ICPT surcharge is set to be reduced in 1HCY20 given the fall in fuel prices but this is earnings-neutral as the savings will be passed through to consumer with a 6-month lag. A RM4b tax dispute last week resulted in a sell-down which aggravated its already weak share price trend. This could be a good buying opportunity as the market has overreacted to the tax issue which is a non-operational issue, in our view. Besides, TENAGA may also win the case. Thus, we upgrade the stock to OP with unchanged TP of RM14.30.

ICPT surcharge to reduce in 1HCY20. Yesterday, in the Minister’s Question Time at the Parliament, the Energy Minister said that while domestic customers are not affected by imbalance cost pass-through (ICPT) surcharge which will be funded by Kumpulan Wang Industri Elekrik (KWIE) amounting to RM62.95m, the non-domestic customers would enjoy a surcharge reduction of 0.55 sen/kWh to 2.00 sen/kWh in 1HCY20 from 2.55 sen/kWh in 2HCY19. This ICPT surcharge is on top of base tariff of 39.45 sen/kWh. So far, the Energy Commission and TENAGA have not made announcement for the new tariff structure yet.

Effective tariff rate to be reduced by 1.3%. The reduction in ICPT surcharge is not unexpected as given the declining trend of fuel costs. In 3QFY19, average coal cost for TENAGA fell to RM301.90/mt against RM356.80/mt in 1HFY19 while average LNG cost also dropped to RM32.75/mmbtu as opposed to RM36.16/mmbtu in 1HFY19. In fact, both fuel prices have fallen below the reference prices of RM315.90/mt for coal and RM35.00/mmbtu for LNG to use for the formulation of base tariff of 39.45 sen/kWh for Regulatory Period (RP) 2 between 2018 and 2020. Should fuel prices continue to trend lower, we may see a lower base tariff in RP3 over 2020-2022.

Share price hit by tax dispute. Last Friday, TENAGA faced a heavy sell-down after it was slapped with RM3.98b additional tax assessment by the IRB for 2015-2017. This is the second additional tax assessment after the still unsettled RM2.1b claim which was announced back in Nov 2015. The tax dispute was mainly relating to reinvestment allowance up to 2018. As such, TENAGA may face another dispute claim for 2018 that could amount to another RM1b. However, in our opinion, the sell-down is overdone as this is an isolated event which is not an operational issue. Furthermore, after a good four years, the first dispute is still not settled and TENAGA may also not lose the case while this second dispute could take an even longer time to resolve.

Sell-down overdone; upgrade to OUTPERFORM. We believe the sell-down over the tax dispute is overdone given that it is not an operational issue. At worst, the total dispute claims of up to RM6b could wipe out an entire financial year’s earnings but TENAGA may not lose the case. Meanwhile, under the Incentive Based Regulation (IBR) framework with fuel cost past through via ICPT, TENAGA’s earnings are expected to be stable with a regulated return of 7.3%. This also offers dividend certainty of c.4% based on 50% payout. As such, the recent sell-down provide further buying opportunity into this heavyweight index-linked stock. Thus, we upgrade the stock to OUTPERFORM from MARKET PERFORM with an unchanged target price of RM14.30 which is based on 3-year moving average of 14x FY20 PER. Risks to our new recommendation are: (i) sharp decline in regulated return rates under new RP3, from 7.3% currently, as well as (ii) a sudden surge in fuel prices resulting in short-term earnings weakness.

Source: Kenanga Research - 4 Dec 2019