We reverse our previous optimistic view on MALAKOF following a 2Q16 results briefing yesterday as we now believe the near term earnings growth is limited as contributions from the new T4 is fairly immaterial while KEV may not be turn around anytime soon. Although management has identified local RE and overseas ventures for future growth drivers this takes time, in our view. Our new price target is now revised to RM1.79/share after an 18% cut in FY16-FY17 estimates mainly on T4 adjustment. MALAKOF is now a MARKET PERFORM.

T4 is not attractive as it seems. The briefing unveiled more details about the 2Q16 results which saw core earnings falling 15% sequentially to RM71.6m from RM84.1m despite a full-quarter contribution from the new T4 which was operational on 21 Mar 2016. This was due to the inclusion of: (i) depreciation charges of about c.RM150m a year for T4, and (ii) interest costs incurred of c.RM93m in 2Q16 alone, for T4. As such, the group did not see higher profitability even though T4 has come into the system. On the other hand, high interest costs which include: (i) the expense-off for equity borrowings at group level, and (ii) interest expense at asset level, will continue to pressure the returns of T4 in the future. Management suggested that it will look for refinancing, especially for the equity borrowings to bring down interest costs.

KEV another wild card. Although owning an associate stake of 40%, KEV has been a dampener to MALAKOF’s earnings in the past 1-2 years due to operational issues at its coal-fired generation units of GF2 and GF3. On a positive note, KEV has signed the 6th Supplemental Agreement of the PPA with TENAGA (OP; TP: RM17.50) recently and the unplanned outage rate (UOR) for GF2 and GF3 was reset to 0% from 10% in June this year. This will mean KEV is able to receive capacity payments for UOR of not more than 6%. This should help to ease earnings pressure where management expects KEV to turn around by year end with the new signing of Supplemental Agreement. However, we remain cautious on KEV as this is not good enough as the operational issues have yet to be sorted out.

Looking for local RE and overseas venture for sustainability. With limited opportunity in the domestic power generation industry, the company is exploring opportunities in renewable energy space, especially solar energy where the government targets a cumulative solar capacity of 1,000MW by 2020 with a commencing target of 300MW in 2017. On the other hand, MALAKOF said it needs to aggressively explore opportunities abroad, focusing in the Middle East North Africa region, ASEAN, Australia as well as South Africa by way of M&A and JV. Currently, the overseas units contribute about 3%-4% to top line and c.10% to bottom line. It targets to double up the contributions in the near future.

Expect flat earnings this year. While T4’s depreciation charges are well within estimate, we had understated the interest costs for the new plant previously. Also, we were too bullish in our O&M business assumptions. After adjusting the T4’s interest costs, O&M business as well as the non-KEV associate units to reflect the latest number updates, we trimmed FY16-FY17E earnings by 18%. We keep our KEV assumptions of which we expect it to be loss-making.

Cut to MARKET PERFORM. Following the earnings adjustment, our new target price is now reduced to RM1.79/share from RM1.97/share based on 10% holding company discount to its SoP valuation. Although we like its longterm recurring income streams, which are backed by PPAs, we see limited upside in view of muted T4 contributions, at least in the near term. Thus, we downgrade the stock to MARKET PERFORM. Risk to our downgrading call includes a fast turnaround of KEV and better-than-expected T4 earnings.

Source: Kenanga Research - 19 Aug 2016