We recently met management of Petronas Gas Bhd (Pet Gas), where discussions largely centered on the looming liberalization of gas infrastructure (transmission and regasification). Whilst negotiations with EC are still fluid, we believe there is material risk of lower returns. This is underpinned by expectations of:- 1) lower return on assets, in-line with peers, and 2) due to Pet Gas’ reduced WACC. In the worst case scenario, we estimate topline erosion of 15% post-tariff revision. The corresponding reduction in FY18-19 net profit is 13%, resulting in lowered TP of RM17.53 (-10%). On the bright side, we expect limited downside to asset valuation, as we believe methodologies will remain status quo for both regasification assets (Net Book Value), and transmission pipelines (Depreciated Replacement Cost). Additionally, management assuaged our concerns of capacity risk, as it shall remain status quo that Pet Gas’ capacity is fully-underwritten. Lastly, we believe that the group will maintain its market monopoly in the near-to-medium term, due to high barriers of entry. Based on our estimates, the cost of building a transmission network similar to Pet Gas’ exceeds RM9.0bn. We maintain Sell on Pet Gas (TP: RM19.02), mainly due to earnings risk postTPA and lofty valuations.

(I) GAS SUPPLY AMENDMENT ACT & 3rd PARTY ACCESS

Gas Transportation Tariffs Will be Tweaked. To recap, GSA enables Third Party Access (TPA) to Pet Gas’ pipelines and regasification infrastructure. Upon implementation (target: 2018), Pet Gas would likely tweak the terms of its existing 2014 agreements with sole customer, Petronas. Currently, Pet Gas is waiting for the Energy Commission (EC) to issue guidelines for determination of gas transportation tariffs. In essence, tariffs reflect the allowable return on asset values.

WACC Reduction Likely Preludes Lower Returns. We believe there is downside risk for tariffs as the allowable return is likely based on Pet Gas’ current cost of capital. Recall that the group’s existing 2014 Gas Transmission Agreement (GTA) (Figure 1) was based on WACC of 9.2%. Whereas current WACC has now reduced to 7.8%. This was due to lower market beta, coupled with procurement of low-cost debt (USD500mn loan from Mizuho Bank Ltd; average rate: 1.3%). Furthermore, regulated returns for other utility providers (i.e. Tenaga and Gas Malaysia) whom are subject to Incentive Based Regulation (IBR), are lower at 7.5%-8.0%

Valuation Method for Pipelines Should be Status Quo. Whereas for determination of asset values, Pet Gas and EC are currently exploring two valuation methodologies, namely Net Book Value (NBV) or Depreciated Replacement Cost (DRC). To recap, DRC is the current cost of building assets, after accounting for its residual life. Given that the existing GTA uses DRC, we believe there is high likelihood this will remain status quo. Furthermore, Pet Gas’ pipeline assets are aged, with estimated remaining useful life of 30 years (lifespan: ~55 years). Recall that DRC is typically used to value older pipelines, as in the case of UK, Netherlands, and Australia.

Regasification Assets Likely to Apply NBV. If NBV is applied, there will be significant erosion to Pet Gas’ transmission returns. This is because DRC valuation translates to circa 2.5x NBV. On the other hand, Pet Gas is agreeable to the use of NBV for valuation of its regasification assets, which are new. They include Sg Udang Regasification Terminal (RGT1) (completion: 2013) and the upcoming Pengerang RGT (RGT2) (target completion: 4Q17). Meanwhile, RGT2 is in the final stages of crystalizing its Regasification Sales Agreement (RSA) with Petronas. The new RSA terms will largely mirror that of RGT1 (Figure 2)

15% Topline Erosion Under Black Skies. In the black skies scenario, we estimate topline erosion of 15% post-TPA tariff revision. Our underlying assumptions include:- 1) NBV valuation is used, 2) regasification revenues remain status quo, 3) NBV of transmission assets amount to RM2.5bn, and 4) 7.8% WACC. Correspondingly, we estimate reduction in net profit by 13% in FY18-19, which would result in lower SOP target price of RM17.12 (-10%).

Capacities Remain Fully Underwritten. On the bright side, according to management, there will be no capacity risk for Pet Gas after TPA. As per current arrangement, capacity for both pipelines and regasification facilities will be fully-underwritten. Recall that under existing agreements, 100% capacity is leased out to Petronas regardless of utilization. Nevertheless, following TPA, management does not discount the possibility that some capacity may be assigned to other users. They may include customers such as Tenaga Nasional, Gas Malaysia, and independent power producers (IPPs). Therefore, the burden of underwriting capacity may be partially shifted from Petronas to other users

Guaranteed Offtake Mitigates Risk of Lower Demand. To justify its premium valuations, we believe it is important that Pet Gas is assured full capacity offtake, which limits earnings risks. This is particularly true for RGT capacities, which risk underutilization due to the shift in Malaysian power generation mix from gas to coal (Figure 3). Recall that the power sector drives the lion’s share of local gas demand. Due to the progressive gas subsidy withdrawal, the share of gas generation mix will decrease from 49% to 29% in 2015-20. Correspondingly, gas consumption in Malaysia is expected to decrease by 305 mmscfd (-23%) to 980mmscfd in 2015-20. Furthermore, we understand that RGT1’s utilization in 2016 was well below 50% due to LNG’s significant price premium over subsidized gas (Figure 4)

High Barriers of Entry for New Players. We do not discount the possibility that new licensed gas transportation players may emerge in future. They may include new gas suppliers or infrastructure companies with the financial capacity to build a new extensive network. However, the hefty cost of constructing a nationwide network may render it commercially unfeasible for new market entrants. Recall that Pet Gas’ PGU (Peninsular Gas Utilization) pipelines (Figure 5) in West Malaysia spans 2,550km with capacity of 3,000 mmscfd. We estimate that the current cost for building a network similar in size to Pet Gas’ would exceed RM9.0bn. Additionally, there would also be costs and hurdles related to land acquisition, including compensation and regulatory approvals.

Entrenched with Strong Grip on Monopoly. As such, we believe it is likely that Pet Gas’ entrenched market leadership and monopoly will remain status quo in the near-to-medium term. Nevertheless, for a start, new entrants could target areas where Pet Gas does not have network reach. Alternatively, they could also build shorter last mile connections that link to Pet Gas’ network. Whilst the group may be reluctant to lease out capacity to competitors, we believe it is the government’s intent for full market liberalization. This is based on EC’s general concept of TPA, where ‘other parties are able to utilize without discrimination the three major gas infrastructures in Malaysia, irrespective of ownership’.

(II) PENGERANG PROJECTS

Possible New Projects in Pengerang. In our view, it is possible that Pet Gas may participate in associated facilities (Figure 6) currently developed by parent Petronas at Pengerang Integrated Complex (PIC). They include:- 1) PRPC (Utilities and Facilities Sdn Bhd), 2) PCP (Cogeneration Plant), and 3) PAMER (Projek Air Mentah). We believe they are a strategic fit for the group, given Pet Gas’ track record and expertise in such projects. Additionally, these assets do not fit into Petronas’ core business (which is ownership of Malaysian petroleum resources). To recap, out of the six facilities under construction, Pet Gas is currently developing two projects. They comprise of the RM2.7bn RGT2 (65% stake) and USD172mn ASU (Air Separation Unit) (51% stake)

Balance Sheet Ready to Invest. To recap, Pet Gas’ sister company, Petronas Chemicals, took over Petronas’ USD3.1bn RAPID petrochemical complex in Nov- 15. Whereas PIC’s liquid bulk terminal (SPV2) is spearheaded by Dialog Group. If Petronas disposes the other PIC projects to private sector companies, we expect its timing to be in 2018-19. This is to accommodate RAPID’s launch by end-19. Given the scenario that Pet Gas takes over, it would be a much anticipated earnings growth catalyst. Furthermore, the group has ample capacity to undertake new projects, underpinned by:- 1) underleveraged balance sheet (net gearing: 0.06x, cash: RM1.7bn), and 2) robust cash flows (2017E-19F average FCFF: RM1.5bn p.a).

Impact

• We incorporate the following:- 1) contribution from RGT2 (start: FY18), 2) audited figures for FY16, 3) higher consensus earnings estimates for Gas Malaysia, 4) lower interest costs, and 5) higher taxes in FY17. Correspondingly, our FY17/18/19 forecasts are revised by -1%/11%/14%.

• For our SOP valuation, we effect the following changes:- 1) tweaked WACC to 7.8% (previous: 7.4%), 2) raised Gas Malaysia consensus TP to RM3.04, and 3) removed RGT2 contribution, and 4) incorporated ASU valuation. Following this, our target price is lowered to RM19.02 (previous: RM19.64).

Valuation

• We maintain Sell on Pet Gas (TP: RM19.02), mainly due to downside risk on asset returns post-TPA and lofty valuations. The stock is currently trading at:- 1) 2SD above historical forward P/E average, and 2) 1SD above historical forward P/B average

Source: TA Research - 18 Apr 2017