3Q18 results were a big let-down, hit by rising fuel costs and interest cost. However, we believe this is merely a temporary hiccup as the higher fuel costs will eventually be passed on to end-users in the next tariff review for 1H19. Overall, demand growth is still healthy at 2.7% in 9M18. Despite earnings cut, the stock still trade at attractive CY19 PER of 12.5x. We maintain OUTPERFORM with a revised target price of RM16.45.

9M18 below expectations. 3Q18 results missed expectations with core earnings declining 43% QoQ to RM879.3m, bringing YTD 9M18 core profit to RM4.13b which only made up 61%/58% of house/street’s FY18 estimates. This was largely due to higher-than-expected (i) fuel costs on rising fuel prices and (ii) finance costs on the RM3b Sukuk issuance raised in end-Aug. The 3Q18 core earnings were adjusted for: (i) RM79.9m reinvestment allowance, (ii) RM166.7m forex translation loss, and (iii) RM291.5m impairment for its 30%-owned Turkish associate Gama on forex losses following the significant depreciation of Turkish Lira (TRY). No dividend was declared in 3Q18 as it pays a semi-annual dividend. Given the change of financial year- end to December from August, there is no YoY comparison.

Fuel cost hit bottom-line. Although revenue rose 5% solely led by LPL, 3Q18 core profit contracted 43% to RM879.3m, the lowest profit in more than three years, due to the abovementioned higher total fuel costs by 15% and interest cost by 13% as well as higher other opex on staff costs by 24% and repair & maintenance by 22%. The surge in fuel costs was largely owing to rising coal price, which jumped 13% to USD102.5/mt from USD91.1/mt while the weakening of MYR against USD resulted in coal price in MYR term hiked by 17%. In addition, higher consumption of gas/LNG by 10% to 1,016mmscfd drove total LNG cost tripling to RM60.7m while gas cost rose 10% on the scheduled half-yearly price hike.

Higher ICPT under-recovery in 3Q18. TENAGA continued to incur higher fuel costs as fuel prices were higher than the reference prices set in RP2. Thus, the ICPT under-recovery increased to RM479.6m in 3Q18 from RM245.2m in 2Q18. During the period, as mentioned above, average coal price was 17% higher to RM422.6/mt against RM361.4/mt in 2Q18 and 34% higher than reference price of RM315.9/mt. With coal price still staying elevated currently, we are likely to see tariff surcharge in the next Review Window in Dec for 1H19.

However, 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, 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. Post-3Q18 results, we cut FY18-FY19 estimates by 16%-8% to account for higher (i) fuel costs in 2H18 and fine-tune assumption in FY19, and (ii) finance costs in FY18-FY19 for the new Sukuk issuance. With an unchanged targeted CY19 PER of 14x based on +1.0SD of the 2-year mean, our new target price is reduced to RM16.45 from RM17.90 previously. However, rating remains unchanged as OUTPERFORM for its undemanding valuation and earning profile. Main risk to our OUTPERFORM call is the change of ICPT mechanism, which will change the entire operating cost structure.

Source: Kenanga Research - 28 Nov 2018