The power sector in Peninsular Malaysia is mature. However, there are decent opportunities in the generation space due to a low reserve margin of 23%. Our Top Picks are: i) Tenaga as we believe the market has substantially priced in the risk of it acquiring Edra at premium valuations, and ii) Malakoff given its earnings defensiveness and attractive dividend yields of 4-6%.

A mature market. The power sector in Peninsular Malaysia is mature with demand growth of only 3-4% per annum. However, due to a reserve margin that was at a 10-year low of 23% in 2014, we believe there are decent opportunities in the generation space.

Industry consolidation. In July, Tenaga Nasional (Tenaga) (TNB MK, BUY, TP: MYR15.53) submitted an “indicative non-binding proposal” with an undisclosed price to acquire all five domestic and eight international power assets of Edra Global Energy (Edra) with total effective capacity of5,594 megawatts (MW) but there are concerns Tenaga may pay premium valuations for the assets. However, Tenaga’s loss in market value of close to MYR10bn since Mar 2015 should have substantially reflected the risk.

Malakoff is a pure-play independent power producer (IPP). We like Malakoff Corp (Malakoff) (MLK MK, BUY, TP: MYR2.18) for its: i) strong earnings visibility backed by long-term power purchase agreements(PPAs) signed with off-takers, ii) earnings growth driven by Unit 4 of the Tanjung Bin Power Plant that is slated to come on-stream in FY16 –boosting its effective generating capacity by 17% to 7,036MW from 6,036MW, and iii) export opportunities given the proximity to Singapore and Thailand and the availability of sites to accommodate more power plants. Its dividend yields are attractive at 4-6%.

YTL Power needs more power in Malaysia. YTL Power International (YTL Power) (YTLP MK, NEUTRAL, TP: MYR1.55) has won a short-term capacity bid from the Energy Commission for the supply of power from its 808MW Paka Power Plant from 1 Mar 2016 to 31 Dec 2018, extending the economic life of the plant beyond its original PPA that ended on 30 Sep 2015. While this is earnings-accretive, the impact is short term. Also, we doubt if the Paka Power Plant is in a position to win another shortterm supply contract beyond 2018 due to the plant’s age (24 years by then) and its dated technology.

Risks. These include: i) regulatory risks, ii) unplanned outages atexisting power plants, and iii) construction risk of greenfield power plants.

Maintain OVERWEIGHT on the power sector. Our Top Picks are Tenaga and Malakoff as shown in the table below.

A mature market. The power sector in Peninsular Malaysia is mature with demand growth of only 3-4% per annum, based on our projection. However, due to a reservemargin that was at a 10-year low of 23% in 2014 (see Figure 1), there are decent opportunities in the generation space in terms of new power plant projects (see Figure 2) and short-term supply contracts to existing power plants of which theiroriginal PPAs have expired or are expiring.

Industry consolidation. In an unexpected turn of events recently, a strategic development company owned by the Ministry of Finance (MOF) decided not to proceed with the IPO of Edra, but intends instead to pursue an outright disposal of its power unit. In July, Tenaga submitted an “indicative non -binding proposal” with an undisclosed price to acquire all five domestic and eight international power assets of Edra, with total effective capacity of 5,594MW as reported by The Edge Weekly. There are concerns though that Tenaga may pay premium valuations for the assets. However, the company’s loss in market value of close to MYR10bn since Mar 2015 should have substantially reflected the risk. Otherwise, Tenaga is a good proxy to theeconomy and offers earnings defensiveness, large market value and high share liquidity. We also advocate owning the stock for its ability to gradually regain lost ground in the more lucrative power generation business vis-à-vis transmission and distribution, having emerged as the biggest winner of new power plant projects in Malaysia in recent years (see Figure 2).

Imbalance cost pass-through (ICPT). Meanwhile, Tenaga no longer stands to gain from lower fuel costs. This is following the Government’s decision to cut power tariffs from 1 Mar 2015 by 5.8% or 2.25 sen per kilowatt hour (kWh) to 36.28 sen per kWh in West Malaysia, and 3.5% or 1.20 sen per kWh to 33.32 sen per kWh in Sabah to pass back fuel cost savings to consumers. The reduction applies to all users (domestic, commercial and industrial) other than domestic users with electricity consumption of 300kWh per month or less. This is in accordance with the ICPTmechanism, as stipulated in the new energy policy effective 1 Jan 2014. On the other hand, it is unclear if there is a political will to invoke the ICPT mechanism to raise power tariffs if fuel costs go up. Nonetheless, the continued slump in fuel costs is surely a respite for Tenaga.

Malakoff is a pure-play IPP. We like Malakoff for its: i) strong earnings visibility backed by long-term PPAs signed with off-takers, ii) earnings growth driven by Unit 4 of the Tanjung Bin Power Plant that is slated to come on-stream in FY16 – boosting its effective generating capcity by 17% to 7,036MW from 6,036MW, and iii) export opportunities given the proximity to Singapore and Thailand and the availability of sites to accommodate more power plants. Its dividend yields are attractive at 4-6%.YTL Power needs more power in Malaysia. YTL Power has won a short-term capacity bid from the Energy Commission for the supply of power from its 808MW Paka Power Plant from 1 Mar 2016 to 31 Dec 2018, extending the economic life of the plant beyond its original PPA that ended on 30 Sep 2015. While this is earningsaccretive, the impact is short term. Also, we doubt if the Paka Power Plant is in the position to win another short-term supply contract beyond 2018 due to the plant’s age (24 years by then) and its dated technology. Meanwhile, the other domestic power plant, namely, the 404MW Pasir Gudang Power Plant, was retired upon expiry of its PPA on 30 Sep 2015. Coupled with the fact that it has yet to secure any new power plant projects in Malaysia, YTL Power is losing its appeal as a domestic IPP play. While the company has been actively scouting for opportunities in the overseas market, we believe investors are slow in warming up to its efforts, particularly when it comes to greenfield projects given the high execution risks.

Risks. These include: i) regulatory risks, ii) unplanned outages at existing power plants, and iii) construction risk of greenfield power plants.

Maintain OVERWEIGHT on the power sector. Our Top Picks are Tenaga and Malakoff.