Analysts' Recommendation

ECM Libra: YTL Power in growth, yield and M&A BUY

ECM Libra, 2 March 2005

 

YTL Power International: Power in growth, yield and M&A 

By Ong Chee Ting

 

Recommendation: BUY

Target Price: MYR2.44

 

- Global utility offers growth, yield and M&A, backed by RM4bn war chest

- Expect CAGR of 16% for EPS over next 3 years

- Initiate coverage with Buy, RNAV of RM2.44 as price target

 

Global utility offers growth, yield and M&A, backed by RM4bn war chest

As a home grown global owner-operator of utilities, we believe YTL Power International (YTLPI) offers investors a very unique combination of robust earnings growth, rising and attractive dividend yield and a strong balance sheet (read RM4bn war chest) capable of returning handsome acquisitive growth. Importantly, unlike its local peers which are just beginning to explore opportunities abroad, YTLPI already has an impeccable track record in acquiring and enhancing growth.

 

Expect CAGR of 16% for EPS over next 3 years

The combination of Wessex’s water tariff hike and contributions from recently acquired PT Jawa Power (PTJP) are the key drivers of YTLPI’s net profit growth of 20%, 24% and 7% for FY05, FY06 and FY07 respectively or a 3-year CAGR of 16%. Assuming a sustainable dividend payout of about 50%, we believe the stock will return dividend yield of 5.7%, 7.0% and 7.5% over the next three years from FY05.

 

Initiate coverage with Buy, RNAV of RM2.44 as price target

We believe YTLPI shares should be valued at its RNAV of RN2.44, with further upside to be had from future M&A opportunities. In PE terms, YTLPI deserves a premium over the market given its global reach and superior EPS growth, relative to the market, both in terms of quantum and visibility. We initiate coverage on YTLPI with a Buy recommendation.

 

Global utility player worthy of premium valuation

Management has proven its capabilities in managing foreign acquisitions not only in one but three overseas acquisitions thus far over a span of five years. This is a testament of YTLPI management’s business acumen that few Malaysian corporations can boast or successfully emulate. Though management explains that its strategy is simple; right price at the right time. In reality this is far from simple. It requires discipline, patience, vision and timely execution. Importantly, these acquired units are all independently funded and without recourse to YTLPI.

 

With gross cash reserves of approximately RM4billion and a net gearing ratio of only 1.3x shareholders’ funds, there is room for further acquisitions without over-stretching its book. Assuming all these cash reserves were utilised for acquisitions, net gearing ratio will only reach 2x shareholders’ funds. For comparison purpose, it may be worthwhile to note that Malakoff’s net gearing will approximate 1.9x shareholders’ funds by end FY05.

 

Wessex Water and PT Jawa Power are two key drivers of growth

The combination of Wessex Water’s (Wessex) water tariff hike and contributions from recently acquired PTJP will be the main key growth drivers for YTLPI over the next few years. YTLPI’s net profit is set to grow by 20%, 24% and 7% for FY05, FY06 and FY07 respectively. This translates into a CAGR of 16% over the next three years.

 

Oftwat’s final price determination to 2010 set to boost earnings

On 3 Dec 2004, Ofwat (the UK water regulator) published a final set of price limits for the period 2005-10 (refer to www.ofwat.gov.uk) for the entire water industry in UK. This final price determination for Wessex averages 5.2% above inflation over the next five years.

 

The higher price set by Ofwat was the result of a detailed assessment of Wessex’s past performance and their future investments needs while setting new efficiency targets to be met by Wessex. The capital expenditure expected to be incurred over the next five years totals GBP755m or averages GBP151m per annum.

 

The fact that Wessex is the most efficient water and sewerage company in the UK mitigates the risk that it may not achieve the efficiency improvements set by Ofwat.

 

(Note that we have assumed an exchange rate of RM7.20:GBP1.00 in arriving at our earnings forecast for FY05 and beyond. We estimate that 1% change in GBP for FY06 and FY07 will result in 0.6% and 0.7% change in YTLPI’s net profits respectively.)

 

PT Jawa Power’s acquisition is value enhancing, and just the first move?

YTLPI has on 10 Dec 2004 completed the acquisition of a 35% stake in PTJP and its USD17.1m loan stocks for a total consideration of USD139.4m (or RM529.7m @ RM3.80:USD1.00). This acquisition is value enhancing to the shareholders of YTLPI as PTJP was acquired at a PE ratio of below 4x (based on PTJP 2003’s net profit of USD110m), which more than compensates for regulatory risks in a developing country like Indonesia.

 

We understand from management that this acquisition is estimated to contribute approximately RM85.5m to YTLPI for the six months period ending 06FY05. At RM85.5m, this translates to a significant 12% share of FY05’s earnings (before financing cost). For FY06, we forecast earnings contribution to approximate 19% of earnings; representing PTJP’s full year’s contribution.

 

With this first investment, we believe YTLPI is looking to invest at other energy opportunities in Indonesia given the low and falling reserve margin in that country. Frequent power outages is a common phenomenon in Indonesia as the nation continues to register healthy economic growth with peak demand growing at least 7% p.a.. As Indonesians are hungry for more power, government is luring more foreign investments into this area. Regulatory risk is therefore mitigated by current “pressing” circumstances as any unnecessary changes to the power purchase agreement (PPA) will be viewed negatively by investors.

 

YTL Power Generation, the stable cash cow within YTLPI to provide the necessary cash for further acquisition

YTL Power Generation (YTLPG) is the 1st Independent power producer (IPP) awarded by Tenaga in 1993 and it is the only IPP in Malaysia to be awarded a minimum take-or-pay quantity scheme under its PPA.

 

Under YTLPG’s minimum take-or-pay quantity scheme, the company is obliged to deliver 7,450 Gwh per annum of electricity to Tenaga, which represents about 70% of the combined capacities of both plants (1,212 MW) at full-load operations vs historical availability of YTLPG’s power plants averaged above 90%.

 

Under this scheme, YTLPG will receive a constant stream of revenue approximating RM1.1b per annum while generating approximately RM500m in annual operating cash flow.

 

A while ago, the market was slightly concerned that the much talked about industry wide restructuring may jeopardise the terms of the existing PPA of IPPs. We believe YTLPG is not impacted as its PPAs with Tenaga belongs to one of the 1st generation PPAs, which are generally immune from such potential industrial restructuring scheme (unlike 2nd and 3rd generation IPPs). In short, these 1st generation PPAs do not have provision for renegotiation of terms and conditions, and so, YTLPG will neither gain nor lose in the event of an industry wide restructuring.

 

Consistently attractive dividend yield an added sweetener while share buyback to provide price support

Despite having achieved sterling net profits CAGR of 12% for the period 2000-04 via various acquisitions, YTLPI has always been mindful of shareholders’ welfare - paying generous dividends to reward shareholders. Over the last 5 years, dividend yield has been in the region of 3.9% to 7.3%.

 

Current dividend payout is approximately 50% of yearly net profit. This translates to a dividend yield of 5.7%, 7.0% and 7.5% over the next three years from FY05.

 

In mid FY05, YTLPI paid a special dividend-in-specie of 1 treasury shares (from past share buyback programme) for every 25 ordinary shares held. This translates to a 4% yield. Coupled with an estimated final cash gross dividend yield of 5.7%, total yield for the year approximates 9.7%.

 

Growth opportunities - Catalysts for re-rating

We list below some of the possible catalysts for re-rating:

1. News has it that YTLPI has been short-listed as one of the six bidders for Intergen’s power plants in the UK, the Netherlands, Mexico, Southeast Asia, China and Australia. Should YTLPI’s bid turn successful, we could potentially see greater earnings growth.

2. Another potential source of growth for YTLPI is via the acquisition of additional equity stake in PTJP. Currently at 35%, YTLPI looks to expand its interest if the terms are right. The balance of the equity is currently held by Siemens (50%) and Bumipertiwi (15%).

3. Besides PTJP’s investment, YTLPI’s entry into the Indonesian market has accorded it with other opportunities at a time when the Indonesian government is luring foreign investors to take up stakes in various projects with an estimated total project value of USD23b up for grab. Having an early presence in Indonesia certainly has its advantages.

4. On the local front, the management has indicated its interest in participating in the privatisation of Malaysian water project if opportunity arises. Given its extensive water experience (via 100% owned Wessex), YTLP is seen as a front-runner and thus a potential beneficiary in Malaysia’s water privatisation project.

5. We do not discount the possibility of a new supplementary agreement with Tenaga in view of lower reserve margin going into 2006. Currently reserve margin stands at approximately 40%-45% but this is expected to drop to approximately 32% in 2006-07. The last supplementary agreement awarded by Tenaga to YTLPI was on 17 Jan 2001 where YTLPG agreed to sell additional 1,400 Gwh p.a of electricity to Tenaga at a fixed selling price of 10.90 sen/Kwh for 3 years to 31 Dec 2003. This could potentially add approximately RM50m p.a. profits to the bottom line should a similar term to that of the earlier supplementary agreement be awarded to YTLPG.

 

Valuation and recommendation

We initiate coverage on YTLPI with a Buy recommendation. Our target price of RM2.44 is pegged to YTLPI’s RNAV and are further supported by the following compelling reasons:

(i) sum-of-parts valuation at RM2.44 per share

(ii) share buyback programme which will provide strong price support,

(iii) attractive dividend yield of 5.7%, 7.0% and 7.5% over the next three years from FY05 which will also provide limited downside,

(iv) CAGR of 16% for EPS,

(v) proven global utility player with strong management that is worthy of a premium valuation, and

(vi) potential M&A play.

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