We continue to rate the Utilities Sector an OVERWEIGHT, for the players’ resilient earnings profile thanks to, 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 reckon that TENAGA’s non-regulated segment was affected by COVID-19 but it will improve once the pandemic is over. Even during such times, the stock is still trading attractively at 20% discount to the market with decent dividend yield of 4%. As such, it remains our TOP PICK for our 1QCY21 strategy. Meanwhile, gas-based players have proven their earnings resiliency in the past two quarters during this difficult period. While earnings for local IPPs are fairly stable, new assets will help to address their earnings gap caused by expiring old IPP assets.

Defensive is key quality; OVERWEIGHT maintained. In these uncertain times, the Utilities sector is a good investment avenue given their earnings defensiveness. Despite such quality, valuation remains attractive as the stocks are trading at discount to the overall market. The resilient earnings of TENAGA (OP; TP: RM12.40), PETGAS (MP; TP: RM16.85) and GASMSIA (MP; TP:2.85) are regulated under the IBR framework which sustain their >4% dividend yields while IPPs MALAKOF’ (OP; TP: RM1.15) and YTLPOWR (MP; TP: RM0.67)’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: RM1.15) offers an exciting growth story in Cambodia coupled with promising rail electrification contract flow in the region. For 1QCY21 strategy, TENAGA is one of our TOP PICKs.

TENAGA’s earnings certainty expected to remain high. In its recent quarterly 3QFY20 results, TENAGA continued to post disappointing results with core profit falling 31% YoY to RM903.0m as the COVID-19 impact on non-regulated business persisted. However, the COVID-19 impact on its non-regulated business plus sales discount and contribution was reduced to a smaller quantum of RM425.8m in 3QFY20 from RM703.8m in the preceding quarter. Nonetheless, we see this as an isolated event and business should be back to normal in 2HFY21 as the bulk of its earnings are covered by the Incentive-Based Regulation (IBR) framework. Meanwhile, the EC has approved a rebate of 2.0 sen/kWh, for 1HFY21 given the falling fuel costs over the past six month, while the authority is agreeable to further RP2 until end-2021 with unchanged base tariff average at 39.45/kWh. We remain positive with this mechanism which removes fuel costs risk from TENAGA which are fully pass-through 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 period 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 is trading at an unwarranted CY21 PER of 12.6x as against FBMKLCI of 16.2x. In addition, it also offers decent yield of 4%.

“Business as usual” before and after MCO for gas producers. Despite the pandemic, both PETGAS and GASMSIA reported impressive 3QFY20 results which beat expectations two quarters in a row, thanks to IBR framework which safeguard their earnings. PETGAS’ 3QFY20 core profit of RM512.2m came slightly above forecast on lower opex for its Gas Transportation and Regasification segments while GASMSIA’s core profit of RM147.9m beat expectations on higher-than-expected sales volume which has already rebounded back to pre-MCO level. Meanwhile, the EC had issued a directive for average natural gas selling price to be determined every quarter over 2021 with first selling price to be announced in early January 2021. While this will not affect GASMSIA’s margin spread of RM1.80/mmbtu-RM2.00/mmbtu, the new quarterly selling price review will affect only its retail margin which is based on c.1% of selling price. We reckon that the impact on retail margin is unlikely to be impactful given the small margin of 1%. Furthermore, our assumption of total margin spread of RM2.10/mmbtu, which consists of the usual margin spread and retail margin, is fairly conservative. Going forth, we see little earnings risk for both stocks for the next three years on RP1 base tariffs but we believe most if not all near-term catalysts are already priced in for both stocks.

IPPs’ outlook to improve. While earnings for existing IPPs are fairly stable as the drop in energy dispatch during MCO was covered under PPA, MALAKOF’s 3QFY20 results came slightly below expectation owing to a one-off outage maintenance costs estimated at >RM22m for TBE while YTLPOWR’s 1QFY21 results matched expectations with a surprise profit from PowerSeraya, due to a low fuel price environment which is not sustainable. We are not too concerned over MALAKOF’s disappointing 3QFY20 results, as with KEV losses eliminated since 1QFY20 its earnings volatility is fairly low taking it back to concession-type stable earnings mode. With the expected losses from PowerSeraya and Mobile unit, and weaker earnings from Wessex Water on new rate coupled with the local IPP’s Extension PPA contract expiring June this year, YTLPOWR’s near-term earnings are set to be lacklustre until earnings of its new assets - greenfield power plant in Jordan and the acquisition of Tuaspring of Singapore, kick in. Meanwhile, despite a seasonally weak quarter, PESTECH reported 1QFY21 core profit which rose 5% QoQ to RM17.4m which met expectations, owing to higher construction profit from BT concession asset. Going forth, the delayed claim in 2HFY20 will be pushed forward to FY21 and together with BT construction profit, this should lead earnings higher.

Source: Kenanga Research - 5 Jan 2021