We still see the Utilities Sector as a good defensive sector under these uncertain times, valuationswise, especially TENAGA which is decently priced with attractive dividend yields. 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 from the players, at above average yields of 4-7%. We believe TENAGA’s disappointing 2QFY20 results is isolated as its non-regulated business was hit by COVID-19 while gas-based players as well as local IPPs have proven their earnings resiliency during the lockdown period. As such, we continue to rate the sector an OVERWEIGHT with TENAGA as our TOP PICK for our 4QCY20 strategy given its undemanding valuations and defensive earnings.

TENAGA’s weak earnings in 2QFY20 an isolated event. In its recent quarterly results, TENAGA (OP; TP: RM13.95) reported a disappointing 2QFY20 with core profit tumbling 50% QoQ to RM620.9m. This was due to the unprecedented COVID-19 which affected its non-regulated business by RM574m, lower contribution from generation business of RM129.8m and sales discount and contribution for various government-led COVID-19 relief initiatives of RM148.0m. However, we see this as an isolated event and business should be back to normal next year as the bulk of its earnings are covered by the Incentive-Based Regulation (IBR) framework. Meanwhile, the EC is agreeable to Regulatory Period (RP) 3 starting in 2022 with 2021 being an interim year to filter the abnormal COVID-19-hit demand in 2020. We remain positive with this mechanism which removes fuel costs risk from TENAGA and fully pass through it to end-user 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 an unwarranted CY21 PER of 11.6x as against FBMKLCI of 16.8x. In addition, it also offers decent yield of 4%.

Gas producers’ resilient earnings proven during the MCO quarter, with both PETGAS (MP; TP: RM16.85) and GASMSIA (MP; TP: RM2.85) reporting impressive 2QFY20 results which beat expectations. While core business remained resilient, the upbeat results were attributable to better-than-expected associate income and a lower-than-expected MI for PETGAS while GASMSIA’s earnings were helped by higher margin spread owing to a new retail margin. We previously were of the view that it was unlikely to get a separate retail margin without compromising the existing RM1.80/mmbtu-RM2.00/mmbtu margin spread. The retail margin is c.1% of gas selling price. As such, we raised GASMSIA’s FY20-FY21 estimates by 9% each on higher margin spread assumption of RM2.10/mmbtu from RM2.00/mmbtu as we now assume the normal margin spread to come at the lower range of RM1.80/mmbtu-RM2.00/mmbtu plus the RM0.30/mmbtu retail margin. On the other hand, PETGAS declared a surprise special dividend of 50.0 sen in 2QFY20. Going forth, we see little earnings risk for both stocks for the next three years on RP1 base tariffs, which were proven in the recent MCO-hit 2QFY20 as the IBR framework safeguard their earnings. Having said that, we believe most if not all near-term catalysts are already priced in for both stocks. Nonetheless, for income seekers, these two stocks are good investment avenues for their decent yields of >4% backed by resilient earnings.

PPAs to keep local IPPs in check but… While earnings for existing IPPs are fairly stable as the drop in energy dispatch during MCO was covered under PPAs, MALAKOF’s (OP; TP: RM1.15) 2QFY20 results beat expectation on higher-than-expected associate incomes with lower taxation but YTLPOWR’s (MP; TP: RM0.64) 4QFY20 results fell short of expectations turning lossmaking given a higher deferred taxation of RM162.4m for Wessex Water albeit operationally the results were fairly in line. With KEV losses eliminated since 1QFY20, MALAKOF’s earnings volatility is fairly low taking it back to concession-type stable earnings mode while the newly acquired Alam Flora and 12% additional stake in Shuaibah bridged up the earnings gap issue. As such, we believe market is still under-appreciating this fact. On the other hand, near-term earnings outlook for YTLPOWR is still weak until its new assets kick in but the scheduled COD in Jun 2020 for greenfield 45%-owned 554MW oil shale-fired Attarat Power Plant in Jordan is already delayed owing to lockdown, further weighed by lower new rate for Wessex Water and Paka Power Plant expiring next Jun. With the lacklustre earnings outlook, YTLPOWR appears fairly priced. Meanwhile, PESTECH (OP; TP: RM1.15) reported yet another disappointing set of results in 4QFY20 given the lockdown-led delayed billing claims which dragged a normally seasonal strong quarter. Nonetheless, earnings recognition is likely to be pushed forward to FY21 while the start of recognising BT construction profit should lead earnings higher. Nonetheless, we still like the stock as a niche utility infrastructure play.

Go for defensive sector; OVERWEIGHT maintained. In these uncertain times, the Utilities sector is a good investment avenue given their earnings defensiveness. Despite its defensive earnings quality, valuation remains attractive which always trade at discount to the overall market. The resilient earnings of TENAGA, PETGAS and GASMSIA are regulated under the IBR framework which sustain their >4% dividend yields while IPPs MALAKOF’s and YTLPOWR’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 offers an exciting growth story in Cambodia coupled with promising rail electrification contract flow in the region. For 4QCY20 strategy, TENAGA is our TOP PICK.

Source: Kenanga Research - 5 Oct 2020