We remain positive on the Power Utilities sector which is the right sector for investors looking for defensive plays under the current uncertain investment climate. Although fuel costs are set to increase in view of high coal prices of late and the scheduled hike in gas prices, these factors have neutral earnings impact on TENAGA as the ICPT framework will address the issues in the coming June Review. In fact, TENAGA’s valuation of 13x at CY18 earnings multiplier is unwarranted due to its earnings quality profile coupled with index-weighting status. Meanwhile, selling pressure on the IPPs has somewhat abated from 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, TENAGA remains our sector TOP PICK while PESTECH is an alternative small cap play.

Defensive is key; OVERWEIGHT maintained. With the uncertainties ahead, especially the impending GE14, we believe the Power Utilities Sector is the right sector for defensive play. In fact, share price of TENAGA (OP; TP: RM17.17)

rose 3.28% YTD which is in line with FBMKLCI’s +3.81%. However, the two IPPs; MALAKOF (OP; TP: RM1.25) and YTLPOWR (MP; TP: RM1.25) saw their shares falling 10.20% and 13.95%, respectively, over the same period. TENAGA’s performance is backed by its fairly defensive earnings with the ICPT framework which has a fuel cost pass-through mechanism eliminating fuel cost risk while the weakness in IPPs offers buying opportunity given that profitability of IPPs is backed by PPAs which guarantee capacity payment as long as requirements are met. On the other hand, valuation for the overall sector is also not demanding at CY18 13.3x PER which is below the FBMKLCI’s 15.3x. TENAGA remains as our Top Pick for the sector given its undemanding valuation, which is supported by its quality earnings profile and index weighting status. Meanwhile, we continue to like small cap PESTECH (OP; TP: RM2.15) as our alternative sector play for its explosive earnings growth story, with near-term strong contract flows expected.

TENAGA on offshore expansion? In recent years, TENAGA completed a few offshore renewal energy (RE) M&A activities including GAMA Energi of Turkey and GMR Energy of India in 2016 as well as acquiring a 50% stake in an UK solar power asset last year. This is part of its 5-year international expansion plan to acquire up to 250MW capacity of RE projects by 2020. In early March, TENAGA had completed the acquisition of an 80% stake in onshore wind turbine businesses in GVO Wind Ltd and Bluemerang Capital Ltd for GBP77.37m. Their wind portfolio consists of young assets with an average age of 2.5 years and an estimated useful life of over 25 years. It also has the support of a 20-year UK government-backed Fit renewable support mechanism and offers attractive financial returns, which are earnings-accretive from year one. Back home, TENAGA has signed eight Large-scale Solar PPAs last month with eight RE players to build c.30MWac plants to generate power over 21 years starting from between September 2019 and December 2020. On the other hand, in a surprise move, YTLPOWR acquired a Dutch hotel, Marriott The Hague for EUR60.3m in the middle of last month. We are negative on this acquisition as it is a noncore to the utility firm. However, given there is a hospitality unit YTL Hotel within the YTL group, we do not rule out the possibility of YTLPOWR facilitating the transaction.

Fuel prices remain firm. While the government had agreed to maintain the tariff at 38.53 sen/kWh in 1H18 with the subsidy of RM929.4m offset by the saving of capex/opex between the actual spent and budget figures, the persistency of fuel prices such as coal staying high at USD90/MT levels and the scheduled half-yearly hike in piped gas price, would lead to higher fuel costs. Thus, the c.RM500m fund available under the Kumpulan Wang Industri Elektrik, which can be used to offset any future subsidy may not be sufficient. Question remains on whether the government will allow TENAGA to raise tariff rates in the future against its new base tariff of 39.45 sen/kWh for 2018-2020. 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 persists in the future especially after GE14.

Overall a better 2018. The recent 4QCY17 results reports card was a mixed bag with YTLPOWR’s 2Q18 falling short of expectations due to interest expense remaining elevated and wider YES’ losses while PESTECH’s 2Q18 earnings beat forecast on two new rail electrification projects. Going forth, 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. Elsewhere, PESTECH should see earnings growth on the back of its RM1.5b order-book coupled with new contract flows to sustain earnings momentum. However, 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.

Source: Kenanga Research - 4 Apr 2018