Inter Market Perspective

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1 Inter Market Perspective Research Entity Number REP Kot Addu Power Company Ltd KAPCO: Attractive yield compensates attached risks; Neutral We initiate coverage on KAPCO with a Neutral stance and a Jun 18 TP of PRs61/sh. KAPCO being multi-fueled and large IPP will be able to withstand FO s phaseout, in our view. This will in turn conserve its payout ability, which is already sector leading (FY18F DY: 18.3%). However, looming PPA expiry (FY21) may keep a lid on price performance. In the backdrop of GoP s decision to rationalize FO based power, KAPCO s GSA with SNGP for 200mmcfd gas supply until Dec 18 will enable the plant to operate at optimal levels near-term. More LNG terminals in Pakistan may result in extension of existing agreement until PPA expiry, in our view. Remaining useful plant life of years and its ability to operate on gas just as well as on FO strengthen the case for GSA and PPA extension beyond FY21. The scrip offers highest D/Y in IMS Power space (FY18/19F D/Y: 18.3/20.1% which is 9.6/11.6 ppts higher than the 10 year PIB rate), implying attractive risk-reward dynamics. Initiate with Neutral We initiate coverage on Kot Addu Power Co. Ltd (KAPCO) with a Neutral stance and a TP of PRs61/sh. KAPCO has recently signed a Gas Supply Agreement (GSA) with SNGP for 200mmcfd gas supply till Dec 18, sufficient for 60% utilization of its plant. We believe upcoming LNG terminals may result in the extension of the GSA beyond CY18, and the plant may continue to remain operational at optimal utilization levels. While looming PPA expiry (FY21) may keep a cap on the scrip s price performance, we flag that continued gas availability strengthen the case for PPA extension; however, this is not our base case. A PPA extension till FY30 with existing tariff may add PRs42/sh to our existing valuations (TP for Case I: PRs103/sh; Upside: 88%). However, if the government extends KAPCO s PPA on a revised tariff, with new base costs and exchange rates for indexation purpose, the same would result in adding PRs13/sh (TP for Case II: PRs74/sh; Upside: 36%). KAPCO may withstand FO s substitution KAPCO the second largest IPP in Pakistan (1,336MW), with 10 multi-fuel fired gas turbines and 5 steam turbines may withstand FO s demise. Not being atop the power purchaser s merit order list, FO based generation by KAPCO will likely decline steeply as potential 16,000MW new and cheap power capacities come online between FY However, with the recently signed Gas Supply Agreement (GSA), effective till Dec 18, KAPCO may switch majorly to LNG from hereon. We expect the ratio of FO to LNG based generation at 60:40 in FY17 to decline to 40:60 in FY18, where KAPCO would operate mostly on LNG in 2HFY18. GSA extension necessary for continued operations We expect KAPCO s GSA with SNGP for 200mmcfd gas supply to extend beyond Dec 18, courtesy government s commitment to LNG based generation, as indicated by: (i) fourth 1,200MW LNG based power plant approved, (ii) financing for 1.2bcfd RLNG III pipeline approved and (iii) 3x600mmcfd LNG terminals under consideration. Assuming GSA extends beyond Dec 18, we expect KAPCO to remain operational, whereby LNG based generation may contribute 85-88% to energy dispatches FY19 onwards. In case the GSA does not extend beyond the 1yr agreement period, we highlight KAPCO s bottom line/payouts will remain immune to low or no energy dispatches. However, timely capacity payments may be at risk amid sub-optimal utilization levels. Highest D/Y in IPP space sufficient reward for PPA expiry risk KAPCO s PPA is set to expire in FY21. The plant will have a remaining useful life of years at FY21, which strengthens the case for PPA extension of the 1,336MW IPP beyond FY21, in our view. Note, this may not be the first instance of PPA extension, where WAPDA extended Kohinoor Energy Ltd s PPA by 8 years in KAPCO offers 18.3/20.1% D/Y in FY18/19F, 9.6/11.6 ppts higher than 10 yr PIB rate. Risks include WAPDA enforcing payment of hefty liquidated damages from peak circular-debt years. ANALYST CERTIFICATION AND REQUIRED DISCLOSURES BEGIN ON PAGE 11 & January 2018 Ailia Naeem ailia.naeem@imsecurities.com.pk Ext: 306 Initiation of coverage Kot Addu Power Company Limited Price (PkR/sh) TP (PkR/sh) Stance Neutral Upside 11.6% Fwd D/Y 18.3% Total Return 29.9% Bloomberg / Reuters KAPCO PA / KAPCO.KA Mkt Cap (US$mn) m Hi-Low (PkR/sh) 84.19/ m Avg. Daily Vol ('000 shrs) 500 3m Avg. Traded Val (US$mn) 0.26 KAPCO - Valuation snapshot FY17A FY18F FY19F FY20F EPS (PRs) EPS Growth (%) 4.1% 27.1% 3.9% 4.1% PER (x) DPS (PRs) DY (%) 16.5% 18.3% 20.1% 20.1% PBV (x) ROE (%) 29.1% 33.6% 32.4% 31.1% EV/EBITDA (x) KAPCO - Price performance 1M 3M 6M 12M CYTD FYTD Absolute % 2 (21) (25) (35) 2 (24) Rel. Index % (8) (27) (21) (22) (3) (15) Index Abs. (%) 10 6 (4) (13) 5 (9) To find our Research on Bloomberg, please type - IMKP <GO>

2 Jan-17 Feb-17 Mar-17 May-17 Jun-17 Jul-17 Aug-17 Sep-17 Oct-17 Nov-17 Jan-18 Perspective Investment Summary KAPCO owns and operates a multi-fuel fired (Furnace Oil, Gas and HSD) power plant. Until FY17, KAPCO s generation has been largely FO based. Higher utilization of KAPCO s plant complex in Nov 17, while other FO based IPPs halted operations, gives a peek into the future normal, whereby the plant may withstand FO s demise by operating on an alternate fuel (LNG). KAPCO has signed 200mmcfd Gas Supply Agreement (GSA) with Sui Northern Gas Pipeline (SNGP) for 1 year till Dec 18, sufficient for the plant to operate at 60% utilization level. Upcoming LNG terminals may result in the GSA extending beyond Dec 18, in our view. As opposed to current fuel mix of FO: LNG at 60:40, the plant will likely operate entirely on LNG by FY21. Indicators for potential GSA extension, to list a few, are as follows: 1.2bcfd RLNG III pipeline to be completed by x600mmcfd LNG terminals under consideration Tariff for fourth RLNG based power plant approved, which may use only 300mmcfd upcoming LNG supply PPA expiry (FY21), however, may keep a cap on stock price performance. Formal talks for PPA extension can commence in FY19, as per PPA terms. The plant shall have at least years of remaining useful life in FY21, making a case for PPA extension. Note that a precedence has been set in 2002, when WAPDA entered into MoU with 124MW Kohinoor Energy Ltd. (KOHE) for PPA extension for 8 years. PPA extension till FY30 may result in two possible scenarios: Case I: PPA extends at existing tariff without any revision in base costs and exchange rate assumptions. (New TP: PRs103/sh) Case II: PPA extends at revised tariff with base costs and exchange rates adjusted at FY21 levels. (New TP: PRs74/sh) KAPCO offers FY18/19F D/Y of 18.3/20.1% which is 9.6/11.6 ppts higher than the 10 year PIB rate, and highest amongst the IMS IPP space, implying favorable risk-reward dynamics, in our view. Shareholding Pattern - KAPCO 35% 6% 9% WAPDA UBL Others & General Public Source: Company Accounts 10% 40% ABL KAPCO Employees Trust About the company Plant Capacity 1,600MW Technical specifications (i) 10 multi fueled gas turbines and 5 steam turbines (ii) Divided into 3 energy blocks (iii) Combined cycle technology Net Capacity 1,336MW Block-I 325MW Block-II 762MW Block-III 249MW Fuel Natural gas, LSFO and HSD Efficiency 44. Commercial Operations Jun 96 PPA Expiry 25 years (FY21) Power Policy 1994 Power Policy Fuel Supplier PSO and SNGP Source: Company Accounts, PPA Key Valuation Assumptions RfR 9% Beta 0.70 MRP 6% Cost of Equity 13% Valuation Method DDM TP (PRs/sh) 61 TP if PPA extends till FY30 Tariff TP (PRs/sh) At existing tariff 103 At new tariff 74 KAPCO Price performance 10% 0% -10% - -30% -40% -50% KAPCO KSE100 Index 2 P a g e

3 FY16 FY17 FY18F FY19F FY20F FY21F FY22F FY23F FY24F FY25F FY26F FY27F FY11 FY12 FY13 FY14 FY15 FY16 FY17 Perspective Utilization levels of KAPCO s Energy Blocks 100% 80% 60% 40% 0% Block I Block II Block III Source: Company Accounts, NEPRA KAPCO s Block I high in merit order list FO based IPPs Capacity (MW) Utilization - FY17 Liberty % KAPCO - I % NCPL % NPL % Attock Gen % Atlas Power % KEL % Narowal % Lalpir % KAPCO - II % Pakgen % Saba % HUBC 1,200 63% Gencos 2,273 40% Total 6,680 53% Source: NEPRA KAPCO may withstand FO s substitution KAPCO, the second largest IPP in Pakistan (gross capacity: 1,600MW), with 10 multi fuel fired gas turbines and 5 steam turbines may withstand FO s demise. Not being at the top of the power purchaser s merit order list, FO based generation by KAPCO may witness a steep decline (currently 60% in KAPCO s total FY17 generation) as potential 16,000MW cheap power capacities come online between FY However, with the recently signed Gas Supply Agreement (GSA) effective till Dec 18, KAPCO may switch majorly to LNG hereon. We expect the ratio of FO to LNG based generation at 60:40 in FY17 to decline to 40:60 in FY18, where KAPCO would operate mostly on LNG in 2HFY18. Liquidity situation is expected to improve as lower short-term borrowing may be required to finance cheaper fuel. Evolving power landscape Between FY17-23, planned power projects are expected to add 16,000MW (~60% of existing capacity) to the grid. Even considering an average of 65% utilization, the cheaper sources (coal and hydel) may push FO based power plants further down, and some even off, the merit order list. To put things in perspective, FO based generation is set to witness an almost certain decline, axing to at-least one-third by FY22. Unlike peer, Hub Power Co. (HUBC), which has majorly FO based capacity of over 1,500MW, KAPCO owns and operates multi-fuel fired gas turbines. Given continued gas availability, we expect KAPCO to maintain 60-62% utilization level hereon, however, with a different fuel mix. Refer to our detailed report on the FO phase-out in Pakistan for our view on the evolving power landscape. Pakistan s evolving power landscape - FO based generation set to decline MW 4,000 3,500 3,000 2,500 2,000 1,500 1, FY17 Fuel Mix KAPCO vs. HUBC 100% 80% 60% 40% 0% 77% KAPCO I (325MW) 0.4% 33% 66% KAPCO II (762MW) 1.0% 63% 37% KAPCO III (249MW) RFO HSD Gas Hydel, Company Accounts 6% 0% 94% HUBC (1500MW), NEPRA GSA with SNGP till Dec 18 just what was needed With a multi-fuel fired power plant, KAPCO has had a basic GSA with SNGP for gas supply at As and when available basis until power purchase agreement (PPA) expiry by FY21. The gas based generation by KAPCO had been as high as average 50% of the total generation, right after commercial operations in 1996, due to better availability of gas. However, by late 2000s until present, due to countrywide gas shortage, KAPCO switched largely to FO, with the fuel making 85% of KAPCO s total generation in FY As per KAPCO s management, KAPCO has amended its existing Gas Supply Agreement (GSA) with SNGP for supply of 200mmcfd gas (equivalent to approx. 800MW or 62% utilization level) till Dec 18. This may enable KAPCO to migrate from its existing fuel mix (FO: LNG was 60:40 in FY17), towards more gas based generation (FO: LNG to be 40:60 in FY18). Gas based operations has already started picking pace The gas based generation in the fuel mix of KAPCO has already started picking pace, clocking in at 37% in FY17, as opposed to last 5 year average of 10%. This has been possible post commissioning of Pakistan s first LNG terminal (600mmcfd), which came online in Mar 15. Going forward, we expect the GSA to extend beyond Dec 18, given new LNG terminals in consideration. Due to abundant availability of imported gas, this may result in KAPCO continuing operations on LNG, while other IPPs face possible risks of (i) low utilization (ii) plant shutdowns and (iii) piling up of capacity payment receivables. 3 P a g e

4 GSA extension necessary for continued operations We expect KAPCO s GSA with SNGP for 200mmcfd gas supply to extend beyond Dec 18, courtesy government s commitment to LNG based generation, as indicated by: (i) fourth 1,200MW LNG based power plant approved, (ii) financing for 1.2bcfd RLNG III pipeline approved and (iii) 3x600mmcfd LNG terminals under consideration. Assuming GSA extends beyond Dec 18, we expect KAPCO to remain operational, whereby LNG based generation may contribute 85-88% to energy dispatches FY19 onwards. In case the GSA does not extend beyond the one year agreement period, we highlight KAPCO s bottomline/payouts remain immune to low or no energy dispatches, as it does not accrue significant efficiencies. However, the capacity payments may be at risk if KAPCO s plant operates at sub-optimal levels, or halts operations. GSA extension likely, as GoP approves another 1,240MW LNG based power plant The government has recently approved tariff for the fourth 1,240MW LNG based power plant, despite pronouncedly banning further imported fuel based power projects in the face of looming power surplus. To note, approx. 3x1200MW LNG power plants (Bhikki, Balloki and Haveli) are already operational at 35-40% utilization level, being fuelled by the second 600mmcfd LNG terminal (Pak Gasport Consortium Ltd, which has sufficient capacity for operating 3 x 1,200MW plants at 70% utilization levels). Given government s commitment to the fourth 1,200MW LNG based power plant, there is higher likelihood of more LNG terminals in the medium term. Note that another 600mmcfd terminal would be sufficient for fuelling 2,400MW additional LNG based plants, after catering for fuel requirements of the fourth LNG based power plant. While all FO based IPPs may witness low demand from NTDC 80% 70% 60% 50% 40% FY17 FY18F FY19F FY20F FY21F HUBCO Base Plant HUBCO Narowal NPL NCPL KAPCO Source: Company Accounts, IMS Research Utilization Levels LNG availability may keep KAPCO operational 1 70% 100% 60% 80% 50% 40% 60% 30% 40% 10% 0% 0% F 2019F 2020F 2021F FO Gas HSD Utilization- Rhs Source: Company Accounts, IMS Research Indicators for Gas Supply Agreement (GSA) extension beyond Dec 18: Potential LNG terminals Fatima Group, Shell Gas BV, Gunvor Group Ltd and Engro Elengy Terminal Ltd Capacity (mmcfd) 600 Lucky Group, Sapphire and Halmore 600 PakGas port and Fauji Foundation 600 Total 1,800 Source: News Reports, IMS Research (i) ECC has recently approved financing plan for 1.2bcfd RLNG III pipeline (Karachi to Lahore) to be undertaken by SSGC and SNGP. (ii) Three potential LNG terminals, each of 600mmcfd, are under consideration. Reportedly, Engro is eyeing 2019 for commissioning of another LNG terminal. KAPCO S bottomline remains immune to no or low dispatch In case the GSA does not extend beyond CY18, we highlight that a decline in dispatch factors may be inconsequential for KAPCO s bottom line and payout, provided government ensures timely capacity payments. By way of background, for IPPs, dividend distributable is a function of (i) ROE component, (ii) O&M savings and (iii) Fuel savings, in case of an efficient power plant. The former two factors form 85% of the dividend distributable. In case of plant closure, IPPs shall continue to get ROE component as part of their capacity payments. However, O&M savings may be affected for 2002 Power Policy IPPs as they receive 70% of O&M payments as part of energy payments (linked to utilization level). 4 P a g e

5 Tariff Structure Capacity Purchase Price Interest Payment Principal Payment Implicit Return Fixed Cost Source: KAPCO's PPA What is a capacity trap? Energy Purchase Price Variable O&M Cost Fuel Cost For every 1,000MW of capacity that is available but unutilized, the capacity payment payable to IPPs amount to PRs10-12bn. Currently, FO based capacity stands at 6,680MW, which operated at 50% utilization level in FY17. Low dispatch implies addition of approx. PRs30bn per annum to the existing quantum of circular debt. Going forward, the build-up in circular debt due to capacity payments may reach PRs50-55bn annually. To note, only 1,000MW of FO based generation in contrast to 6,680MW of capacity may be required beyond FY21, making the government liable to pay ~5,600MW of idle capacity. This may further aggravate circular debt, reportedly hovering around PRs400bn, which has risen at a rate of PRs80bn per annum (mostly fuel payments) since one-time settlement in FY13. In this backdrop, lower dispatch factor is more likely to affect the dividend distributable for 2002 Power Policy IPPs than 1994 Power Policy IPPs like KAPCO. While low energy payments may be inconsequential for 1994 Policy Power plants bottomline, the capacity payments may be at risk. Capacity payments may be at a risk in case plant halts operations The power surplus in Pakistan may result in a capacity trap situation, where the government shall become liable to pay capacity payments for idle power plants. In this backdrop, the government may: (i) shut down inefficient FO based operations, or (ii) convert them to LNG/coal, while operating efficient plants at lower utilization levels. In either of the mentioned situations, there is a risk that the government does not honor its obligations for capacity payments in timely manner, especially to closed plants. A case in consideration is Japan Power Generation Ltd (JPGL) which has halted operations since Oct 12 due to non-availability of fuel payments from WAPDA. In turn, WAPDA has charged the company with Liquidated Damages for the shutdown period and has rejected Capacity Purchase invoices for the company. Upcoming power projects Projects Name Fuel CY18 CY19 CY20 CY21 SSRL Mine Mouth Local Coal 1320 Port Qasim Electric Company Coal Fired Imported Coal 660 Tarbela Ext 4 Hydel 1400 Neelum Jhelum Hydel 969 4,349 Engro thar Local Coal 660 Lucky Electric Local Coal 660 Siddiqson Local Coal 350 Sachal Wind Farm, Jhimpir, Sindh Wind 50 1,720 HUBCO Imported Coal 1320 HUBCO Local Coal 330 ThalNova Power Thar Ltd Local Coal 330 Thar Coal Block Power Generation Company Ltd Local Coal ,300 Karot Hydropower Station, AJK & Punjab Hydel 720 Suki Kinari Hydro power Station, KPK Hydel 870 Dasu Dam Hydel ,910 Source: NEPRA, IMS Research * Utilization for coal and hydel based plants is expected to be 70% and 50% respectively Electricity Generation Numbers (MW) Nov 15 Nov 16 Nov'17 Others RLNG Gas 2,188 1,926 1,778 FO 1,856 1, Coal Hydel 2,302 2,843 2,212 Total 6,722 6,935 7,170 Source: NEPRA FO based generation in Nov 17 - A peek into future normal As per the government s directive, FO based operations were halted in Nov 17 (an already low demand season), courtesy new coal and LNG capacities. However, KAPCO s dispatch factor doubled to 35% in Nov 17, when the dispatch by other FO based IPPs halved as compared to the same period last year. This was a result of KAPCO s fuel mix changing from 55:45 for FO: LNG in Nov 16 to 25:75 in Nov 17. Making Nov 17 generation a basis for future normal, we expect KAPCO to continue uninterrupted operations, given the flexibility of operating on gas just as well as on FO (complex fuel efficiency 44%). More LNG terminals would further strengthen our case. We have currently assumed LNG based generation to clock in at an average of 80% in FY18-21F, with plant s overall dispatches to sustain at FY17 levels i.e. 62%. 5 P a g e

6 From a public to private entity Shareholding History 1996 WAPDA divested 36% to stake to National Power of UK 2005 Another divestment of 18% to general public via IPO 2013 Strategic investor sells entire shareholding to general public Source: Company Accounts Remaining useful life of KAPCO plant complex Useful Life S. No. Fuel Type Capacity (MW) at FY21 (yrs) Gas Turbines 883 GT-1 Gas + HSD + LSFO 95 7 GT-2 Gas + HSD + LSFO 95 7 GT-3 Gas + HSD 82 7 GT-4 Gas + HSD 82 7 GT-5 Gas + HSD + LSFO 79 8 GT-6 Gas + HSD + LSFO 82 8 GT-7 Gas + HSD + LSFO 77 9 GT-8 Gas + HSD + LSFO 79 9 GT-13 Gas + HSD + LSFO GT-14 Gas + HSD + LSFO Steam Turbines 462 STG STG STG STG STG Total 1,336 Source: KAPCO s IPO Document, IMS Research Base Cost Assumptions - Existing Tariff RFO (PRs/ton) 3,195 HSD (PRs/kg) 7 Gas (PRs/mmbtu) 298 USD/PKR 34 Base Cost Assumptions - New Tariff RFO (PRs/ton) 65,793 HSD (PRs/kg) 88 Gas (PRs/mmbtu) 1,744 USD/PKR 127 Source: KAPCO s PPA, IMS Research Highest D/Y in IPP space sufficient reward for PPA expiry risk KAPCO s PPA is set to expire in FY21. The plant will have a remaining useful life of years at FY21, which makes a case for PPA extension of the 1,336MW IPP beyond FY21 insofar it is yielding cheap power. A PPA extension till FY30 with existing tariff may add PRs42/sh to our existing valuations (TP for Case I: PRs103/sh; Upside: 88%). However, if the government extends KAPCO s PPA on a revised tariff, with new base costs and exchange rates for indexation purpose, the same would result in adding PRs13/sh (TP for Case II: PRs74/sh; Upside: 36%). Note that this may not be the first instance of PPA extension, where WAPDA extended Kohinoor Energy Ltd s (KOHE) PPA by 8 years in KAPCO offers 18.3/20.1% D/Y in FY18/FY19F, highest amongst the IMS IPP Universe, and 9.6/11.6 ppts higher than 10 yr PIB rate. We believe the PPA expiry is sufficiently compensated by the attractive D/Y on offer. Pending privatization amid looming PPA expiry The PPA for KAPCO is expected to expire in FY21. The government invited potential investors to submit EOIs for its 40.25% stake in the entity; however, several issues (PPA expiry and liquidated damages outstanding worth PRs27bn) kept potential investors at bay. The privatization process may continue to face delays until and unless government issues comfort letter for KAPCO s PPA and fuel supply agreement extension beyond FY21, in our view. Formal talks for PPA extension can begin in FY19, as per the PPA terms. In case the GSA does not extend beyond Dec 18, we highlight that KAPCO s dispatches may decline in line with FO based generation. In worst-case scenario, plant shutdown may deter potential investors again. For conclusion of the privatization process, we believe LNG-based KAPCO is more likely to stay operational in the near term. PPA extension: A case in history KAPCO, despite being the largest, is not the first case in history for which PPA would be extended beyond expiry date. WAPDA entered into a MoU with Kohinoor Energy Ltd (KOHE) in 2002 to extend its existing PPA of 22 years, by another 8 years until KOHE is a 131MW FO based plant, which operated at 72% utilization level in FY17. Later on, Generation License for KOHE was also extended in 2014 to match its PPA term. Sufficient useful life strengthens case for PPA extension For KAPCO, the remaining useful life of 6 out of 10 of its multi-fuel gas turbines would vary from 7-8 years in FY21, as per management guidance. However, in terms of number of operating hours this actually translates into a useful life of years, if plant is operated at 60% utilization levels. Hence, sufficient remaining useful life makes a case for PPA extension, especially since a precedent exists in the form of KOHE. What if PPA extends beyond FY21? For PPA extension beyond FY21, there may be two possible scenarios: (I) PPA is extended based on existing tariff or, (ii) a revised tariff similar to one given to 1,320MW LNG based plant is given to KAPCO. Case I: In case of continuation of existing tariff till FY30, we expect the same to add PRs42/sh to our current valuations (Case I TP: PRs103/sh; upside: 88% on last close). Note that the upside results from extremely low base costs and USD/PKR used for indexation purpose in the tariff. Henceforth, extension of the previous tariff with revised base assumptions may result in lower valuations than our base case TP. Case II: On the other hand, if the government decides to extend the PPA with a revised tariff, we assume it would be based on revised base fuel cost and exchange rate assumptions. It would add PRs13/sh to our current valuations (Case II TP: PRs74/sh; upside: 36% on last close). PPA Expiry (PRs/sh) Base Case (FY21) FY26F FY28F FY30F Case I - Old Tariff (TP) Upside from LDCP 12% 62% 77% 88% Case II - New Tariff (TP) Upside from LDCP 12% 30% 33% 35% 6 P a g e

7 Attractive D/Y of 18.3% on offer! KAPCO has maintained a payout of 85% in last 5 years on average. In FY17 too, KAPCO paid out PRs9.05/sh, in line with its historical payout trend, in contrast to other IPPs, which curtailed dividends due to burgeoning circular debt (oil price up 18%YoY in FY17), or expansion, in case of HUBC. The scrip has already priced in the negatives, in our view, and offers 18.3/20.1% D/Y in FY18/FY19F, highest amongst the IMS IPP Universe, and 9.6/11.6 ppts higher than 10 yr PIB rate. The low probability risk of PPA expiry is sufficiently compensated by the attractive D/Y on offer, in our view. FY18F Dividend Yield is 9.6 ppts higher than the 10 year PIB rate KAPCO s payout ratio has historically been second only to HUBC s KAPCO 80.0% 89% 12% HUBC 80.0% 107% 8% NCPL 40.0% 72% 12% 10% 9% 18% NPL 40.0% 60% NPL NCPL HUBC KAPCO 10Yr PIB IMS Average Source: Bloomberg, IMS Research 0% 40% 60% 80% 100% 1 Avg. (FY18-FY20F) Avg. (FY15-FY17) Source: Company Accounts, IMS Research Bid for longevity through HUBC acquisition fell apart In a recent development, KAPCO bid for 17.37% stake in HUBC, as the latter s sponsor Dawood Hercules is looking to sell its 14.9% stake in the IPP, but this was put on hold. Among initial plans, KAPCO was looking to finance the acquisition (US$200mn at bid price of PRs109 per share of HUBC) majorly through debt. Had the transaction transpired, KAPCO would have overcome its major concerns on longevity as HUBC s expansion projects would have stretched cash flows to 2050; however, this would have come at the cost of lower earnings, trimmed dividends, and out pressure on cash-flows (more circular debt in the near term). While KAPCO s major sponsor, WAPDA, approved the deal, we understand the GoP expressed reservations about a state-owned entity acquiring an FO based power plant, especially when GoP is aiming to rationalize FO based generation in the country. Based on that premise, we rule out KAPCO reinitiating the process in future. Given that the deal fell apart, KAPCO has again revitalized its aim for PPA extension and is thus counting on GSA extension and GoP s paradigm shift for a stronger case than before. 7 P a g e

8 Key Valuation Assumptions RfR 9% Beta 70% MRP 6% Cost of Equity 13% Valuation Method DDM TP (PRs/sh) 61 Valuation We have valued KAPCO using DDM method, whereby we have assumed a 30% haircut on equity portion received by the shareholders. Our TP of PRs61/sh implies an upside of 12% on last close (Neutral), while PPA extension is a potential upside to our base case valuations. Valuation Matrix Case I: If PPA extends beyond FY21 at existing tariff FY18F FY19F FY20F FY21F FY22F FY23F FY24F FY25F FY26F FY27F FY28F FY29F FY30F DPS (PRs) Present Value (PRs/sh) Equity Value (PRsmn) 44,851 54,941 58,464 62,935 PV of Equity Value (PRsmn) 30,909 20,363 16,904 14,200 PV of Equity Value (PRs/sh) Target Price (PRs/sh) Case II: If PPA extends beyond FY21 at new tariff FY18F FY19F FY20F FY21F FY22F FY23F FY24F FY25F FY26F FY27F FY28F FY29F FY30F DPS (PRs) Present Value (PRs/sh) Equity Value (PRsmn) 44,851 50,308 52,521 54,983 PV of Equity Value (PRsmn) 30,909 18,645 15,185 12,406 PV of Equity Value (PRs/sh) Target Price (PRs/sh) P a g e

9 Risks Downside Risks: (i) (ii) (iii) Surplus capacity risking PPA extension: We expect approx. 7,000MW coal based and 8,000MW hydel based capacities to add to the national grid by FY23, with the former coming online at a more rapid pace between FY19-FY21. If the new capacities start operating above 70% by FY21, coal based generation (Cost per KWh FY17: ~PRs4.0) may risk KAPCO s LNG based operations (Cost per KWh FY17: ~PRs7.5) to extend beyond FY21. However, note that coal based generation has environmental risks associated with it, while hydel based generation is prone to water availability and seasonal issues. Higher utilization of 3x1200MW LNG plants may cause gas supply issues: If the 3x1200MW LNG plants, which have operated at 30-40% utilization levels in 1HFY18, start operating at higher utilization levels i.e. at 70%, KAPCO may have gas availability issues, as the existing agreement is for as and when available gas supply. It may have to revert to FO based generation until new terminals materialize, risking continued operations. Spike in oil prices: The international oil prices have increased by 18%YoY in FY17 and continue to rise, having recently touched their 3 year high. With LNG price linked to Brent, and new coal capacities (2,400MW Sahiwal and Port Qasim) past their gestation stage, the plant s dispatch may again be at risk. As highlighted earlier, the clearing of outstanding receivables from NTDC would be directly proportional to the IPP s rank in the merit order, in our view. (iv) Liquidated Damages: WAPDA has claimed liquidated damages of PRs27bn (60% of equity value in FY21) for FY09-FY16 due to KAPCO s failure to dispatch electricity. This issue will be resolved through arbitration, where we highlight all recent cases have come in favor of Pakistan IPPs. Our valuations do not incorporate a deduction of the same from KAPCO s receivables at PPA expiry. Upside Risks: (i) (ii) (iii) (iv) Delays in Hydel capacities: Any delay in upcoming hydel capacities (8,000MW) may make PPA extension more appealing for the government. LNG terminals: Financial close of any LNG terminals and the prospect of abundant LNG supply may strengthen case for GSA extension and may bring the scrip in limelight. Lower circular debt: Any potential agreement with KAPCO to bring its existing billing cycle of 60 days closer to that of IPPs with SNGP (10 days) hints towards better liquidity situation. The government has directed to reconsider these anomalies for 4 IPPs which were earlier operational on a mix of HSD and LNG, and have recently been allocated 40mmcfd gas each, on as and when available basis. PPA extension: If the gas availability issue resolves, materialization of PPA extension in FY19 is also a potential upside risk. KAPCO s management will have a stronger case to push to WAPDA and the government. 9 P a g e

10 Jul-08 Jul-09 Aug-10 Sep-11 Sep-12 Oct-13 Nov-14 Nov-15 Dec-16 Jan-18 Jul-09 Jan-10 Jul-10 Feb-11 Aug-11 Mar-12 Sep-12 Mar-13 Oct-13 Apr-14 Nov-14 May-15 Nov-15 Jun-16 Dec-16 Jul-17 Jan-18 Perspective KAPCO - Valuation Summary Profit & Loss Account (PRsmn) FY16 FY17 FY18F FY19F FY20F Net Revenue 64,178 81,847 65,315 52,927 57,465 Cost of sales 50,770 67,667 48,567 35,837 39,509 Gross profit 13,408 14,180 16,748 17,090 17,957 Admin & Selling Exp EBITDA 19,143 20,778 23,243 21,523 21,983 Dep & Amortization 2,143 2,125 2,109 2,092 2,088 EBIT 16,999 18,653 21,134 19,431 19,895 Financial Charges 3,237 4,425 2,907 1,581 1,327 Other income 4,041 4,991 5,095 3,130 2,832 Other charges Profit before Tax 13,683 14,073 18,193 17,817 18,547 Taxation 4,612 4,626 6,186 5,345 5,564 Net Profit after Tax. 9,071 9,447 12,008 12,472 12,983 Key Ratios FY16 FY17 FY18F FY19F FY20F EPS (PkR) EPS Growth (%) 15% 4% 27% 4% 4% PER (x) P/S (x) BVPS (PRs) PBV (x) DPS (PRs) DY (%) 16% 17% 18% ROE (%) 30% 30% 35% 34% 32% ROA (%) 10% 9% 12% 17% D/E (%) 198% 257% 126% 56% 43% EBITDA Margin 30% 25% 36% 41% 38% Gross Margin 21% 17% 26% 32% 31% Net Margins 14% 12% 18% 24% 23% Balance Sheet (PRsmn) FY16 FY17 FY18F FY19F FY20F Non-Current Assets 12,756 11,047 10,048 8,685 7,324 Total Current Assets 79, ,953 73,056 55,353 57,818 Total Assets 92, ,001 83,104 64,039 65,143 Share capital 8,803 8,803 8,803 8,803 8,803 Reserves 21,708 23,256 26,461 29,251 32,551 Surplus on revaluation of F.assets Total Equity 30,955 32,503 35,708 38,497 41,797 KAPCO - Dividend yield trend 25% 15% 10% 5% Long Term Debt Total Non current Liabilities 2,942 2,203 2,203 2,203 2,203 DY (%) Mean (%) Short term Debt 41,346 46,133 26,126 7,939 2,873 Total Current Liabilities 61,255 83,497 45,105 21,725 18,032 Total Liabilities 64,197 85,700 47,308 23,928 20,234 KAPCO - PER (x) Band FY18F PRs (x) Cash Flow Statement (PRsmn) FY16 FY17 FY18F FY19F FY20F CF from Operating Activities 494 4,613 31,452 24,612 15,353 CF from investing Actitivities , CF from Financing Activities 14-3,723-29,221-27,870-14,749 Change in cash ,379-2,495 1,353 cash at beginning ,008 1,513 2, Cash at end of year 299 1,062 7, , P a g e

11 I, Ailia Naeem, certify that the views expressed in the report reflect my personal views about the subject securities. I also certify that no part of my compensation was, is, or will be, directly or indirectly, related to the specific recommendations made in this report. I further certify that I do not have any beneficial holding of the specific securities that I have recommendations on in this report. Ratings Guide* Upside Buy More than 15% Neutral Between 0% - 15% Sell Below 0% *Based on 12 month horizon unless stated otherwise in the report. Upside is the percentage difference between the Target Price and Market Price. Valuation Methodology: We use multiple valuation methodologies in arriving at a Target Price including, but not limited to, Discounted Cash Flow (DCF), Dividend Discount Model (DDM) and relative multiples based valuations. Risks: Please refer to page 9. Disclaimer: Intermarket Securities Limited has produced this report for private circulation only. The information, opinions and estimates herein are not direct at, or intended for distribution to or use by, any person or entity in any jurisdiction where doing so would be contrary to law or regulation or which would subject Intermarket Securities Limited to any additional registration or licensing requirement within such jurisdiction. The information and statistical data herein have been obtained from sources we believe to be reliable where such information has not been independently verified and we make no representation or warranty as to its accuracy, completeness and correctness. This report makes use of forward looking statements that are based on assumptions made and information currently available to us and those are subject to certain risks and uncertainties that could cause the actual results to differ materially. No part of the compensation of the author(s) of this report is related to the specific recommendations or views contained in this report. This report is not a solicitation or any offer to buy or sell any of the securities mentioned herein. It is meant for information purposes only and does not take into account the particular investment objectives, financial situation or needs of individual recipients. Before acting on any information in this report, you should consider whether it is suitable for your particular circumstances and, if appropriate, seek professional advice. Neither Intermarket Securities Limited nor any of its affiliates or any other person associated with the company directly or indirectly accepts any liability whatsoever for any direct or consequential loss arising from any use of this report or the information contained herein. Subject to any applicable law and regulations, Intermarket Securities Limited, its affiliates or group companies or individuals connected with Intermarket Securities Limited directly or indirectly may have used the information contained herein before publication and may have positions in, or may from time to time purchase or sell or have a material interest in any of the securities mentioned or may currently or in future have or have had a relationship with, or may provide investment banking, capital markets and/or other services to, the entities mentioned herein, their advisors and/or any other connected parties. 11 P a g e

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