We believe 2018 is a better year for the sector as earnings will continue to grow given the GDP-push demand to drive sales, and earnings for IPPs should see better clarity following the PPA Extension contracts in 2H17 while PESTECH starts its maiden recurring income in January. Investors should appreciate that the ICPT framework frees TENAGA from fuel cost risk. This makes its current valuation unwarranted despite its earnings profile and index-weighting status. Meanwhile, selling pressure on the IPPs had somewhat abated with previous expectations of YTLPOWR facing lower dividend payout while MALAKOF is expected to see weaker earnings. PESTECH should break its 2- year lacklustre share price performance despite improving earnings, as it is entering a new phase of business dynamic with its rail electrification capability. In all, the Power Sector is a fairly stable industry which is a good investing avenue for passive investors. TENAGA remains our sector TOP PICK while PESTECH as an alternative small cap play.

A better year in 2018? Big cap TENAGA (OP; TP: RM17.17) finally had a better performance in 2017 with share price rising 12.45% while the IPPs performed poorly for another year as YTLPOWR (MP; TP: RM1.30) and

MALAKOF (OP; TP: RM1.25) saw their share prices contracting 9.16% and 28.96%, respectively, in 2017. With GE14 around the corner and a new base tariff for second regulatory period starting Jan 2018 remaining unchanged at 38.53 sen/kWh which was not a surprise as the fuel costs will be adjusted by way of surcharge in the case of higher cost or rebate should actual fuel costs go lower than preference price. Having said that, it remains earnings neutral to TENAGA, which also means that the integrated utility should warrant a higher PER valuation as fuel risk is pass-through. Meanwhile, as the cut in capacity payments for Gen1 IPPs has already been reflected in the latest earnings, we believe the selling pressure on YTLPOWR and MALAKOF should have abated. Thus, a better year for the sector in 2018.

Earnings to improve further. We expect TENAGA`’s earnings to grow further on the back of 2.1% electricity demand growth in 2018, to be led by domestic and commercial segments, while YTLPOWR should see a rebound in earnings as the Paka Power Plant recommenced in September last year after it resolved the dispute with TENAGA pertaining to land issue. Meanwhile, MALAKOF’s earnings are likely to be flattish given that upside is capped by cut in SEV’s capacity payment following the PPA Extension Contract. Going forth, operational efficiency is the key to determine TENAGA’s bottomline as fuel cost risk is eliminated by the Imbalance Cost Pass Through (ICPT) mechanism. TENAGA has indicated its keen interest for offshore expansion to drive earnings growth although it does not expect to provide material impact anytime in the near future. On the other hand, YTLPOWR’s dividend payout could be lower as it needs to conserve cash for two greenfield projects, namely PT Tanjung Jati coal-fired power plant in Indonesia and Attarat Power’s oil shale-fired power plant in Jordan over the next 3-4 years. Meanwhile, MALAKOF is still actively looking for offshore M&A and greenfield opportunity to sustain earnings growth given the cut in SEV’s capacity payments. Elsewhere, PESTECH (OP; TP: RM2.00) should see earnings growth on the back of its RM1.5b order-book coupled with new contract flows to keep earnings momentum.

New base tariff to maintain. The government had agreed to subsidise RM929.4m or 1.8 sen/kWh for 1H18. This also means that there is no change in the new base tariff at 38.53 sen/kWh which starts from 1st of January. This is against our expectation of a higher base tariff given the rising fuel costs where the government already subsidised a total of 2.54 sen/kWh in 2H17. We believe the maintaining of the new base tariff could be due to upcoming GE14, which is due any time before August. However, while the balance of PPA savings fund of c.RM40m as of end-December is highly unlikely to be sufficient to net off the rising fuel costs, question remains on whether the government will allow TENAGA to raise tariff rates in the future. Nonetheless, under the principle of ICPT framework, fuel cost risk is passed through to end-consumer; thus, with neutral impact to TENAGA’s earnings. In our view, we believe TENAGA will be allowed to continue passing through fuel cost risk to end-consumer in the future. As such, consumers are likely to pay for the surcharge should ICPT under-recovery situation persist in the future especially after GE14.

OVERWEIGHTing this defensive sector. Despite relatively defensive earnings, the Power Utility sector is trading at undemanding valuations. This is fairly unwarranted especially for TENAGA given its index-linked heavyweight status and earnings quality profile where the ICPT mechanism frees it from fuel cost movement risk. Meanwhile, selling pressure on MALAKOF has somewhat abated and it is now trading at 41% discount to its SoP valuations which appears to be attractive, in our view. We believe MALAKOF could be a dark horse as in the stretched valuation in which we remove the problematic SEV, T4 and all associate valuations, its SoP of RM1.08/share is still higher than current price. Besides, any M&A opportunity should boost sentiment. On the other hand, we are neutral on YTLPOWR as it is expected to distribute lower dividend payout at least in the next 3-4 years as it needs to conserve cash for two greenfield projects namely PT Tanjung Jati coal-fired power plant in Indonesia and Attarat Power’s oil shale-fired power plant in Jordan. Elsewhere, we continue to like alternative play PESTECH for its earnings growth story as well expected maiden recurring income from the consensus asset Diamond Power starting this month.

Source: Kenanga Research - 3 Jan 2018