With a regulated asset base to fully reflect the book value by 2025, we have turned negative on PETGAS’ earnings prospect as a 7.5% asset return will lead to a severe 60% cut in base-tariff for PGU by 2026. Therefore, a gradual decline in earnings is expected over the next six years. We believe the recent sell-down has priced in the tariff cut risk and cut rating to MP with a lower TP of RM16.45/SoP share.

Base-tariff to fully reflect historical cost on asset base returns by 2025. We turned negative on the earnings prospects of PETGAS following our recent meeting with the management. Furthermore, the EC guidelines revealed that the regulated asset base (RAB) will be fully based on historical cost or net book value, (NBV) by 2025. To recap, the recently announced IBR framework which set the base-tariff at RM1.072/GJ for the Peninsular Gas Utilisation (PGU) in the Pilot Period of 2019 was based on optimised replacement cost. (ORC, or depreciated replacement cost). For Regulatory Period 1 (RP1) in 2020- 2022 and Regulatory Period 2 (RP2) in 2023-2025, the valuation for RAB which is based on ORC currently will be reduced by 20% each year and to be replaced by NBV. Thus, by 2025 the RAB will be fully based on historical costs.

Impact from NBV base’s calculation is more severe. We had always thought that the Third Party Access (TPA) would have neutral earnings impact to PETGAS looking at TENAGA (OP; TP: RM16.45) and GASMSIA (MP; TP: RM3.05) under their respective Incentive Base Regulation (IBR) frameworks in which the net impacts are fairly neutral to slight positive. However, PETGAS had used and proposed ORC to value its RAB in contrast to NBV for TENAGA and GASMSIA, thus PETGAS had posted superior ROA of above 10% in the past as compared to 5-6% for TENAGA and 8-9% for GASMSIA. Therefore, a shift of valuation method to NBV will definitely severely impact its RAB as the pipelines are mostly 20-30 years old assets with low carried values.

We expect 60% cut in tariff by 2026. Given the assets returns of 7.3%/7.5% for TENAGA’s/GASMSIA’s RAB, we believe that the return rate for PETGAS is unlikely to be lower than 7.5%. Due to the dearth of details of PETGAS’ RAB, we decided to use the group’s ROA as its targeted earnings over assets, and tagged a targeted ROA to reduce to 8% by 2026 from c.11% in 2018. This reduces base-tariff for PGU by 60% to RM0.502/GJ in 2026, from RM1.248/GJ in 2018, when the RAB is fully based on NBV. Assuming other assumptions such as Gas Processing, Utilities and tariffs for RGT remaining unchanged, FY26 earnings will fall by 21% from FY18E. Likewise, its net yield will also drop to 3.1% by then from 3.9% currently. Meanwhile, while keeping FY18 estimates unchanged, we trimmed FY19 forecast further by another 3% mainly on adjustment for PGU.

Recent sell-down priced in tariff cut risk; Cut to MP. As the RAB will be valued based solely on NBV by 2025, earnings will be impacted by two step-downs, in RP1 and RP2, before stabilising from 2026 onwards. We take the view that its ROA will eventually taper to 8% by 2026; this reduces our target price to RM16.45/SoP share from RM22.65/SoP share as ROA was estimated at 11.7%. With its share price falling 8% YTD since the TPA announcement, we believe the base-tariff cut risk could have been priced in. As such, we rate the stock as MARKET PERFORM from OUTPERFORM previously. Risk to our downgrading is RAB’s return is better than expected.

Source: Kenanga Research - 25 Jan 2019