and YTLPOWR

KDEB will make another offer. Recently, StarBizWeek published an article “Water solutions in the pipeline” after it interviewed Suhaimi Kamaralzaman, President of KDEB, (i.e. the SSG’s arm/offeror of the Selangor’s water concessionaires’ takeover). Mr. Suhaimi is optimistic that the long-standing water issues in Selangor will eventually see a workable solution. He mentioned that SSG will make another offer but this time the price will be fixed as at the previous offer of RM9.65b. The fresh offer will be made carefully and most importantly PAAB will be part of the offer which we understand are currently preparing a counter-proposal in response to KDEB’s offer. It will be a “willing-buyer-willing seller” scenario which all the parties will come face-to-face to resolve the issue.

Who are the beneficiaries? Both upstream and downstream players stand to benefit from the restructuring exercise and Langat 2 WTP awards. The biggest upstream player in Selangor, PUNCAK, certainly will benefit from the sale of its 100%-owned PNSB and 70%-owned Syabas followed by GAMUDA and KPS through SPLASH’s sale and lastly Konsortium Abass. Meanwhile for downstream players such as SALCON, JAKS, and ENGTEX, they will also benefit in terms of securing contracts for the Langat 2 WTP works such as pipelays, ancillaries, and reservoirs. In addition, we expect infrastructure contractors like GAMUDA, AZRB and MMCCORP to benefit in terms of securing the physical infrastructure construction work of the project.

Special dividend for shareholders? There is a strong likelihood that the water players such as PUNCAK and GAMUDA would announce special dividends after disposing their water assets. 

Source: Kenanga