The Power Utilities Sector offers resilient earnings exposure given that the ICPT framework will free TENAGA from fuel cost risk whereas the PPA Extension Contracts awarded to Gen1 IPPs will help to extend their earnings till 2018. With the government’s commitment towards the ICPT mechanism which has now become a scheduled half-yearly review, the sector is moving in the right direction with transparency in fuel cost structure coupled with the newly launched New Enhanced Dispatch Arrangement to reduce cost further. In view of this, TENAGA will be the prime beneficiary of the reform, but it could be a double-edged sword to end-user should fuel prices swing upwards. On the other hand, with the scheduled upward adjustment on piped gas price for every six months, future tariff rebates are likely to reduce further. TENAGA remains as our TOP PICK for the sector for its earnings quality profile and its index-weighting status. Besides, we also like small cap PESTECH as an alternative play for its explosive earnings growth story.

Resilient earning is the selling point. With the 1MDB overhang already removed in end-2015, the sector is now on the right track and one should appreciate the stability earnings that the industry players could offer. Tenaga Nasional Bhd (TENAGA, OP; TP: RM16.49) is the key beneficiary of the implementation of Imbalance Cost Pass Through (ICPT) mechanism, which help to eliminate fuel cost risk while the recent award of three PPA Extension Contracts should help to extend earnings continuity up to 2018 for Malakoff Bhd (MALAKOF, OP: TP: RM2.07) and YTL Power International Bhd (YTLPOWR, OP; TP: RM1.66) for their Gen1 IPPs, which expired between 4Q15-1Q16, up to 2018. We see this PPA Extension Contract as a win-win for both TENAGA as well as the IPPs as the former will benefit from lower tariff rate while to the latter, it is a bonus, as their power plants are already fully amortised based on previous PPA, as they are now running on much lower operating costs. Meanwhile, once the Cambodian BOT project completes in end 2018, the small cap Pestech International Bhd (PESTECH, OP; TP: RM7.43) will no longer be dependent on EPC contracts as the concession business will generate sustainable recurring income over the next 25 years.

ICPT to free TENAGA from fuel cost risk. This year is the second year we see the tariff adjustment based on the ICPT framework which was implemented in 2014. Given the recovery of fuel prices coupled with a scheduled upward revision of piped gas price of RM1.50/mmbtu once every half-yearly, the ICPT over-recovery savings are likely to decline, which will translate into a lower tariff rebate to end-user in the future. So far, we see the tariff rebate being reduced to 1.52 sen/kWh for the first time for Jan-Jun 2016 after a constant 2.25 sen/kWh tariff rebate in 2015. Meanwhile, the current base-tariff of 38.53 sen/kWh is to be maintained till end-2017 and a new base-tariff will be implemented from 2018 onwards. In all, we laud the government’s commitment towards the ICPT framework. At current fuel prices which are still below the preference prices set in end 2013, end-users are likely to enjoy tariff rebate at least in the next review in Jun 2016. The key take away from the government’s commitment is that TENAGA is now freed from fuel cost risk.

PPA Extension to extend Gen1 IPP’s life to 2018. In Feb, two Gen1 IPPs, namely MALAKOF’s PD Power and Powertek’s (Not Listed) Teluk Gong Power Plant, signed the PPA Extension Contracts with TENAGA for the period of Mar 2016 to Feb 2019 and Mar 2016 to Dec 2018 respectively. With this, YTLPOWR is the only Gen1 IPP which has yet to sign the PPA Extension Agreement with TENAGA although its Paka Power Plant has been already been awarded a PPA extension for Mar 2016 to Dec 2018 from Energy Commission in Aug last year. Together with the new plants commencing such as the 1,071MW CCGT Prai Plant in January and MALAKOF’s 1,000MW T4 in March, we believe there should be no problem of electricity supply in the next few years. On the other hand, the New Enhanced Dispatch Agreement (NEDA) is already fully implemented in Jan. This is to ensure effective power generation in the country as NEDA allows generators to compete based on their variable operating rates (VOR) in exchange for more dispatch and thus higher returns. On the off-taker’s side, a lower VOR means lower operating cost and hence the savings will pass through via the ICPT mechanism to the end-user eventually. This is win-win to all parties, including the end-user.

Still OVERWEIGHT. In the current uncertain times, investors are looking for avenue of defensive play. We believe the Power Utilities is the right sector for now as the ICPT framework and the PPA Extension are timely. In addition, valuations for the overall sector is not demanding too at CY16 13x PER which is below the FBMKLCI’s 16x. TENAGA remains as our Top Pick for the sector given its undemanding valuation, which is backed by its quality earnings profile and index weighting status. On the other hand, we continue to like small cap PESTECH as our alternative sector play for its explosive earnings growth story, with near-term strong contract flows expected. 

Source: Kenanga Research - 5 Apr 2016