ESCALATING free cash flow and prospects for expansion at home and abroad have put the spotlight on the local power sector.
Free cash flow is a measure of financial performance calculated as operating cash flow minus capital expenditure plus disposal of assets.
ECM Libra Securities Sdn Bhd is bullish and overweight on the power sector despite the recent regulatory issues on tariffs.
“The Malaysian power industry is in a relatively good standing going into 2006. We expect a strong build up of positive catalysts over the next 12 months to drive robust sector performance,” research analyst Lucius Chong said.
According to Chong, a clear trend was that all players in the sector have begun generating stronger cash flows, after coming off a period of investment either in new capacity or acquisitions.
Of particular significance is Tenaga Nasional Bhd, which has consistently been in negative territory but has moved to positive free cash flow since 2004.
“This is positive for dividends and balance sheet potential for acquisitions, going forward. We have already seen even Tenaga, together with Malakoff Bhd, take a small but meaningful stake in the US$2.5bil water desalination and power project in Saudi Arabia,” he said.
Although the equity commitment for Tenaga’s effective 6% stake was only RM157mil, it was the utility’s first venture overseas since the Asian financial crisis, reflecting a growing confidence on the back of a foreseeable stronger balance sheet.
“YTL POWER INTERNATIONAL BHD stands in the best situation while Malakoff will go from negative free cash flow to positive by 2008 because of the capital commitment of the RM7bil Tanjung Bin plant.
“All three players in the power sector can look forward to investment opportunities both overseas and at home at a time when their balance sheets are getting stronger,” Chong said.
He believes Indonesia would provide a good investment opportunity for the local power players.
“Indonesia drastically needs investment in new power capacity and the power players can play an active part.
“Vast potential lie in future plant-up requirements there. The Java-Bali grid is effectively running at a reserve margin of 8% and the Indonesian government needs to urgently execute US$5.9bil worth of power projects to ensure a reliable amount of supply going forward,” he said.
The Middle East is also another avenue of growth and a potential for strategic relationships, Chong noted.
Mayban Research analyst Tursina Yaacob expects power companies, especially the independent power producers (IPPs) to seek overseas investments, given the limited opportunities to grow earnings locally.
“However, the participation of Tenaga and Malakoff in Saudi Arabia’s water desalination and power plant project has failed to excite the market. Earnings contribution is not expected to be significant in the next few years.
“For Tenaga, a tariff hike and an increase in economic activities would boost revenue but earnings could fluctuate since the company is exposed to a large amount of foreign loan,” she said.
Chong said the immediate growth driver for Tenaga's earnings was the run down on excess capacity.
“The only two big capacity additions over the next five years are 2,100MW from Tanjung Bin in Johor and 1,400MW from Jimah in Port Dickson, totalling 3,500MW.
“Peak demand for power grows at a pace of 1,000MW a year – so demand will outstrip supply. The prime beneficiary of this is Tenaga since it is the sole bearer of excess supply,” he said.
For the IPPs, however, run down of the reserve margin would be an indirect growth driver.
Chong expects Tenaga to start planning for the next round of capacity, which would invariably involve the IPPs next year.
In order for new capacity to kick-in in 2010 and to keep the reserve margin above the minimum required level of 20%, Chong reckons the award of new contracts should begin next year, to give a three-to four-year lead time for the next cycle of plant ups.
“If power demand remains sustainable at 7% to 9% per annum, the power sector is assured of continued expansion. However, it remains to be seen how robust electricity demand will be,” he said, adding that traditionally, the rule of thumb has been 1.2 times gross domestic product growth.
Chong prefers YTL Power for its valuations and visibility in earnings, followed by Tenaga, for its beta and leverage in structural improvement.
“Malakoff, in comparison, looks fully valued at these levels without many catalysts on the table,” he said.
Tursina has recently upgraded YTL Power to a ‘buy’ given its compelling valuation.
“The full impact of its investment in Jawa Power and the increase in its British utility Wessex Water’s tariff by 12% are expected to be reflected in earnings for the year ending June 30, 2006,” she said.
Tenaga remains a ‘hold’ for the research house due to its relatively unattractive valuation.
“Nevertheless a re-rating of the stock is expected with any announcement of an electricity tariff increase,” Tursina said. Mayban is neutral on the sector.
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