Our recent meeting with YTL Power’s management reinforced our view that handsome dividend payouts will likely remain intact. In addition, longer term payouts are boosted by incubating power projects with high IRRs of 15%-20%. This includes Tg Jati coal plant in Indonesia (start: 2020), and Attarat shale plant in Jordan (financial close: 1QCY17). Meanwhile, wildcards include bids for Jurong desalination plant and Pasir Gudang Track 4A gas plant. Whereas for the mobile segment, earnings drag will ease following commencement of 1Bestarinet Phase 2 in CY17, and improving YES 4G subscriber traction. Lastly, whilst UK operations are running smoothly, Seraya’s fortunes will be uplifted by Singapore’s tapering electricity reserve margin. We maintain Buy with SOP target price of RM1.81. Attractive valuations and potential M&A from RM10bn cash pile are sweeteners.

Consistent Stellar Performance by Wessex. Operations of Wessex Water have been smooth sailing, whereby in 2013-16, Wessex ranked Top 3 (out of 18) water companies in England & Wales in terms of Service Incentive Mechanism (SIM). Whereas on the impact of the Brexit referendum on water companies, the Office of Water Services (OFWAT), which is the economic regulator, reiterated that sector fundamentals remain intact. According to OFWAT, investability of water companies post-Brexit are unchanged - underpinned by sound fundamentals, predictable regulatory environment, and customer legitimacy.

Crown Jewel Underappreciated. Management intends to maintain dividends in FY17, largely supported by cash flows from Wessex. We estimate annual FCFE of circa £136mn – £167mn (FY16: £156mn) (RM746mn-921mn) for Wessex over FY17E-19F. This accounts for 92%- 114% of forecasted dividend payout of RM810mn p.a (yield: 6.8%). On the back of this, we regard Wessex as the group’s most valuable asset, given its superior cash generative ability, coupled with stable business. However, we believe this is underappreciated by the market, as YTL Power is currently trading at 1SD below historical forward P/B (Figure 1).

Ready War Chest for Assault When Crisis Hits. Despite cheaper valuations for UK assets following Brexit, management guided that it will likely hold back on M&A activities at this juncture. This is because the group is not keen to acquire UK utilities unless it entails a controlling stake. According to management, there are restrictions governing foreign ownership of UK utility companies. Therefore, UK acquisitions will likely remain on the backburner, despite a chunky cash pile of RM9.5bn, whereby circa RM8bn is earmarked for M&A. Nevertheless, we do not discount any potential M&As on the international front or in other utility sectors.

1Bestarinet Phase 2 back in Business. YTL Power’s targets for 1Bestarinet Phase 2 include increasing bandwidth speed, and enhancing take-up rate. To recap, this RM4bn project was awarded by the Education Ministry in 2011. It will be rolled out over 15 years in 3 phases, whereby YTL Power had earlier completed Phase 1 in Jun-14. This project involves implementation of 4G broadband and Frog VLE (Virtual Learning Experience) online software for 10,000 schools. Recall that back in Dec-16, the Public Accounts Committee (PAC) requested a second review on Phase 1’s effectiveness. Nevertheless, we are optimistic that headwinds for this project have largely cleared. Phase 2 has now received the green light after YTL Power’s explanation to PAC, along with other measures by the group. This includes nominal rental payment for tower sites, and engaging content providers to enhance Frog’s content.

Phase 2 is a Cash Cow Now. We believe Phase 2 will provide a much needed cushion to losses in the Broadband segment. In addition, 1Bestarinet is now highly cash generative, given that future capex will be minimal after the completion of expensive 4G network rollout in Phase 1. Furthermore, management expects improved take-up rates as teething issues are resolved. In our forecasts, we assume annual revenue recognition of RM450mn for Phase 2 in the form of government grants (start: 3QFY17) until 3QFY18. Assuming a pretax margin of 10%, this translates to PBT of RM45mn p.a. In addition, on an encouraging note, the broadband segment reported shrinking losses (Figure 2) in the past 3 quarters. We attribute this to improving subscriber traction at YES 4G. To recap, losses have progressively narrowed to RM15mn in 2QFY17, after having peaked at RM109mn in 4QFY16.

Seeing Light at Power Seraya. Meanwhile, there is a glimmer of hope at Power Seraya, as evident from improving results over the past 3 quarters (Figure 3). To recap, after pre-tax profits peaked at RM267mn in 4QFY11, it had progressively tumbled to a low of RM6mn in 3QFY16. This was attributed to:- 1) oversupplied market, where the current reserve margin is circa ~90%, 2) dip in vesting volumes for the government from as high as 70% to current levels of 25%, 3) weak contribution from oil trading and sale of fuel oil. We attribute the latter to:- 1) volatile oil prices over 2015-16, and 2) lower demand for marine bunker due to the slowdown in E&P activities for the oil and gas industry.

Easing Electricity Reserve Margin in Singapore. On a bright note, we see light at the end of the tunnel, as we understand that government initiatives are in place to arrest new power capacity additions and maintain current vesting volumes. Correspondingly, the Energy Market Authority (EMA) of Singapore projects total electricity supply to reduce in 2019 by 700MW to 13,000MW (Figure 4). This is net of a 300MW increase in 2017 due to new investments, and 700MW decrease in 2019 following retirement of aged capacity. Correspondingly, the reserve margin (Figure 5) is expected to taper off to circa 70% by 2020. On top of an improving outlook for power generation, we believe Seraya’s earnings will also be uplifted by the group’s shift in focus to high-margin non-regulated ancillary businesses (i.e. steam sales, oil storage tank leasing, and bunkering services etc.)

Earnings Rerating if Seraya Bags Desalination Plant. In addition, earnings may potentially be catalysed if Seraya secures the contract to design, build, own, and operate (DBOO) Singapore’s 5th water desalination plant at Jurong, (capacity: 137,000 m3). To recap, in Feb-17, Seraya was shortlisted for this project alongside Keppel Infrastructure, Sembcorp Utilities and Tuas Power. This project is targeted for completion in 2020, which suggests that the award will likely be in CY17-18. We view earnings from this project as largely water tight, unlike that of Seraya’s existing power business. This is underpinned by a 25-year offtake agreement from Singapore’s national water agency, the Public Utilities Board (PUB).

Fighting Chance Vs. Water Competitors. As a benchmark, according to Hyflux Ltd, for its Tuaspring Desalination Plant (capacity: 318,500 m3), equity IRR is in the attractive low-teens. To recap, this DBOO project with 25 year concession (start: 2013) is the 2nd desalination plant in Singapore (Figure 6). Therefore, this reinforces our view that Seraya may derive attractive and stable returns from the Jurong desalination project. On the flipside, Seraya is competing against strong contenders, particularly government linked players, Sembcorp and Keppel. Recall that both are established players with a track record in water management. However, we believe Keppel will not be prioritized for this tender, given that it was recently awarded Singapore’s 4th desalination plant (start: 2020). On the bright side, Seraya’s financial capacity exceeds that of its competitors, given a healthy balance sheet with FY16 net debt/EBITDA of 3.6x (peers average: 8.1x).

Not Counting on Paka. For Paka’s delayed extension, management intends to lobby for a revised PPA with a full 2-year tenure. This is because the PPA extension granted earlier was for the period Mar 2016-18. In addition, we understand that YTL Power’s land lease with Tenaga, which is the source of the delay, will also expire in 2017. Therefore, at this juncture, management is reviewing the contract terms amidst ongoing negotiations with Tenaga. Nevertheless, regardless of the outcome, we have priced-in the black skies scenario of FY17E losses from Paka, and zero contribution thereafter. This is underpinned by our expectations that even if Paka secures a new PPA, this 22-year old plant will likely not be prioritized in Tenaga’s IPP power despatch queue. We understand that older and less efficient plants are now relegated to the back of the queue. This is following the start-up of modern plants, including Janamanjung 5, Tg. Bin Energy, etc.

Maintain Buy on Rosier Outlook. Nevertheless, loss of Paka’s contribution will be more than offset by upcoming plants in the pipeline. Recall that YTL Power has two power plants in the offing, including:- 1) Tg Jati coal plant in Indonesia (start: 2020), and 2) Attarat shale plant in Jordan (target financial close: 1QCY17). Recall that both projects in emerging economies carry high project IRRs of 15%-20%. In addition, we do not discount the possibility of the group reviving its bid for Track 4A (1,000MW) gas plant in Johor. We incorporate FY16 audited figures for Power Seraya and roll forward its DCF valuation to FY17E. As a result, its equity value (EV) is reduced to 33 sen (previous: 45 sen) due to higher-than-expected net debt levels. In addition, its FY17 pre-tax profit forecast is raised by RM60mn on account for higher retail spot prices. Correspondingly, the group’s FY17 profit forecast is raised by 7%, but the SOP target price (Figure 7) is lowered to RM1.81 (previous: RM1.90) in tandem with Seraya’s reduced EV. Against an improving backdrop for YTL Power, we maintain our Buy recommendation.

Source: TA Research - 10 Mar 2017