We maintain our OVERWEIGHT recommendation on the utilities sector as it offers defensive earnings which also anchor decent dividend yields for the players. Earnings of power utility TENAGA will be backed by a fixed rate of return of 7.3% on its regulated asset base with a 1.7% annual demand growth embedded in the Regulatory Period 3 (RP3) under the Incentive based Regulation (IBR) framework, while gas utilities PETGAS and GASMSIA are in their final year of Regulatory Period 1 (RP1) and we still expect resilient earnings even in the coming Regulatory Period 2 (RP2) next January. Meanwhile, earnings for independent power producers (IPPs) are supported by power purchase agreements (PPAs). TENAGA is our top pick for the sector.

Power utilities: high fuel cost is sheltered under IBR. Indonesia coal benchmark price rose another 8% QoQ to USD319.94/MT in 3QCY22 from USD295.98/MT and against coal base price of USD79/MT under the RP3 parameter. This also indicates that TENAGA’s (OP; TP: RM10.17) total fuel cost would increase further in 2HFY22 after a 135% YoY hike in 1HFY22. Although the increased fuel cost will eventually pass through to consumer or partly offset by KWIE fund with a 6-month lag, TENAGA may see weaker earnings in 2HFY22 and the lag effect of ICPT adjustment could be delayed into FY23 as well. Meanwhile, TENAGA is allowed to recover the cost of working capital for any costs involved in ICPT-related receivables. So far, it has received a total of RM2.9b cost recovery for July-September from the government. This demonstrates the government’s commitment in upholding the IBR framework and the ICPT mechanism. On demand side, we expect 2022 to recover strongly by 5.8% (against 1.7% guided growth in RP3) after the pandemic-hit demand growth of -5.0% and +1.2% in 2020 and 2021, respectively. For 2023, we have projected a demand growth of 1.8% which is slightly higher than the guided growth of 1.7%.

Gas utilities: high gas price affected non-regulated business. With Petronas’ Malaysia Preference Price (MRP) gas price staying above RM40/mmbtu currently from c.RM30/mmbtu in 1HCY22, GASMSIA (MP; TP: RM3.43) is likely to see good earnings generated from the non-regulated retail margin in 2HFY22 (from low base in 1QFY22) that could offset a slowdown in volume as guided by the company (we believe, on the back of lower production by glove makers that typically contribute a third of its business volume). However, the same cannot be said for PETGAS (MP; TP: RM17.00) as its non-regulated utility unit, which uses gas as fuel to generate and supply power, steam and industries gases to industries, could get hit in the coming 2HFY22 as similar to that in 2QFY22. Having said that, we still expect resilient earnings for the regulated businesses for both PETGAS and GASMSIA while the upcoming RP2 which starts next January could still see earnings growth even if the new rate of returns for regulated asset base (RAB) could be lower (we estimated RP1’s rate of returns of below 8% for PETGAS and 7.3%-7.5% for GASMSIA). The lower rate of return may not impact earnings negatively as the size of RAB is getting bigger over the year. This has also been witnessed in TENAGA earnings as the rate of return fell to 7.3% in RP2 from 7.5% in RP1, its regulated earnings were still higher when it moved to a new RP period.

IPPs earnings to remain resilient. Given the sustained profitability at PowerSeraya, YTLPOWR (OP; TP: RM0.97) should see better earnings stability in 1HFY23 (financial year-end: Jun). Similarly, MALAKOF (OP; TP: RM0.90) ​​​​​​​should also see improved earnings stability in 2HFY22 following the completion of repair works in mid-February 2022 for the forced outage at TBE in 4QFY21. On the other hand, SAMAIDEN (OP; TP: RM0.86) is a poster child of the RE adoption in Malaysia, anchored by continued government-led program where we expect its earnings to grow 17% YoY in FY23 (financial year-end: Jun). However, we are cautious pertaining to the outlook of PESTECH (MP; TP: RM0.35) which is likely to be weighed down by margin compression on soaring input costs and less-than-optimal project execution on top of a depleting orderbook with slower new orders flow.

Resilient earnings; OVERWEIGHT reiterated. We continue to like the sector for its earnings defensiveness backed by regulated assets for power and gas utilities while earnings for IPPs are supported by PPA with assets helping to bridge earnings gap as certain old IPPs assets are expiring. These assets generate recurring cash flows which anchor dividend yield of 4%-7%. TENAGA is our top pick for the sector on the back of: (i) it being an economy reopening play underpinned by the recovery of electricity demand from the commercial and industrial sectors, (ii) its risk premium (largely due to the ballooning under-recovery of fuel costs) easing as energy prices come off their peaks, and (iii) it being a beneficiary of the return of foreign investors given its significant weighting in key indices.

Source: Kenanga Research - 19 Oct 2022