Kenanga Research & Investment

Utilities - Earnings Resilience Backed by Regulated Assets

Publish date: Wed, 07 Dec 2022, 09:18 AM

We maintain OVERWEIGHT on the utilities sector in 2023 given the earnings defensiveness of regulated assets that will anchor decent dividends for yield seekers. The earnings of national power utility company TENAGA will be backed by a fixed rate of return of 7.3% on its regulated assets with an embedded 1.7% annual demand growth during the Regulatory Period 3 (RP3) under the Incentive-based Regulation (IBR) framework. Meanwhile, we expect gas utilities PETGAS and GASMSIA to be entitled to a rate of return during the new Regulatory Period 2 (RP2) commencing Jan 2023, similar to the quantum under the Regulatory Period 1 (RP1) which will also underpin earnings resilience. Lastly, the earnings for independent power producers (IPPs) are supported by power purchase agreements (PPAs). TENAGA (OP; TP: RM10.17) is our top pick for the sector.

Power utility: A 1.8% demand growth to anchor FY23 earnings growth. We project a demand growth of 1.8% in FY23, which is slightly higher than the guided growth of 1.7% under the RP3 parameter. The demand growth will be driven largely by the recovery in the industrial sector in Peninsular Malaysia. On the cost side, prices of fuels such as coal and gas are at record highs. For 11MCY22, the Indonesian benchmark coal price has more than doubled to USD276.14/MT on average from USD121.47/MT a year ago. This compares to a coal base price of USD79/MT under the RP3 parameter, sending the under-recovery of fuel cost under the Imbalance Cost Pass-through (ICPT) to a record high of RM15.92b in Sep 2022 from RM1.29b in Sep 2021. However, this amount will eventually be recovered. Thus far, TENAGA already received from government in Jun-Nov 2022 some RM4.83b which shows the latter’s commitment towards the IBR framework.

Gas utilities: RP 2 to start from Jan 2023. We expect a similar rate of return on the Regulated Asset Base (RAB) in the upcoming RP2 spanning from 2023 to 2025 as compared to RP1 if TENAGA’s experience is any guide. In RP1, the rate of return on PETGAS’ (MP; TP: RM17.00) RAB was below 8% while that of GASMSIA (MP: TP: RM3.54) was 7.3%-7.5%. Even at a lower rate of return, we still expect neutral or higher absolute earnings given the growing RAB base. A case in point is TENAGA; despite a lower rate of return of 7.3% in RP2 as compared with 7.5% in RP1, its regulated earnings grew as it moved to a new RP period. On the other hand, the high cost of input, i.e. gas, will hit PETGAS’s non-regulated business, namely, the utilities division (as it uses gas as fuel to generate and supply power, steam and industries gases to industries) but GAMSIA will benefit from its retail margins which are calculated based on fixed percentage on the gas cost. However, we expect gas prices to normalise from 2HCY23.

Improved earnings expected for IPPs. With improved operating environment (higher retail price and stable input cost) in Singapore, YTLPOWR (OP; TP: RM1.04) should expect sustained profitability at PowerSeraya coupled with new contributions from Tuaspring (from June 2022). Meanwhile, MALAKOF (OP; TP: RM0.94) should also see improved earnings stability following the completion of repair works in mid-February 2022 at its 1,000MW coal-fired power plant under Tanjung Bin Energy (TBE). On the other hand, earnings growth at SAMAIDEN (OP; TP: RM0.86), a poster child of the RE adoption in Malaysia, will be anchored by sustained renewal energy initiatives by the government.

OVERWEIGHT for earnings resilience. We continue to like the sector for its earnings resilience backed by regulated assets for power and gas utilities while earnings for IPPs are supported by PPA. These assets generate recurring cash flows, anchoring dividend yields of 4%-6%. TENAGA is our top pick for the sector for: (i) it being a good proxy to the economic recovery in Malaysia, (ii) its earnings resilience safeguarded by the ICPT mechanism, and (iii) it being a must-own stock in portfolios of Malaysian stocks given its heavy weighting in key indices and shariah status.

Source: Kenanga Research - 7 Dec 2022

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