We believe that FY23 may potentially turn out to be a bumper earnings year for  Ranhill Utilities Berhad (Ranhill). This is mainly driven by: (1) recovery in  Developers’ Contribution, (2) full-year recognition of water tariff hikes for the  non-domestic and special category segments, and (3) increased earnings  contribution from Ranhill Worley. Meanwhile, in terms of cashflow, we believe  that FY23 cash levels may also be augmented. This is underpinned by receipt of:  (1) August-December 2022 tariff hikes billed in arrears, and (2) chunky 12th Malaysia Plan grant from the government following 2021’s Non-Revenue Water  (NRW) achievement. We maintain our Buy recommendation on Ranhill based on  Sum-of-Parts (SOP) target price (TP) of RM0.59.

Tariff Hikes Finally Materialize. To recap, back in Jul-22, the Federal  Government gazetted new water tariffs (Appendix I) for the non-domestic and  special category segments in Peninsular Malaysia and Labuan. The hikes correspond  to: (1) average tariff hike of 25 sen/m3  (6%-10% increase) for the non-domestic  segments, and (2) increase in minimum charge: 3% (Non-domestic), 40% (Shipping),  and 128% (Welfare and Religious Institutions). In our view, the tariff hikes are long  overdue given that the previous tariff adjustment was implemented way back in 2015.  The hikes incentivise 80%-owned Ranhill SAJ (SAJ) to plough healthy capex  investment for the upgrade of water assets. This enables the state to keep up with  growing economic activities, and enhanced water quality standards. Furthermore, it  enables the funding of: (1) pipe rehabilitation and replacement works, and (2)  expansion and construction of new water treatment plants etc. To recap, under the  Water Supply Industry Act 2006, we understand that SAJ is entitled to stable profit  margins of circa 8%-9%. Therefore, SAJ’s earnings are largely shielded from higher  costs emanating from: (1) opex due to inflation and (2) increased lease payments to  Pengurusan Aset Air (PAAB). Nevertheless, tariff hikes translate to an enlarged  revenue base, and hence bottomline growth for SAJ.

Domestic Tariff Hikes Next? Moving forward, we do not discount the possibility  of eventual tariff hikes for the domestic segment. This is given the enlarged disparity  between commercial and domestic rates post-tariff hikes. Thus, this implies heavy  cross subsidies by the commercial sector that are not conducive for businesses.  Furthermore, domestic tariff hikes will likely encourage households to conserve  water and prevent wastage. This is pertinent for Malaysia to achieve UN  Sustainability Goal 12: Responsible Consumption and Production with regards to  fresh water resource. Recall that the Domestic segment accounted for the bulk  (64%) of SAJ’s water consumption volumes in 2021. Moreover, according to SPAN,  water operators are in an unsustainable financial position as their revenue cannot  cover capex and opex expenditures. This is given that the average total tariff charged  to consumers in Peninsular Malaysia and Labuan is RM1.37 per m3 . This falls short  of costs to provide treated water to consumers amounting to RM1.68 per m3.

Petitioning for Adjustments to Lease Rental Rate Too. Against the backdrop  above, SAJ has submitted the following requests to PAAB to partially mitigate margin  erosion and opex inflation: (1) cap lease rental at 5.75%, and (2) lease rental payment  for new assets to start at 4.5%. In comparison, based on existing Master Agreement  terms, SAJ pays PAAB (custodian of national water assets) lease rental at 5% with  2% annual escalation since 2009. This is for assets transferred to PAAB and  subsequent assets developed by PAAB. As such, SAJ’s current lease payments to  PAAB for transferred assets are currently at the rate of 6.47%. Therefore, if PAAB  accedes to SAJ’s request, this may potentially translate to savings of RM16mn p.a for  SAJ.

Bottomline and Cash Boost from Tariff Hikes. On the back of the gazetted  water tariff hikes, Ranhill will implement the tariff adjustments from Jan-23.  Additionally, prior year (FY22) tariff adjustments will be billed to customers  retrospectively in FY23 billings (Figure 1). We understand that management has had  favourable discussions with its major commercial customers on the tariff hikes.  Following this, SAJ revealed that its top customers are willingly ready to pay higher  water tariffs. This is given that the total cost of their water bill remains marginal  relative to overall costs. As a result of the tariff hikes, we estimate additional revenue  of circa RM48mn (3% of FY23 revenue) for SAJ in FY23 that will largely flow to  pretax profits. On the back of this, we project PATAMI accretion of RM26mn (+27%  YoY) vis-à-vis SAJ’s FY22 earnings base.

Potential Recovery in Developers Contribution. We are guided by  management that developers contribution (DC) will likely ramp up in 2023. This is  underpinned by the resumption of real estate projects that were delayed during the  Covid-19 pandemic. Total annual DC may increase to as high as RM36mn in FY23.  In comparison, during the pandemic years, total DC merely amounts to RM15mn  p.a (pre-pandemic: up to RM36mn p.a.). To recap, DC comprises payment by real  estate developers to Ranhill following the completion of their respective projects.  This is to connect their project’s water reticulation systems to PAAB’s main pipeline  system. On the back of this, DC mainly flows directly to SAJ’s pretax profits given  marginal associated costs.

Harvesting Major FY22 Contracts Secured by Ranhill-Worley. Lastly, we  expect a kicker from 51%-owned Ranhill-Worley (RW) to FY23 Group earnings.  This is largely driven by chunky contracts secured in FY22, including: (1) USD50mn  contract for detail design engineering services for Petrobras’ P-82 FPSO, and (2)  RM50mn front-end engineering design for Kasawari Carbon Capture Storage.  Inclusive of these new projects, we estimate that RW’s outstanding orderbook  currently amounts to RM299mn. This translates to circa 1 year of revenue visibility.  In particular, for the major P-82 FPSO project, the bulk of its profits will be  recognized in FY23 given its contract period from Nov-22 to Mar-24. On the back  of this, we estimate YoY expansion in RW’s contribution by circa RM8mn-10mn in  FY23. In comparison, we expect flattish YoY contribution from RW in FY22.

Bumper Cash Reap in 2023 Too. Management expects chunky incoming  government grant of RM129.2mn in 2Q23. This is on the back of SAJ’s achievement  in Non-Revenue-Water (NRW) management for 2021. To recap, under the 12th Malaysia Plan, state water operators are allocated total grant amount of RM1.9bn if  they exceed respective NRW targets set in 2021-25 (2021: 26.2%). Recall that NRW  comprises water that has been produced or treated, but is lost before it reaches the  end-user. In 2021, SAJ managed to achieve 25.1% NRW - thus enabling it to claim  75% of its qualified expenditures (RM172.3mn). Meanwhile, we estimate that Ranhill  may receive revenues in arrears amounting to RM5mn in FY23. This is for the Aug-Dec 2022 tariff adjustments billed to customers in FY23 (Figure 1). Depending on  accounting requirements, the revenue streams above may potentially accrue to FY23  earnings. Hence, this may provide a major kicker to reported profits given that they  will flow directly to pretax profits. Nevertheless, regardless of the above, we are  positive that the cashflows will be received in FY23 – thus boosting dividend upside  risk. However, at this juncture, we do not incorporate the above cash payments into  our forecasts pending actual receipt.

Impact

• We tweak our forecasts to correspond with management’s refreshed guidance  and tariff adjustments. Major changes include: (1) raised FY23-24 blended tariff  to RM2.76 per m3  (+24% YoY) from RM2.43 per m3  previously, and (2) increased  Developer’s Contribution in FY23-24 by 15%-28%. As a result of the above, our  FY23-24 forecasts are raised by 11%-26%.

Valuation

• Following the upgrade in our forecasts, our Sum-of-Parts (SOP) target price  (TP) is raised to RM0.59 (previous: RM0.55). Our TP implies modest CY23  forward P/E of 14.9x. We maintain our Buy recommendation.

Source: TA Research - 27 Jan 2023