The Power Utilities sector is still the selected sector to invest in this uncertain time as the players offer defensive earnings in addition to less expensive valuations. With the new PH government’s commitment to the ICPT mechanism which saw its first surcharge in 2H18, this has cleared concerns of TENAGA not able to pass through higher fuel costs to consumer. This is highly positive. Meanwhile, although PPA guarantees earnings certainty, the slide in earnings following the capacity payment cut after a new PPA Extension will see urgency for IPPs to fill up the earnings gap. In all, we maintain our OVERWEIGHT sector rating with TENAGA as our TOP PICK for its undemanding valuation despite solid earnings quality as well as the heavyweight index-linked status while PESTECH is an alternative small cap play for its earnings growth story.

OVERWEIGHTing the defensive sector. For countless years, power utilities always trade at discount to the overall market, especially heavyweight TENAGA (OP; TP: RM17.90) despite its solid earnings quality. With the first surcharge of 1.35 sen/kWh in 2H18, which showed government’s commitment toward the transparent framework of ICPT, we see little risk of earnings downside of TENAGA, which should be a re-rating catalyst for the integrated utility to at least trade on par with FBMKLCI’s valuation of 16x, if not higher instead of the cheap FY19 12x PER currently. Meanwhile, the acquisition of related-party Alam Flora will continue to be a hangover for MALAKOF (OP; TP: RM1.20) although we believe it is a fair deal while the lack of immediate earnings driver after the capacity payment cut on Paka’s PPA will continue to depress YTLPOWR (MP; TP: RM1.10) before the two greenfield power plants come into system in 3-4 years’ time. On the other hand, the just awarded Gemas-JB Double Track’s electrification job should be positive to PESTECH (OP; TP: RM1.95) which has been quiet in the past two years. In all, TENAGA continues to be our top pick for the sector while PESTECH is our alternative pick for small cap on earnings growth story.

Government’s commitment towards ICPT mechanism is the key. Although earnings prospect appears unexciting under the new Regulatory Period 2 (RP2) with earnings capped by asset return of 7.3%, TENAGA offer earnings stability. This is further cemented with the first surcharge of 1.35 sen/kWh for non-domestic customers in 2H18 as it showed the government’s commitment to the ICPT framework which was once a major concern of the market with TENAGA allowed to raise tariff to cover higher fuel costs. In view of this, the recent rising fuel costs, which caused a weakening in 2Q18 earnings, is not a concern anymore as it can pass through in the next review in December window. As the fund available for Kumpulan Wang Industri Elektrik is at RM760m currently, we believe should be enough to offset the domestic subsidy in 2019 as the subsidy for 2H18 is c.RM100m only. Meanwhile, the impact of its investment in the 30%-owned Turkish company Gama Enerji following the depreciation of Turkish Lira is fairly minimal given its associate stake while the Turkish firm only generated c.RM120m EBITDA in 1Q18. Although its offshore investments are fairly small while consolidated into the group’s earnings, these investments are strategic investment like Vortex Solar and Tenaga Wind Ventures in UK which TENAGA could broaden its technical skills in these areas which could be applied to Malaysia in the future.

Values in IPPs but… The IPPs experienced a roller-coaster ride in their share prices for the past six months, this is especially so for YTLPOWR, which saw a strong rebound from the all-time-low of RM0.75 in end-May to the high of RM1.27 in July, thanks to bargain hunting, before retracing back to current levels of RM1.00-RM1.10. We believe it is trading fairly at the current level given that there is a lack of immediate earnings catalyst after the capacity payment cut on Paka’s PPA Extension before the two offshore greenfield power plants come into system in 3-4 years’ time. Meanwhile, MALAKOF also saw a new low of RM0.825 in end-June before bargain hunting pushed the IPP to the recent high of RM1.05 in early-Aug. However, selling pressure came in after the announcement of Alam Flora’s acquisition in early August. Although it is a related-party transaction, we are fairly positive as it jives well with the group’s long-term aspiration into renewable energy and is a long-awaited earning catalyst. Besides, the acquisition is fairly priced. Nonetheless, we still see value in MALAKOF as the heavy sell-down in the past 20 months has more than priced in foreseeable negatives. On the other hand, we are pleased to see that PESTECH had finally secured the long-awaited Gemas-JB Double Track electrification project, which is worth RM399m, a much-needed catalyst for PESTECH which share price has been lacklustre in the past two years despite a commendable earnings record.

Overall a better 2018. The recent 1QCY18 results season was a disappointment with MALAKOF’s 2Q18 and PESTECH”s 4Q18 missing expectations, which was due to higher taxation for the former while the latter turned loss-making on weaker EPC project margin as well as the adjustment on DPL contribution. Meanwhile, both TENAGA’s 2Q18 and YTLPOWR’s 4Q18 results met expectations. 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 a 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 RM2b order-book coupled with new contract flows to sustain earnings momentum. However, YTLPOWR’s dividend pay-out 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 - 3 Oct 2018