KEY INVESTMENT HIGHLIGHTS

• 3Q20 earnings recovers sequentially, within our estimate but below consensus

• Regulated earnings remains intact, but some further drag from non-regulated units

• ‘Gap year’ between RP2 and RP3 approved by regulators, underpins near-term regulated earnings visibility

• Reveals RE target of 8300MW by FY25F

• Maintain BUY at unchanged TP of RM13.10; significant share price retracement presents value, coupled with reasonably attractive yields

Gradually recovering. Tenaga’s 3Q20 core earnings recovered sequentially, though not as strongly as it could have, given further losses at the retail division, impairment for GMR and a shortfall in capital allowance (CA) recognition. The group reported a core net profit of RM903m, which brought 9M20 core earnings to RM2.6b, accounting for 64%/59% of our/consensus estimates. We deem the results in-line with our estimate (but possibly below consensus) as we expect a stronger 4Q20 on: (1) Absence of further plant outages, (2) Absence of BPN discounts (3) Absence of further retail losses (4) Lower MFRS16 impact in 4Q20 – around RM155m vs. RM299m in 3Q20 (5) A catch up in CA recognition (RM240m).

Key takeaways. Regulated earnings remained intact at RM1b/RM3b in 3Q20/9M20. However, non-regulated earnings and other factors dragged group earnings on a year-on-year basis. Manjung 5 was still impacted by outages in 3Q20, but has been back online since August - impact is estimated at ~RM46m in 3Q20. On top of this, further retail losses of RM82m, additional recognition of BPN discount of RM121m and a RM51m impairment for GMR also dragged the 3Q20 results. On sequential basis, earnings improved given absence of Manjung 2 and KEV outages, narrower retail losses and some recovery at the manufacturing subsidiaries.

Demand recovery. Positively, demand has shown a sharp recovery. 3Q20 demand sales grew 12%qoq to 28,748 GWh and is only slightly short of 3Q19 demand sales levels. This was driven mainly by the industrial segment (3Q20: +0.2%yoy vs 2Q20: -23%yoy), while contraction for the commercial segment narrowed significantly (3Q20: - 8.4%yoy vs 2Q20: -28%yoy).

Regulators essentially agreeable with gap year. The Energy Commission (EC) is essentially agreeable to implement a gap-year in FY21F (RP3 will be pushed out to FY22F instead) and the proposal is awaiting cabinet approval. Essentially, the gap-year is likely to maintain similar parameters with RP2 in terms of allowable returns, capex (similar levels as the past 3 years in RP2) and tariffs. This is positive as it underpins near-term regulated earnings visibility for Tenaga.

Retail dragged by higher provisions, mainly. The retail segment suffered a loss of RM200m in 9M20 due to significantly higher allowance for doubtful debt (ADD), taken as a prudent measure in view of the pandemic’s potential impact on Tenaga’s customers. While ADD is provided for as part of Tenaga’s regulated cost, the amount is capped based on the pre-agreed RP2 parameters, and is smaller relative to the actual amount that had to be taken. Tenaga has been in talks with the EC to renegotiate the levels of ADD allowable and for a clawback of the exceptionally high amount this year. Positively, the EC is alluding to higher ADD for the gap-year, signaling potentially positive outcome from the negotiations.

Drive to release value, before listing is considered. Separation of Genco was completed in October, but a few assets i.e. two hydro assets, are pending transfer to Genco given tax efficiency considerations, while another plant requires approval from financiers to be transferred to Genco. Having transitioned from a dispersed to a centralized operating unit, Tenaga’s priority is to push further efficiency for Genco as an immediate measure to enhance returns. Key areas of focus are optimization of operations, streamlining of processes, cost and working capital management and potentially improving the financing structure to improve yields generated by the units.

Reveals RE targets. In its drive to support sustainability goals, Tenaga revealed that it is targeting to grow it RE capacity to 8300MW by 2025, a 145% increase versus its current RE capacity base of 3390MW (which comprises domestic RE capacity of 2724MW (the majority comprise of large hydros of 2536MW) and international RE capacity of 666MW. Key areas of targeted growth is expected from the UK/EU market, the South East Asian markets (Vietnam will be of particular focus in the near-term) and the domestic RE market (via LSS, G-Sparx and small scale RE e.g. mini hydro, biogas and WTE). The group aspires to ensure that revenue contribution from coal plants do not exceed 25% and targets for it to drop below 20% by 2030.

IAG to spearhead international RE expansion. An important component of the RE expansion drive is the expansion of Tenaga’s footprint in the UK/EU markets. To be executed under TNB International Asset Group (IAG), this will involve firstly, the establishment of RACo (Renewable Asset Company) as a renewable asset ownership company, with Vortex Solar (Vortex) and Tenaga Wind Ventures (TWV) as its initial assets. RACo has a target to grow its operational asset base from the initial 390MW (comprising Vortex:365MW and TWV:26MW) to a targeted 1000MW (under Phase 1) and 3400MW (under Phase 2). Secondly, the establishment of REDC (Renewable Energy Development Company) as an RE developer company focusing on greenfield RE project development (solar and wind) targeting high growth RE markets in Europe. Once operational, assets are to be eventually offloaded to RACo, allowing redeployment of capital to undertake further RE projects. The establishment of RACo is currently in progress. The group is currently executing internal restructuring of its assets to prepare for the injection into RACo and is assessing value creation opportunities through financing. Overall, IAG is targeting to grow its EBIT from ~RM0.1b in FY20F to RM2b by FY25F and in-line with this, its asset base is expected to grow from the current ~RM5b to RM33b in the same period. The expansion could involve external shareholders (investment funds) to reduce the capex burden, but IAG will likely remain in control of operations of the assets.

Recommendation. Maintain BUY at unchanged DCF-based TP of RM13.10. Tenaga’s share price has retraced significantly by some 15% in the past 12 months and now trades at just 13x FY21F earnings. Dividend yields of 4% (FY21F, assuming a conservative 50% payout) are reasonably attractive in the current low interest rate environment, underpinned by: (1) Easing capex for generation in the near-to-mid-term, which suggests base dividends of at least at the higher end of the group’s 30%-60% payout policy (2) Stretched Government fiscal position suggests potentially higher cash upflow requirement from key GLCs. Other catalysts: (1) RE expansion drive internationally (2) Positive outcome from LSS4 bidding (3) Recovery in FY21F earnings from absence of plant outages, BPN discounts and inflated ADD provisions, that were experienced in FY20F

Source: MIDF Research - 27 Nov 2020