The Energy Commission has confirmed a higher base tariff of 39.45 sen/kWh for 2018-2020 with a lower asset return of 7.3% from 7.5% which remains earnings neutral to TENAGA. We also believe that TENAGA will be able to adjust tariff accordingly to cost structure post GE14. This should re-rate the stock further. It remains our TOP PICK for the sector at target of RM17.17. OUTPERFORM retained.

A higher base tariff. Yesterday, the Energy Commission (EC) conducted a briefing for analysts and media to detail out the electricity tariff review in Peninsular Malaysia under the Regulatory Period 2 (RP2) for 2018-2020. To our surprise, the new base tariff was raised to 39.45 sen/kWh in RP2 from 38.53 sen/kWh previously for Regulatory Period 1 (RP1) for 2015-2017. This is contrary to TENAGA’s announcement in end-Dec 2017 that the tariff structure is to be maintained in RP2. In addition, the regulated return to TENAGA, i.e. WACC was reduced to 7.3% in RP2 from 7.5% in RP1.

Same as the actual cost in RP1. The generation costs makes up 69% of the average base tariff. Thus, the new base tariff of 39.45 sen/kWh is based on average generation cost assumption of 27.05 sen/kWh which takes into consideration the scheduled half-yearly hike of RM1.50 /mmbtu over to 1H19. On the other hand, assumption of LNG is reduced to RM35/mmbtu from RM41.68/mmbtu while coal cost is reduced to USD75/mt from USD87.50/mt but in MYR term the coal cost is raised to RM315.90/mt from RM271.25/mt as MYR against USD weakened to 4.212 from 3.10 previously. In fact, the actual average tariff in RP1 was 39.45 sen/kWh which is the same for RP2.

How it affects TENAGA? The new base tariff will not affect TENAGA’s profitability as the fuel costs are passed through to end-user under the Imbalance Cost Pass-through (ICPT) mechanism. In fact, the reduced WACC is unlikely to affect earnings as well as its asset base will grow over time as the Incentive-based Regulation (IBR) encourages capex to improve efficiency. In RP2, the assumption of asset base is RM57b on average as opposed to the average of RM42b in RP1. As such, the asset return is c.RM4.1b a year for TENAGA. Meanwhile, the total subsidy of RM929m to maintain tariff of 38.53 sen/kWh in 1H18 will be borne by TENAGA which will offset the saving of actual capex and opex spent of RM17.0b and RM17.5b against the approved numbers of RM18.5b and RM18.4b, respectively.

Main concern: does it allow surcharging end-users? Given the limited funds available, such as PPA Saving Fund, to offset subsidies, question remains on whether the government will allow TENAGA to raise tariff rates in the future should the ICPT rebate situation persist. Nonetheless, in the principle of ICPT framework, fuel cost risk is passed through to end consumer, thus with neutral impact to TENAGA’s earnings. In addition, GE14 is likely to be in 1H18; hence, the tariff rates were maintained for 1H18, in our opinion. Besides, there is c.RM500m fund available under the Kumpulan Wang Industri Elektrik which can be used to offset any future subsidy.

Still undervalued. We continue to like TENAGA for its earnings quality while RP2 offers better earnings clarity which was reflected in the recent strong accumulation of the stock. With its heavy index-weighted status, we still believe it is still undervalued at current PER level of 13x. It remains OUTPERFORM with unchanged price target of RM17.17 based on CY18 14.4x PER which is based on +1.5SD of 2-year moving average. Risks to our call include: (i) a slowdown in economy growth, which will affect electricity demand, and (ii) a sudden surge in fuel prices resulting in a short-term earnings weakness.

Source: Kenanga Research - 17 Jan 2018