We still see upside potential for GASMSIA despite the less than rosy earnings prospect from the regulated gas sector as the IBR regime enables 8% return from its asset base. As such, it is no longer a volume play while the current margin spread of RM1.58/mmbtu is not extended beyond 2016. A new base for gas tariff will be introduced next January over 2017-2019 with half-yearly reviews while the margin spread will be adjusted annually, confined to the 8% WACC. This framework is similar to that of the power industry which eventually will be marked to market and fully pass-through. Although margin spread may not be attractive as before, we take comfort that at least bottomline is guaranteed under the IBR mechanism. Meanwhile, the new ventures in non-regulated businesses, which will be starting contributing this year albeit immaterial, will lead earnings growth post 2020. We maintain OUTPERFORM and price target of RM2.68/DCF share.

Margin spread to maintain in 2016. Last Friday, we attended Gas Malaysia Bhd’s (GASMSIA) analysts’ briefing where management revealed details of the weak 4Q15, the Incentive Based Regulation (IBR), capex for regulated business and updates on non-regulated businesses. To recap, 4Q16 core earnings fell 16% QoQ to RM28.2m, mainly attributable to the one-off additional billing for price differential between market price and regulated price for LNG for the full-year adjustment in 2015. Given that the new gas price tariff for 1H2016 of RM25.53/mmbtu has already been implemented in January, the higher cost arising from the said additional billing will be reflected in the 2H 2016 new gas tariff structure, which will start in July. Despite expecting a higher profitability in 2H16, this should be earnings neutral to GASMSIA under the IBR mechanism which will enable it to make RM1.58/mmbtu margin spread on a normalised basis in 2016.

A new gas tariff rate for 2017-2019. We are made to understand that this year is an IBR trial period while a new IBR period will start next January over a period of three years 2017-2019. A base gas tariff will be set for 2017-2019, which is similar to the electricity base tariff for 2014 to 2018. This means the base gas tariff will be maintained at the fixed rate while cost adjustment will be aligned via cost over or under recovery like the TENAGA’s (OP; TP: RM16.49) case. Having said that, IBR does not guarantee a certainty in margin spread but a capital return based on WACC of 8%. This also means that the current RM1.58/mmbtu margin spread guaranteed is not extended beyond 2016. The 8% WACC and capex budget coupled with the expected business volume will be the key factors to determine forward margin spread. Given the planned RM400m capex over 2016-2019, which will increase its asset base, earnings will be increasing based on the 8% WACC. And based on this, margin spread will be set once every 12 months over the next three years.

Non-regulated businesses to kick start in 2Q16. Given that earnings growth for the regulated gas business will be capped by a return of WACC 8%, the new ventures in non-regulated businesses, i.e., (i) Virtual Pipeline (VP), (ii) Combined Heat & Power (CHP), and (iii) BioCNG, which facilities started construction two years ago, are timely to lead earnings growth. VP with yearly capacity of 420,000 mmbtu, will start delivering to eight customers in Gebeng, Pahang by 2H2016. CHP has its first 3MW plant with capacity of 1.1m mmbtu/year in Prai which is now at 90% completion, should be able to be operational by 3Q16 while it is looking for a 2nd plant with 2MW capacity in Klang Valley. Meanwhile, BioCNG’s 25,000 mmbtu/year supply facility has already been completed, which should be able to start operating in 2Q16. Returns for these businesses are fairly attractive at IRRs of 15%-20% for VP, 10%-15% for CHP and 18%-25% for BioCNG given their relative low capex requirement. However, the initial profit contributions to the group is immaterial of <5% in the first two years and a meaningful 25%-35% PAT contribution by 2020.

A resilient play, maintain OUTPERFORM. With the IBR in place; while a meaningful non-regulated businesses contribution will only be felt in 2020, GASMSIA’s earnings are expected to be less rosy but resilient over the next four years. Having said that, GASMSIA is likely to pay lower than the near-100% earnings payout since 2012 given the rising capex requirement, but it should be able to meet its 75% dividend payout policy. In all, it is no longer a volume play business but operational efficiency is the key to its profitability. Despite that, we still see upside potential from this stock. We maintain our OUTPERFORM rating with unchanged price target of RM2.68/DCF share.

Source: Kenanga Research - 28 Mar 2016