Despite a sequential weaker quarter due to higher fuel costs and lower ICPT under-recovery, 2Q18 results are satisfactory and on track to meet forecasts. Demand growth also healthy at 2.7% in 1H18. With the first surcharge in 2H18, we believe the implementation of ICPT mechanism is fairly well in check. It remains OUTPERFORM at target price of RM17.90.

2Q18 inline. At 48%/45% of house/street’s FY18 estimates, 1H18 core profit of RM3.25b came within expectations. The core earnings are adjusted for; (i) RM564.7m reinvestment allowance, (ii) RM80.6m forex translation loss, and (iii) RM206.5m impairment for its 30%-owned Turkish associate Gama on forex losses following the significant depreciation of Turkish Lira (TRY) of late. It declared first interim NDPS of 30.27 sen which represents 50% earnings pay-out. Given the change of financial year-end to December from August, there is no YoY comparison.

A weaker quarter sequentially. Despite revenue inching up 2%, 2Q18 core profit slipped 10% QoQ to RM1.54b from RM1.71b in 1Q18. This was largely owing to higher opex by 9% to RM10.68b as total fuel costs leapt 8% to RM6.63m while non-fuel costs rose 12% to RM4.06b. Overall, higher fuel costs were attributable to higher total IPPs costs by 6% and total fuel costs at TENAGA of 10% owing to higher generation, especially coal generation, which jumped 14% over the quarter despite a lower average coal price of USD91.1/mt or RM361.4/mt from USD92.1/mt or RM361.7/mt in 1Q18. Thus, coal consumption increased to 8.0m mt from 7.1m mt previously,

ICPT under-recovery in 2Q18. TENAGA continued to incur higher fuel costs as fuel prices were higher than the reference prices set in RP2. Thus, there was an ICPT under-recovery of RM245.2m in 2Q18 but it was lower than RM634.1m in the preceding quarter. This also partly contributed to the weaker QoQ earnings in 2Q18. During the period, average coal price was RM361.4/mt, against RM361.7m, which was 14% higher than reference price of RM315.9/mt. We believe the drop in ICPT under-recovery despite fairly flattish average fuel prices QoQ, could be due to the increase in coal generation of 58% from 54%, which was closer to reference rate of 61% set for RP2; thus, requiring less-cost effective non-coal fuels.

High fuel cost is not a matter of concern, as it is transferable under the ICPT framework to end users. As such, we are not worried with the sequential weaker earnings which were largely affected by higher fuel costs as it will be matched in future by ICPT under-recovery at its top- line level. Going by the fuel price trend, coupled with the 2Q18 coal generation mix of 58% against 61% set in RP2, which will lead to TENAGA’s requiring to use more less-cost effective non-coal fuels, total fuel costs are expected to stay high, thus the surcharge which happened in 2H18 is likely to persist at least until end-2019. Meanwhile, the fund available for Kumpulan Wang Industri Elektrik is RM760m currently which we believe should be enough to offset the domestic subsidy in 2019 as the subsidy for 2H18 is c.RM100m.

Maintain OUTPERFORM. We continue to like TENAGA for its earnings quality and cheap valuation despite its heavy index-weighting status. The first surcharge in 2H18 also showed the government’s quest to keep ICPT framework, which removes the concern of TENAGA not being able to pass-through higher fuel cost. We keep our FY18-FY19 estimates unchanged for now. It is our top pick for the sector. An OUTPERFORM at target price of RM17.90, based on +1.0SD of 2-year moving average of 14x PER. Main risk to our OUTPERFORM call is the change of ICPT mechanism, which will change the entire operating cost structure.

Source: Kenanga Research - 03 Sep 2018