Power and utilities sectors
Maintain “overweight”. We see two key catalysts in 2015: i) the usual half-yearly tariff review and ii) the long-awaited listing of 1Malaysia Development Bhd (1MDB) and Malakoff Corp Bhd. 

The falling fuel costs like coal price and lesser consumption of expensive liquefied natural gas (LNG) as the coal plants are back in action augur well for Tenaga Nasional Bhd (TNB), which also means a less-pressing tariff hike in the coming June 2015 review. In fact, with the ongoing recognition of the power purchase agreement (PPA) savings, TNB can afford a zero adjustment in the June 2015 review. Nonetheless, the June 2015 review is still a tough call given the planned goods and services tax (GST) implementation in April 2015. The two new initial public offerings (IPOs) are likely to be in the first half of 2015 (1H15) with 1MDB expecting to raise one of the biggest proceeds in market history. Nevertheless, with the current lacklustre market condition and the less-than-promising 2015 outlook, these listings may prove challenging in terms of pricing. 

In all, we remain “overweight” on the sector while TNB is still our top pick for the tariff hike catalyst. For alternative play, we still like the small cap Pestech International Bhd for its explosive earnings growth story.

Under the imbalance cost pass-through (ICPT) mechanism which was implemented in January 2014, it allows the government to review the tariff every six months based on changes in fuel costs. 

In November 2014, the authority announced that there was no tariff adjustment till June 2015 as the incremental ICPT cost amounting to RM1.68 billion for the period from January 2014 to June 2015 would be offset by the savings from the renegotiation of Gen1 (first-generation) PPA. With the balance of PPA savings of RM170 million, a decision for a tariff adjustment in June 2015 is possible. However, this is a tough call for the government given the planned GST implementation in April 2015, which could lead to inflationary pressure.

We learnt that the PPA savings is RM1.6 billion which is from April 2013 to June 2017, which implies RM400 million savings a year. This also means that TNB could recognise another RM200 million savings come June 2015 based on a half-yearly basis. Based on the 1,000 mmscfd guaranteed gas supply at a subsidised price of RM15.20 per mmbtu, TNB’s gas fuel cost could increase by RM274 million on a six-month basis should the subsidised gas price rise by RM1.50 per mmbtu as per scheduled earlier. With declining fuel cost like coal, the actual increment for tariff adjustment in the June review could be fairly lower. In fact, if the government wants to be aggressive, there could be no tariff adjustment for 2H of 2015. In our opinion, the gas price should rise accordingly as per schedule, at RM1.50 per mmbtu per six months or the previous planned RM3 per mmbtu per six months. With the help of PPA savings, the impact could be lessened and hastened to bring it to market price in meeting the subsidy rationalisation target.

After delaying several times, MMC Corp Bhd announced at the end of November that the listing of its power assets, Malakoff, is to be in the second quarter of 2015. Based on our discounted cash flow valuation, MMC would be able to raise RM2.1 billion, valuing the IPO at 12.3 times on calendar year 2015 earnings. In our opinion, pricing is fair in line with YTL Power International Bhd’s valuation of 10 times. It may even fetch better valuation given its quality power assets. On the other hand, 1MDB may see its power assets listed as soon as March 2015 as reported in the press. It was reported that the listing would raise US$3 billion (RM10.5 billion), making it one of the biggest IPOs, and believed to be priced at 20 times earnings multiplier. If this is true, we believe the valuation is on the high side. In all, we believe that pricing for both 1MDB and Malakoff IPOs are crucial and heavily dependent on general market underlying performance. Given the current lacklustre market performance and less optimistic market outlook, getting good pricing may prove challenging.

We were surprised and disappointed with the zero tariff adjustment this round in December 2014 when the government used the PPA savings to offset higher fuel costs resulting in no adjustment in the tariff structure. In our opinion, the government should raise fuel cost to better match the market price.

Judging from the fuel cost trends and availability of PPA savings fund, there could be another zero adjustment in tariff in the coming June review in 2015. The upcoming 1MDB and Malakoff IPOs could offer another two defensive stocks to the market. 

TNB continues to be our top pick for the rerating catalyst coupled with still compelling valuations. The small cap Pestech also remains as our alternative sector play for its explosive earnings growth story, with near-term strong contract flow expected. — Kenanga Research, Dec 29

This article first appeared in The Edge Financial Daily, on December 30, 2014.