Tenaga Nasional Berhad TP: RM17.38 (+16.5%)

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1 COMPANY UPDATE Wednesday, December 20, 2017 FBMKLCI: 1, Sector: Power & Utilities THIS REPORT IS STRICTLY FOR INTERNAL CIRCULATION ONLY* Tenaga Nasional Berhad TP: RM17.38 (+16.5%) RP2 Uncertainty Last Traded: RM14.90 BUY Kylie Chan Sze Zan Tel: The Energy Commission (EC) will announce details of the Regulatory Period 2 (RP2: ) for Incentive Based Regulation (IBR) framework anytime before end Although Tenaga is protected from fuel price inflation under the IBR mechanism, there are concerns that the group s earnings would be reduced via lowered asset returns or a deflated Regulatory Asset Base (RAB). Based on our estimates, every 0.1 ppt reduction in RP1 s current 7.5% Rate of Return (RoR) will result in earnings erosion of 0.6%- 0.7% p.a to our FY18F-20F forecasts. Despite the uncertainty emanating from RP2, we remain Buyers of Tenaga (TP: RM17.38), underpinned by aggressive international M&A expansion, proactive capital management, and attractive valuations. Earnings Uncertainty from RP2. RP2 will be implemented following the end of the first regulatory period (RP1) in (interim regulatory period: 2014). According to Tenaga, the revision of IBR parameters for RP2 will have a neutral impact on its financials, and the final outcome is expected to be fair to all parties. Recall that Tenaga s chairman, Tan Sri Leo Moggie, indicated that base tariff would likely be maintained for RP2. This is understandable, given that higher tariffs are counter-populist in the wake of a looming General Election. Given the current reality of fuel price inflation, this implies that higher fuel costs will either be borne by consumers, the government, or Tenaga. Therefore, unless the government provides subsidies, there are concerns that higher generation costs would be at the expense of Tenaga, via lower asset returns. ICPT Turned to Under-Recovery in 2H17 on Higher Fuel Costs. Recall that under RP1, the average tariff increased from sen/kwh as at June-2011 to sen/kwh (+4.99 sen kw/h). The bulk of the increase (82%) was mainly driven by higher fuel costs, which comprised 68% of average tariff (Figure 1). Nevertheless, consumers enjoyed tariff rebates totalling RM4.1bn under RP1 (Figure 2), on the back of: 1) Over-recoveries of Imbalance Cost Pass-Through (ICPT) up till Jun-17, and 2) Cost savings from renegotiations of first-generation power purchase agreements (PPA) from Jun-17 onwards. However, the latter is unlikely to recur in RP2 given that the PPA Savings Fund balance is expected to deplete to circa RM0mn by end Share Information Bloomberg Code TNB MK Stock Code 5347 Listing Main Market Share Cap (mn) 5,659 Market Cap (RMmn) 84,319 Par Value (RM) wk Hi/Lo (RM) 15.68/ mth Avg Daily Vol ('000 shrs) 10,067.0 Estimated Free Float (%) 39.0 Beta 0.5 Major Shareholders (%) Khazanah EPF Forecast Revision (%) FY17* FY18 Forecast Revision (%) 0 0 Core Net Profit (RM mn) 7, ,449.1 Consensus 7,1.0 7,428.0 TA/Consensus (%) Previous Rating Buy (Maintained) *Annualized 16 months earnings Financial Indicators FY17 FY18 Net Debt/Equity (x) ROA (%) ROE (%) BV/Share (RM) P/BV (x) Share Performance Price Change (%) TNB FBMKLCI 1 mth mth 2.3 (2.4) 6 mth 3.6 (3.1) 12 mth (12-Mth) Share Price relative to the FBMKLCI Source: Bloomberg Page 1 of 5

2 Figure 1: RP1 Average Tariff Breakdown Source: EC Figure 2: IBR Timeline & ICPT Review Source: Company Gas & Coal Price Pressure. Upside risk to RP2 fuel price parameters is underpinned by rising costs of coal and gas (Figures 3 & 4), which are the main fuel components in FY17 (Coal: 50%, Gas: 48%). Furthermore, this is exacerbated by progressive removal of gas subsidies. To recap, gas and coal price budgeted under RP1 was set at RM15.20/mmbtu and USD87.50/mt respectively. However, the actual gas and coal price realised by Tenaga in FY17 amounted to RM20.95/mmbtu and USD70.2/mt. Therefore, unless the government steps in to subsidise higher fuel costs, we do not discount the possibility of lower returns for Tenaga to ease consumers burden. Figure 3 : Australia Newcastle Port Thermal Coal kcal/kg FOB Spot trading at USD74.5/mt as at 11-Dec-17 Figure 4 : Indonesian Coal Reference Price Melawan Coal 5400 Kcal trading at USD72/mt as at end-sep 2017 USD/mt USD/mt Feb-09 Feb-10 Feb-11 Feb-12 Feb-13 Feb-14 Feb-15 Feb-16 Feb-17 Page 2 of 5

3 Leeway to Lower Returns for Tenaga. Furthermore, Tenaga s earnings outperformance provides additional basis and headroom for EC to reduce its returns. Recall that in 12MFY17, asset returns for Tenaga (mainly consisting of Transmission and Distribution (T&D) businesses) amounted to RM4.5bn, which far exceeded EC s average RP1 budgeted T&D return projections of RM3.4bn p.a Furthermore, this is in spite of Tenaga underspending on T&D capex (RP1 budget: RM18.2bn). To-date, since RP1 s implementation, we estimate that the group merely spent capex of RM13.6bn over 2 years 8 months. This was mainly underpinned by lower-than-expected electricity demand. Nevertheless, management guided that it will play catch-up in capex spend over the remaining 4 months of RP1. We see more Downside Risks for RAB. There are two variable factors (Figure 5) under IBR that affects Tenaga s earnings, namely: 1) Rate of Return (RoR) or WACC, and 2) Average Rate Base or Regulated Asset Base (RAB). Downside risks for RAB, include: 1) deflated asset base as Tenaga underspent on capex by an estimated RM4.6bn to-date during RP1, and 2) subdued demand growth, whereby EC projects electricity demand growth of 1.92% ( : 2.9%). Correspondingly, budget for new T&D investments under RP2 could turn out below expectations. On the other hand, we see upside pressure for RP1 WACC (Figure 6), of 7.5% given expectations of rising interest rates and current lower tax rate of 24% (RP1: 25%). Figure 5: Revenue Requirement Building Block Model Under IBR Framework Figure 6 : WACC Parameters for RP1 WACC Parameters RP1 TNB Stock Beta Market Return 8.8% Risk Free Rate 4.0% Debt Margin 2.2% Tax Rate 25% Source: EC Source: Company, TA Securities 0.6%-0.7% Earnings Impact for Every 0.1ppt Reduction in WACC. Based on our estimates, every 0.1 ppt reduction in RoR will result in earnings erosion of 0.6%- 0.7% p.a (RM46mn-49mn p.a.) to our FY18F-20F forecasts. For instance, given the scenario whereby Tenaga s WACC for RP2 computation is lowered to 7.0% from RP1 rate of 7.5%, this would translate to a 3.1%-3.2% reduction for FY18F-20F earnings. Underlying key assumptions for our average RAB estimate of RM47.8bn during RP2 include: 1) average capex spend of RM5.1bn p.a., and 2) estimated end- 17 RAB of RM44.9bn. Final Outcome is a Wildcard. In conclusion, given the plethora of factors that influence EC s decision, the final outcome of Tenaga s WACC and tariff determination under RP2 is a wildcard. We maintain our earnings forecasts pending final details on RP2, which is expected to be unveiled in end We remain buyers of Tenaga (DCF TP: RM17.38), underpinned by: 1) Earnings growth kicker and newsflow from international M&A plans - which target 3.7GW new capacity from overseas market by 2020, 2) Dividend upside from proactive capital management with strong balance sheet (Net gearing: 0.6x, Cash: RM5bn), and 3) Attractive Page 3 of 5

4 valuations where Tenaga is currently trading 1SD below historical mean FY18 P/E (Figure 7), and at 18% discount versus regional peers in terms of FY18 EV/EBITDA. Figure 7 : Historical Forward P/E PER (x) Jan-00 Jun-01 Nov-02 Apr-04 Sep-05 Feb-07 Jul-08 Dec-09 May-11 Oct-12 Mar-14 Aug-15 Jan-17 Forward PER Historical Mean [THE REMAINDER OF THIS PAGE IS INTENTIONALLY LEFT BLANK] Page 4 of 5

5 Earnings Summary Income Statement Balance Sheet FYE Dec* (RM mn) E** 2018F 2019F FYE Dec* (RM mn) E** 2018F 2019F Revenue 43, , , , ,382.9 Property, Plant & Equip 90,0.3 96, , , ,328.6 EBITDA 13, , , , ,328.9 Prepaid Op Leases 5, , , , ,172.7 Depreciation & amortisation (5,294.2) (5,722.2) (8,214.8) (6,383.8) (6,585.5) Associates & JVs , , , ,171.2 Net interest expense (662.7) (740.3) (1,3.2) (711.5) (793.4) Others 2, , , , ,623.3 Associates Non-Current Assets 98, , , , ,295.8 Forex gain/(loss) (932.3) (358.2) (87.5) Pretax profit 7, , , , ,053.9 Inventories , Taxation (1,072.8) (746.0) (1,463.4) (1,318.3) (1,991.9) Trade receivables 8, , , , ,288.1 Minority interest Cash and Deposits 2, , , , ,373.8 Net Profit 6, , , , ,113.2 Others 6, , , , ,715.0 Core Net Profit^ 7, , , , ,113.2 Current Assets 18, , , ,4.4 29,9.5 Per Share Data Total Assets 117, , , , ,605.2 Core EPS^ (sen) DPS^ (sen) Borrowings 23, , , , ,232.7 Book Value (RM) Employee benefits 10,2.0 11, , , ,048.8 FCF (sen) Deferred taxation 7, , , , ,394.0 Deferred income 1, , , , ,165.6 Ratios Others 11, , , , ,205.1 FYE Dec* (RM mn) E** 2018F 2019F Non-Current Liabilities 54, , , , ,046.1 Valuations Core PER (x) Trade payables 10, , , , ,098.0 Dividend Yield (%) Other payables EV/EBITDA (x) Deferred income 1, , , , ,139.2 P/BV (x) Borrowings 1, , , , ,488.8 FCFF Yield (%) Others 1, , , , ,385.3 Current Liabilities 15, , , , ,870.8 Profitability Ratios EBITDA margin (%) Share capital 5, , , , ,643.6 EBIT margin (%) Reserves 41, , , , ,997.0 Pretax margin (%) Minority interest Net margin (%) Equity 47, , , , ,688.3 Core net margin (%) ROE (%) Total Equity + Liabilities 117, , , , ,605.2 ROA (%) Cashflow Statement Liquidity ratios FYE Dec* (RM mn) E** 2018F 2019F Current ratio (x) PAT 6, , , , ,062.0 Quick ratio (x) Add: Net Taxes Depreciation 5, , , , ,585.5 Leverage ratios Net Interest , Gross Gearing (x) Associates & JCEs (101.1) (93.3) (128.1) (100.9) (103.9) Net gearing (x) Net change in working capital 1, , ,645.3 (959.2) (51.0) Total Debt/ Assets (x) Others (1,535.9) (1,714.5) 1, ,394.3 Interest Coverage (x) CF from Operations 11, , , , ,277.9 Growth ratios Capex (10,363.7) (11,142.8) (15,000.0) (10,000.0) (10,000.0) Revenue (%) (21.0) 5.2 Interest income EBITDA (%) (24.2) 3.9 Others (2,547.7) (7,552.1) PBT (%) (21.9) 3.0 CF from Investing (12,829.1) (18,395.9) (14,735.3) (9,558.9) (9,681.7) Core Net Profit (%) (3.5) (0.1) (4.5) Core EPS^ (%) (3.5) (0.1) (4.5) Dividends (1,636.7) (1,636.7) (2,204.7) (3,442.6) (2,607.2) Net Change in debt (1,775.2) 9,063.4 (201.5) (1,201.5) (1,201.5) Interest paid (451.1) (890.3) (1,568.0) (1,152.6) (1,111.6) Others (388.7) CF from Financing (4,251.7) 6,593.4 (3,974.1) (5,796.7) (4,920.3) * : FYE Aug Net Cash Flow (5,641.4) 1, ,645.9 (1,524.9) ** 16 months for FY17 Beginning Cash 8, , , , ,076.1 ^ 12 months Pro-Rated for FY17E Ending Cash 2, , , , ,357.7 Stock Recommendation Guideline BUY : Total return within the next 12 months exceeds required rate of return by 5%-point. HOLD : Total return within the next 12 months exceeds required rate of return by between 0-5%-point. SELL : Total return is lower than the required rate of return. Not Rated: The company is not under coverage. The report is for information only. Total Return is defined as expected share price appreciation plus gross dividend over the next 12 months. Gross dividend is excluded from total return if dividend discount model valuation is used to avoid double counting. Required Rate of Return of 7% is defined as the yield for one-year Malaysian government treasury plus assumed equity risk premium. Disclaimer The information in this report has been obtained from sources believed to be reliable. Its accuracy and/ or completeness is not guaranteed and opinions are subject to change without notice. This report is for information only and not to be construed as a solicitation for contracts. We accept no liability for any direct or indirect loss arising from the use of this document. We, our associates, directors, employees may have an interest in the securities and/or companies mentioned herein. As of Wednesday, December 20, 2017, the analyst, Kylie Chan Sze Zan, who prepared this report, has interest in the following securities covered in this report: (a) nil Kaladher Govindan Head of Research TA SECURITIES HOLDINGS BERHAD (14948-M) A Participating Organisation of Bursa Malaysia Securities Berhad Menara TA One 22 Jalan P. Ramlee Kuala Lumpur Malaysia Tel: Fax: Page 5 of 5