Downgrading to HOLD. We believe a fuel cost pass-through mechanism is unlikely to be implemented in the next six months, at least. Near term upside hinges on the market lowering coal price expectations further, and this is not likely to be significant in our view. With the stock already up 18% YTD (22% since our upgrade in Dec 2011), we think TNB’s risk-reward profile is no longer compelling.

The coal conundrum. Coal prices have corrected by USD33/t (or 29%) YTD and we believe this has been a major driver of TNB’s rally. We estimate a 42bps accretion to TNB’s FY13 ROIC from a USD5/t fall in coal price. However, the biggest catalyst for TNB remains the implementation of a fuel cost pass-through mechanism. Unfortunately, TNB’s case for this weakens as its financials improve.

Raising FY13-14 earnings by 13% and 3% respectively. We now assume 1) demand growth of 4% p.a. (from 4.5%), 2) USD95/t average coal prices (from USD100/t), 3) c.MYR0.6b lower capacity payments (accounting-induced). In the absence of a tariff revision, we expect TNB to bear a third of the costs of oil, distillates and LNG-sourced gas. This implies ROIC’s of 7.7%-7.9%, signifying EVA breakeven.

Further ROIC accretion if management has its way. Using the assumptions behind the 2011 tariff hike (coal price of USD85/t and 1,250 mmscfd of subsidised gas at MYR13.70/mmbtu), we estimate TNB would generate ROIC’s of between 8.8-8.9%, about 1ppt above our present forecasts. We estimate a DCF-derived valuation of MYR9.40/share under these assumptions.

Target price shaved to MYR7.50. We switch to a DCF methodology (from PER) in order to price in various long-term operating scenarios. We assume WACC of 8.0%, 1% growth and long term incremental ROIC of 8%. Our target price implies 1.0x FY13 P/B and 10.9x FY13 PER. Current valuations may appear attractive, but we note valuations have historically not been major share price drivers. A rerating opportunity could present post the 13th general election.

Source: Maybank Research - 19 Nov 2012