We had been bullish on the sector given the resilient earnings, but this has come to an end following lower earnings return under the new phases of regulated periods for TENAGA and PETGAS while GASMSIA may see lower asset return for new RP2 period next year. Meanwhile, the two IPPs are still waiting for new earnings stream to fill up income gap, which may not happen in the near term. Going forward, government’s commitment towards ICPT mechanism is key factor. However, the continuation of surcharge after the KWIE fund will be fully utilised, likely in 2020, a key critical factor. As such, we are downgrading the Utilities Sector to NEUTRAL from OVERWEIGHT. However, PESTECH is still an alternative small cap play.

Powering down forward, cut to NEUTRAL. We had been bullish on the sector given the resilient earnings, but this has come to an end following lower earnings return under the new phrases of Regulatory Periods (RP) for TENAGA (MP; TP: RM13.30) and PETGAS (MP; TP: RM16.45). The new RP led to RM600-700m lower earnings for TENAGA in RP2 while PETGAS, which is currently in a trial period, will see two earnings step-downs in RP1 and RP2 as base-tariff will be cut severely by 60% by 2026. Meanwhile, GASMSIA (MP; TP: RM3.05) which is in its final year of RP1 may see lower asset return in RP2 for 2020-2022 as TENAGA experienced a lower return of 7.3% in RP2 from 7.5% in RP1. On the other hand, IPPs MALAKOF (OP; TP: RM1.00) and YTLPOWR (MP; TP: RM0.90) are still waiting for new earnings stream to fill up gaps as certain IPP concessions are running towards expiries. In addition, YTLPOWR is facing challenging business environment for PowerSeraya which affects profitability. On the flipside, PESTECH (OP; TP: RM1.40) is expecting a strong 2H19 results on seasonality. As such, we are downgrading the Utility Sector to NEUTRAL from OVERWEIGHT previously.

A lower earnings base for TENAGA. In the recent results season, TENAGA reported sub-par FY18 core earnings of RM5.42b which came 14% below market consensus and fell short of our forecast by 4% largely due to a lower regulated asset base return of 7.3% in RP2 for 2018-2020 from 7.5% previously in RP1. The regulated asset base was c.RM50b in 2018 thus generating a fixed return of RM3.7b in FY18 leaving the balance of c.RM1.7b for earnings derived from non-regulated assets as well as offshore assets. As such, the earnings base for the remaining years in RP2 in 2019 and 2020 will yield similar profits reported in FY18, which was RM600-700m lower as opposed to FY17. Besides, its ability to pass through higher fuel costs is a key test when the fund available in Kumpulan Wang Industri Elektrik (KWIE) to offset these higher costs is exhausted. Based on the fund available of RM760m for KWIE in July 2018, the fund is likely to be exhausted by 1H20 should fuel costs remain high at the current level. On the other hand, we believe the concern pertaining to industry-wide reform is overplayed. TENAGA should be able to face the challenges given its entrenched position with existing extensive infrastructures that should give it a costadvantage over the new comers. In addition, with its efficiency record, TENAGA should be able to stand up to the competition.

PETGAS to face base-tariff rate decline; lower margin spread for GASMSIA in RP2? Although the Pilot Period of 2019 will see less severe impact to PETGAS, its earnings will be impacted by two step-downs, in RP1 in 2020-2022 and RP2 in 2023- 2025, before stabilising from 2026 onwards. We take the view that its ROA will eventually taper to 8% by 2026 from >10% currently. Thus, we expect base-tariff for PGU to reduce sharply by 60% to RM0.502/GJ in 2026 from RM1.248/GJ in 2018 and earnings are set to decline by 21% over these periods. To recap, PETGAS had used optimised replacement cost in the past in contract to NBV for TENAGA and GASMSIA, thus PETGAS posted superior ROA of above 10% as compared to 5%-6% for TENAGA and 8%-9% for GASMSIA. As such, the shift of valuation method of NBV will result in severe impacts as mentioned above. On the other hand, GASMSIA is in its final year of RP1 before the RP2 is introduced next year. Although a gas selling price is trending upward with the subsidy removal every half-yearly, GASMSIA’s earnings certainty is embedded under the Gas Cost Pass Through (GCPT) framework as its margin spread is capped at RM1.80-2.00/mmbtu based on regulated asset base return of 7.5%. However, judging from TENAGA’s case, GASMSIA may see lower return of 7.3% in RP2 from 7.5%, which was exactly the case for TENAGA. This could reduce the margin spread to c.RM1.50-1.70/mmbtu and bring down our FY19/FY20 estimates by 5% each and DCF valuation by RM0.20/share.

IPPs face declining earnings. Share prices of IPPs, namely YTLPOWR and MALAKOF have been depressed in the past 2-3 years given the declining earnings trend on the back of capacity payment cuts arising from PPA Extension as well as difficult business condition for YTLPOWR’s PowerSeraya and MALAKOF’s faulty power plants. Not forgetting the PPA Extension for MALAKOF’s PD Power had already expired in February while the 2-year 10 months PPA Extension for YTLPOWR’s Paka Power Plant will be expiring in mid-2021; all these will erode both IPPs’ earnings further. As such, both IPPs are in urgency to fill up the near-term earnings gap. So far, YTLPOWR is expected to only see its two offshore greenfield power plants come into the system in 3-4 years’ time while the MALAKOF’s Alam Flora’s acquisition is only set to be completed by 3Q19. As such, nearterm earnings prospects for these two IPPs are lacklustre. Meanwhile, PESTECH had a weak set of 1H19 results but a stronger 2H19 is expected to make up the shortfall. However, PESTECH should see earnings growth post 1H19 on the back of its RM2b order-book coupled with new contract flows to sustain earnings momentum.

Source: Kenanga Research - 3 Apr 2019