• 3QFY17 came in at high end of our estimate

• Earnings contracted against exceptionally high base

• Margins to recover from PPA savings utilisation for 2HCY17

• Re-affirm BUY at unchanged TP of RM16.80/share

Results at high end of our estimates. Tenaga reported core earnings of RM1.6b for its 3QFY17 which brought 9MFY17 core earnings to RM3.9b (excluding RM535m of provision for receivables & inventories). This accounted for 80% of ours and 76% of consensus’ FY17F. The 9M17 results were at the high end of our numbers, but we keep our forecasts in anticipation of seasonally weak 4Q demand.

Earnings naturally contracted against high base. Against an exceptionally high base in 3QFY16 (which registered peak demand, driven by the heatwave), electricity demand registered a 2%yoy contraction in 3QFY17. Notably however, the industrial segment (accounts for 40% of demand), which has shown several consecutive quarters of contraction has finally shown +ve growth (+1.8%yoy) on the back of improved manufacturing numbers. However, this was offset by a contraction in domestic segment (accounts for 22% of total demand) against a temporary high base last year. Sequentially, the domestic segment actually registered a 1.2% growth.

Earnings should improve from Jul17 onwards. On the back of normalised volumes and a spike in fuel cost (mainly due to the weak RM), 3Q17 core earnings were down 22%yoy. The margin compression from higher effective fuel cost should be temporary given utilisation of RM1.3b PPA savings to compensate Tenaga from Jul17 onwards. To recap, ICPT should have effectively turned to a surcharge of 1.02sen/kwh instead of a rebate of 1.52sen/kwh given higher fuel cost. However, the Government is subsidising the difference on behalf of consumers for the 2HCY17 period by utilising RM1.3b of the RM1.8b total PPA savings (estimated up till May17).

PPA savings to be returned to Govt. Additionally, 3Q17 was impacted by an essentially one-off, retrospective interest charge (payable to the Government) of RM150m on the PPA savings that Tenaga has been holding on behalf of the Government since 2013. Post-utilisation of the RM1.3b to subsidise consumers in 2HCY17, the remaining PPA savings of around RM500m will eventually be returned to the Government, which will eliminate further impact of interest charges on the remaining PPA savings. Tenaga will cease accumulating PPA savings at end Aug17, which is when the last of the renegotiated 1st Gen PPAs expire.

RP2 uncertainties weighing down on share price. Tenaga is in discussions with the regulators on the Regulatory Period 2 (RP2) terms and forecasts. RP1 will be reaching an end towards Dec17. Concerns on allowable returns in RP2 has been weighing down on Tenaga’s share price given the large discrepancy between Tenaga’s recommendations on cost of equity (Ce) vs. the regulator’s in determining allowable ROAs in the 1st IBR period. Nonetheless, we think current price levels have more than reflected this risk. In a worst case scenario where allowable returns are reduced to 6.5% from the current 7.5%, we estimate a ~RM485m/annum, or 7%-8% impact to Tenaga’s bottomline; our TP falls to RM15.40/share (from RM16.80/share currently) if we factor in this “worst case” scenario, which still entails meaningful upside against the depressed RM14.20/share levels Tenaga is trading at currently.

Tenaga (BUY, TP: RM16.80) remains our top sector pick. Key catalysts: (1) Dividend catalyst on the back of an under-geared balance sheet and capital optimisation exercise (2) Overseas expansion provides scope for stronger growth in the mid-term (3) Strong earnings visibility post-ICPT implementation (4) At just 12x FY18F PE Tenaga trades at a discount to sector average of 13x and the index’s 16x-17x. Tenaga is a liquid proxy to the GDP growth and trade upcycle, but share price has yet to move meaningfully relative to the broader market. Foreign shareholding now stands at 25%, close to a 2-year trough of 23% and peak of 29%.

Source: MIDF Research - 28 Jul 2017