We remain NEUTRAL on the Utilities Sector given limited growth prospects as earnings are capped by regulations with lower rates of return for regulated assets impacting TENAGA, PETGAS and to a certain extent GASMSIA while IPPs are hard-pressed to seek for new earnings streams to bridge the gap caused by certain concession assets expiring soon. Nonetheless, the expected earnings decline at PETGAS is not as bad as expected while for IPPs - MALAKOF has several corporate exercises that improve earnings prospect and YTLPOWR is expected to see a new offshore power plant starting operations in mid-2020. All these should help to alleviate the earnings gap concern. In all, we are neutral on the sector with PESTECH touted as an alternative small-cap play as well as TOP PICK for this quarter.

ICPT surcharge set to be reduced in 1HCY20 by 0.55 sen/kWh to 2.00 sen/kWh given the fall in fuel prices, on top of base tariff of 39.45 sen/kWh. This effectively reduces tariff rate by 1.3% but this is earnings-neutral as the savings will be passed through to consumer albeit with a 6-month lag. Should fuel prices continue to trend lower, we may see a lower base tariff in the upcoming Regulatory Period 3 (RP3) over 2021-2023. On the other hand, TENAGA (OP; TP: RM14.30) faced a heavy sell-down after it was slapped with RM3.98b additional tax assessment by the IRB for 2015-2017, which aggravated its already weak share price trend. 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 related 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 the second dispute could take an even longer time to resolve.

RP1 for PETGAS and GASMSIA to start in 2020. To everyone’s surprise, PETGAS (MP; TP: RM15.75) saw a 5.3% hike in PGU base tariff of RM1.129/GJ over 2020-2022 for Regulatory Period 1 (RP1) as opposed to market expectation of a severe cut given the change of Regulated Asset Base (RAB) valuation method coupled with lower RAB return rate. However, we have learnt that the new base tariff rate which has already included costs of Internal Gas Consumption (IGC) is part of its operating costs. Therefore, the Gas Transportation segment effectively will see lower gross profit by 8-10% albeit higher revenue. On the flipside, RGT unit will see better gross profit by 3-5% post tariff rate adjustment in RP1. Overall, the drop in earnings from the new tariff structure is better than market expectation. The RAB’s rate of return is set at the higher range of 7% which is better than TENAGA and GASMSIA (OP; TP: RM3.00). Meanwhile, GASMSIA will see its revenue stream bifurcating into shipper and distribution system under RP1 regime, where distribution system’s tolling fee of RM1.573/GJ base tariff plus surcharge of RM0.520/GJ will form part of cost structure in shipper which is incorporated into the average gas selling price of RM33.65/mmbtu. Nonetheless, margin spread is expected to maintain at current RM1.80-2.00/mmbtu. We also learnt that the RAB’s rate of return is between 7.3% and 7.5% which is slightly lower than 7.5% currently. As such, the earnings impact from the change is immaterial.

IPPs are open to fuel cost risk in the future. With IPP having options to procure their own fuels under Malaysia Electricity Supply Industry 2.0 (MESI 2.0), there is no more risk-free PPA. However, this is an incentive for IPPs to optimise cost as any savings will flow down to bottom-line. Nonetheless, this has little impact on YTLPOWR (MP; TP: RM0.70) as the PPA Extension contract for the 585MW Paka Power Plant will be expiring on 30 Jun 2021 which will have only six months effect when this new measure take place in early 2021. However, this will impact MALAKOF (OP; TP: RM1.00) more as the two major IPPs namely TBP and TBE still have another 10-20 years concession period. Having said that, in theory, IPPs could benefit as long as they are able to secure cheap fuel costs but practically, such purchase requires bulk purchase with sizeable quantity which may proof difficult. Therefore, in our opinion, this new measure does offer margin accretion if managed efficiently but also acts as a doubleedged sword if it is badly managed. In any case, we believe at this point of time, both listed IPPs should put their focus on new assets to fill up their earnings gap given their 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 previous unplanned outages problem at its plant. So far, MALAKOF had completed acquisition of Alam Flora, disposal of Macarthur and won two small Hydro plants in Dec 2019 while YTLPOWR should see its 45%-owned 554MW Jordanian Attarat Power Plant starting operation by middle of this year

Outlook still lacklustre; Maintain NEUTRAL. There is lack of factors to be upbeat about the sector given limited upside for the industry players. Although we have recently upgraded TENAGA to OUTPEFORM which was due mainly on price weakness due to news of a tax dispute, we see little earnings growth for the integrated utility. Meanwhile, another heavyweight PETGAS is also expected to see declining earnings in RP1 while GASMSIA is likely to see neutral impact from the implementation of RP1. On the other hand, although valuations look attractive for IPPs, a meaningful earnings recovery is vital to put them back in investor’s radar. Nonetheless, we expect PESTECH (OP; TP: RM1.75) to post 26%/14% earnings growth for FY20/FY21 which is backed by RM1.7b order-book. We continue to like this niche utility infrastructure play which could potentially benefit from the revival of mega projects domestically and the fast growing energy infrastructure development market in Cambodia. In all, we maintain our NEUTRAL stand on the Utilities Sector but PESTECH is still our alternative small-cap play and one of the TOP PICKs for 1QCY20.

Source: Kenanga Research - 3 Jan 2020