We see the Utilities Sector as a good defensive sector under these uncertain times, especially as valuations have become undemanding following the recent price weakness after the market meltdown in mid-Mar. Earnings for the industry players are resilient, thanks to their regulated asset returns for TENAGA and gas-based players, and PPA-bound income for the IPPs. This also ensures sustainable dividends to be paid by the players which are above average yields of 4%-7%. As such, the pandemicinduced economic slowdown will have little impact on the industry. We are upgrading the sector to OVERWEIGHT from NEUTRAL as utilities stocks have become attractive following the sell-down. We also pick TENAGA and MALAKOF as our TOP PICKs for our 3QCY20 strategy given the undemanding valuation with earnings defensiveness for the former and great value in the latter on better earnings profile on eliminated earnings risk in KEV and added new assets. However, we cut PETGAS to MP as it has priced-in the positives on recent strong price performance.

Go for defensive; upgrade to OVERWEIGHT. In these uncertain times especially when valuations have become less expensive following the recent price weakness, the Utilities sector is a good investment avenue given earnings defensiveness coupled with above average yield of 4%-7%. The resilient earnings of TENAGA (OP; TP: RM13.95), PETGAS (MP; TP: RM17.20) and GASMSIA (MP; TP: RM2.80) are regulated under the Incentive-Based Regulation (IBR) framework which make their 4% dividend yield sustainable while IPPs MALAKOF (OP; TP: RM1.02) and YTLPOWR (MP; TP: RM0.65)’s earnings are backed by PPA and new assets helping to bridge earnings gap as certain old IPP assets are expiring. These IPPs also offer attractive yield of >6%. Meanwhile, niche utility infrastructure play PESTECH (OP; TP: RM1.05) offers an exciting growth story in Cambodia coupled with promising rail electrification contract flow in the region. For 3QCY20 strategy, TENAGA and MALAKOF are our TOP PICKs.

TENAGA’s earnings stability is covered by ICPT. In 2HCY20, there is no ICPT adjustment from a 2 sen/kWh ICPT surcharge in 1HCY20 to the base-tariff of 39.45 sen/kWh given the decline in fuel costs in the last review period. This is also the first time without ICPT adjustment, be it surcharge or rebate, since 2014. TENAGA has requested for 2021 to be a “gap year” after the completion of Regulatory Period (RP) 2 this year as the current ongoing COVID-19 has distorted demand growth. Should the government is agreeable with the gap year proposal, RP3 will start only from 2022 while the asset return of 7.3% for RP2 will remain for another year in 2021. We remain positive with this mechanism which removes fuel cost risk from TENAGA and fully pass through it to enduser while revenue and price cap are a check and balance for demand and average selling price risk. Therefore, the fall in demand during MCO will be adjusted by revenue cap to be earnings neutral to TENAGA. However, even with such mechanism in place which ensures earnings certainty together with its heavyweight index-lined status, TENAGA trades at unwarranted CY21 PER of 12.8x as against FBMKLCI of 16.2x. In addition, it also offers decent yield of 4%. On the other hand, there are two stimulus packages that involved TENAGA, namely its contributions to Prihatin Rakyat Stimlus Package in Mar and Bantuan Prihatin Elektrik Tambahan in Jun for RM150m and RM100m, respectively. As tax deductibles, the earnings impact to TENAGA is immaterial at 3.6% of our FY20 estimates.

IBR to safeguard PETGAS and GASMSIA’s earnings. While business volume has little impact from COVID19-led slowdown as PETGAS is an essential needs provider, the regulated tariff rate which is based on asset returns at the higher range of 7% in RP1 ensures earnings certainty over 2020-2022. Its asset return is better than TENAGA’s RP1 of 7.5% and GASMSIA’s RP1 of 7.3%- 7.5%. On the other hand, the impact from the MCO-led lockdown is less severe than expected on GASMSIA with volume in JanApr declining by single-digit YoY but was seen picking up in May onwards as businesses are gradually re-starting. In fact, sector of the hour and its biggest off-takers, glove makers posted a strong c.9% off-take growth in 1QFY20. With gloves highly in demand in this pandemic period coupled with other sectors already reopened, this should mitigate the demand decline during the then MCO period. With asset return set at 7.3%-7.5% levels ensuring margin spread of RM1.80/mmbtu-RM2.00/mmbtu, GASMSIA’s earnings growth is sustainable on the back of volume growth. In all, we downgrade PETGAS to MP from OP with unchanged target price of RM17.20/SoP share given it is fairly valued after a strong share price performance post-1QFY20 results while GASMSIA is also fully priced-in at target price of RM2.80.

PPAs to keep IPPs in check as earnings for existing IPPs are fairly stable as the drop in energy dispatch during MCO was covered under PPAs. With value already written down to zero for KEV, MALAKOFF expects lower earnings volatility while newly acquired Alam Flora and increased stake in Saudi asset will boost earnings growth. In 1QFY20, these two assets added RM25mRM30m profit to the group. On the other hand, YTLPOWR still faces challenges in YES and PowerSeraya where the telco business is getting competitive with price wars while the power business in Singapore remains competitive and challenging. Not helping is the new 554MW oil shale-fired Attarat Power Plant in Jordan is delayed from the scheduled COD in June on lockdown. Going forward, we believe the main concern for IPPs are old issues such as unplanned outages. While YTLPOWR is fully valued, we see great value in MALAKOF given the change in its earnings profile following the abovementioned status of KEV, Alam Flora and Saudi asset. On the other hand, the flattish sequential PESTECH’s 3QFY20 results were disappointing as the lockdown-led slow billing claims dragged a normally seasonal strong quarter. Thus, earnings recognition is likely to be pushed forward to FY21 while profit margin should normalise as higher opex during the period was an isolated event

Source: Kenanga Research - 8 Jul 2020