In the current uncertain times, we believe Power Utilities is the right sector for investors who are looking for defensive play. There is little earnings risk for the sector given that the Imbalance Cost Pass Through (ICPT) framework will free TENAGA from fuel cost shock while the IPP’s capacity payments are guaranteed by PPAs. On the other hand, we see Brexit exerting little impact on TENAGA given that its foreign-denominated borrowings are <15% in case of USD and JPY appreciating. Operationally, there is little effect on YTLPOWR’s Wessex Water but there could be material impact from forex translation as a 1% decline in GBP to MYR could translate into almost 1% decline in earnings. In all, 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.

Defensive is key, OVERWEIGHTing the sector. In the current uncertain times, we believe the Power Utilities is the right sector for investors who are looking for defensive play. Earnings of Tenaga Nasional Bhd (TENAGA, OP; TP: RM17.50) are fairly defensive with the ICPT framework which has removed the fuel cost risk as the mechanism is a fuel cost pass-through in nature while profitability of IPPs is backed by PPAs which guarantee capacity payment so long as requirements are met. In addition, valuations for the overall sector are not demanding too at CY16 12x 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 International Bhd (PESTECH, OP; TP: RM7.52) as an alternative sector play for its explosive earnings growth story, with near-term strong contract flows expected.

Resilient earning is still the selling point. With the 1MDB overhang already removed end-2015, the sector is now on the right track and one should appreciate the stable earnings profile the industry players could offer. In our view, TENAGA is the key beneficiary of the implementation of ICPT mechanism, which help to eliminate fuel cost risk while the award of three PPA Extension Contracts early of the year should help to extend earnings continuity up to 2018 for Malakoff Bhd (MALAKOF, OP: TP: RM1.97) and YTL Power International Bhd (YTLPOWR, OP; TP: RM1.54) 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 rates while to the latter, it is a bonus, as their power plants are already fully amortised on previous PPAs, and they are currently running on much lower operating costs. Meanwhile, once the Cambodian BOT project is completed at end 2018, small cap PESTECH 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. As such, the tariff rebate for Jan-Jun 2017 is likely to be lower than the 1.52sen/kWh for Jan-Dec 2016. In 2015, the tariff rebate was 2.25sen/kWh throughout the year. 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 end 2013, end-users are likely to enjoy tariff rebate at least in the next review in Dec 2016. The key take away from the government’s commitment is that TENAGA is now free from fuel cost risk.

YTLPOWR’s PPA Extension hit a snag? While MALAKOF’s PD Power and Powertek’s (non-listed) Teluk Gong Power Plant have already signed the PPA Extension Contracts in Feb with TENAGA for the period of Mar 2016 to Feb 2019 and Mar 2016 to Dec 2018 respectively, YTLPOWR is still waiting to sign the PPA Extension Agreement with TENAGA although its Paka Power Plant has already been awarded a PPA extension for Mar 2016 to Dec 2018 from Energy Commission (EC) in Aug last year. Latest development is TENAGA taking EC and the Minister of Energy, Green Technology and Water to court in early July over the issue of Paka’s PPA Extension involving a land dispute between TENAGA and YTLPOWR. The land for the Paka Plant Power is owned by TENAGA, which is leased to YTLPOWR. We believe this event is actually more material to YTLPOWR than TENAGA given the former needs new earnings to mitigate falling PowerSeraya’s earnings. This PPA Extension makes up c.6% of YTLPOWR’s operating profit in FY17 with 3.0 sen addition to its SoP valuation. For TENAGA, any further delay has minimal impact to supply since Paka’s installed capacity is a mere 808MW, or <4% of total installed capacity in Peninsular Malaysia.

Source: Kenanga Research - 12 Jul 2016