We still see the Power Utilities sector as a good defensive sector under these uncertain times, especially when valuations have become less expensive following the recent sell-down. The 2nd ICPT surcharge in 1H19 which reaffirmed government’s commitment to the ICPT mechanism offers earnings certainty to TENAGA, which is a positive for sentiment. Meanwhile, although PPA guarantees earnings certainty, the slide in earnings following the capacity payment cut on 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 its heavyweight index-linked status.

Government’s commitment on ICPT mechanism is key. The continued ICPT surcharge of 2.15 sen/kWh in 1H19 is not unexpected given the rising coal prices. The applicable coal prices in 3Q18 and 4Q18 were RM359.87/mt and RM428.42/mt, respectively, which were much higher than the benchmark coal price of RM315.9/mt for new Regulatory Period 2 (RP2) in 2018-2020. Thus, the additional generation cost in 2H 2018 was RM1.82b. The RM2.15 sen/kWh surcharge reaffirmed the government’s commitment towards the fuel cost pass-through mechanism, which is positive to sentiment. However, we are more interested to see the situation after the Kumpulan Wang Industri Elektrik (KWIE) fund is fully utilised. Earlier in July, it was announced by the Energy Ministry that the fund available for KWIE was RM760m. Should fuel costs remain high at the current level, the KWIE is likely to be exhausted by 1H 2020. In any case, we still believe any extra fuel costs will be transferred to all customers under the principle or spirit of ICPT mechanism.

Value 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 (MP; TP: RM1.05), which saw a strong rebound from the all-time-low of RM0.75 in end-May to a high of RM1.27 in July, thanks to bargain hunting. It now trades around its 6-month low at RM0.80-level. We believe it is trading fairly at the current level given the 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 (OP; TP: RM1.00) 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-Aug18. However, selling pressure came in after the announcement of Alam Flora’s acquisition in early-Aug18 and the stock is now trading at 6- month low of around RM0.80-level. Although it is a related-party transaction, we are fairly positive as it jives well with the group’s long-term aspiration in 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 (OP; TP: RM1.45) finally securing the long-awaited Gemas-JB Double Track electrification project, which is worth a total of RM474m for two packages; a much-needed catalyst for PESTECH which share price has been lacklustre in the past two years despite a commendable earnings record.

A better 2019? The recent 3QCY18 results season was another disappointment with TENAGA’s (OP; TP: RM16.45) 3Q18, YTLPOWR’s 1Q19 and MALAKOF’s 3Q18 missing expectations. TENAGA’s 3Q18 results missed forecast on higher fuel costs as well as rising finance costs on new Sukuk issuance. YTLPOWR’s 1Q19 earnings fell short of expectations led by PowerSeraya’s losses for the first time while narrowing losses at YES was the only positive. MALAKOFF’s 3Q18 results were hit by another boiler-related issue in TBE, which may lead to operational uncertainties. Meanwhile, PESTECH had a slow start in FY19 in the seasonally weak 1Q19 due to lower work claim progress. Going forth, TENAGA should see better earnings in 1H19 as the higher fuel costs in 2H18 will be adjusted by the abovementioned surcharge in 1H19 while YTLPOWER expects a fullyear contribution in FY19 from Paka Power Plant, which recommenced in September 2017 after it resolved a dispute with TENAGA pertaining to a land issue. 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. 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.

Go for the defensive sector; OVERWEIGHT maintained. Power utilities have always trade at discount to the overall market, especially heavyweight TENAGA despite its defensive earnings quality. TENAGA came under pressure in the past one month following the Energy Minster’s comment on disrupting the power industry by opening up the industry to new players. We believe the sell-down is excessive as TENAGA should be able to stand up to the competition based on its efficiency record. Thus, TENAGA remains as our Top Pick for the sector. Meanwhile, the acquisition of related-party Alam Flora will continue to be an overhang for MALAKOF 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 before the two greenfield power plants come into the system in 3-4 years’ time. On the other hand, we reduced PESTECH’s target price to RM1.45 from RM1.95 previously as we lowered the valuation of EPCC earnings to 11x (-1SD 3-year mean) from 15x (3-year mean) following weak sentiment towards the stock on a weak set of 1Q19 results. However, we are comfortable with the results as the profit margin and minority interest had reverted to normalised levels. The stock remains an OUTPERFORM.

Source: Kenanga Research - 3 Jan 2019