Elixir Securities Limited – Elixir Insight

Karachi, December 06, 2017 (PPI-OT): Pakistan IPPs Sector – Fuel Efficiencies to Evaporate as Utilization Levels Fall for Nishat IPPs

Following up on our detailed power sector report, we have incorporated changes in Nishat IPPs pertaining to falling utilization levels on furnace oil.

New capacity additions to the grid will reduce utilization levels for NPL/NCPL to 37.2% by FY19 from 76.4% in FY17.

This will eliminate roughly 28% of fuel savings and 18% of operational savings for both companies.

Resultantly we expect PKR3.0/4.0 in dividends for NPL in FY18/19 and PKR2.0/4.0 in dividends for NCPL in FY18/19.

We maintain a BUY call for NPL based on a revised PT of PKR35/share after rolling over our valuation to Dec-18. This results in 27.7% total potential upside (including 10.1% leading dividend yield).

We also maintain our BUY call on NCPL based on a revised PT of PKR33/share after rolling over our valuation to Dec-18. This results in 25.0% total potential upside from last close (including 7.1% dividend yield).

14,316MW Capacity Additions will Substitute RFO Plants: As outlined in our previous report “What Lies Ahead for IPP’s, OMC’s and Refineries” on 27th November 2017, we see 14,316MW of capacity additions to the grid till FY19. These will cause utilization levels for all RFO plants to decline with the most efficient (Tier 1) RFO plants running at only 30.1% utilization by FY20.

This poses a significant downside risk for Nishat Power (NPL) and Nishat Chunian Power (NCPL) as both plants have benefited from fuel, operations and maintenance related savings in the past.

We have forecasted the following utilization levels for these plants based on rationale already discussed in our previous report.

NPL and NCPL Derive Significant Cash Earnings from Savings on Fuel and Operating Expenses: NPL and NCPL derive on average 28% savings on account of fuel (as a % of reported earnings) and 18% savings on average on operations and maintenance expenditures. We see fuel savings going down as utilization levels fall. Since ~70% of operations and maintenance revenue is variable, we see this as a diminishing source of savings as well for both plants.

Finishing of Third Party O and M Contracts Has Worsened Earnings Quality Already: Historically IPP earnings have not reflected cash flows due to tariff anomalies e.g. debt servicing component is included in revenue but not in costs, which raises earnings artificially. End of NPL and NCPL’s third party operations and maintenance contracts has further reduced earnings quality. Previously plant capital expenditures were expensed off as these were incurred by the O and M contractor which was paid a regular fee under the “O and M Fee” head. However compared to FY16, NPL’s earnings remained flat despite a drop in both fuel savings and O and M savings. This is due to the shift in plant upkeep costs from “O and M Fee” (which is expensed of) to capital expenditure (which are capitalized). As a result earnings remained flat while capex rose 110% in FY17.

As the plants age further and capex rises for NCPL, declining O and M savings will not be reflected completely in earnings, increasing the disparity between earnings and dividends even further.

Earnings for NPL and NCPL Expected to Rise By CAGR’s of 4.6% and 7.4% Respectively over FY16-FY20, Dividends to Remain Flat: We see a slight rise in earnings for both companies going forward despite elimination of fuel and operational savings due to the aforementioned point on capital expenditures. We expect dividends for both companies to remain at PKR4.0/share give or take. Company wise distortions exist due to slight differences in thermal efficiency and operational expenditures. NPL has higher wage costs due to which the earnings CAGR is lower.

Plant Shutdown Post FY21 Raises Concerns Over Delayed Capacity Payments: Transmission and Distribution losses, electricity theft, under recovery of bills and delayed tariff notifications for DISCOs leads to circular debt build up. Payments have historically been delayed for IPPs with varying rates of receivables build up depending on the company. While we do not believe capacity payments (CP) will be withheld indefinitely, plant shut down reduces the urgency of making payments to power producers as slower payments do not contribute to any electricity short fall (for closed plants).

The rising circular debt situation has already affected NPL and NCPL, both of which saw a 50% and 70% reduction in dividends respectively in FY17 compared to FY16. Therefore we have built in an additional 1.0% risk premium to our Cost of Equity, raising it to ~14.0%.

Complete Halt in Capacity Payments is Unlikely as Payments will Drop Beyond FY21: We have looked at 13 Gas and RFO based IPPs incorporated under the 2002 Power Policy which started their operations in 2010-11. While their current capacity payments include debt and interest servicing components, these will end by FY21, which will reduce aggregate capacity payments from PKR48.3bn to PKR19.0bn. This will reduce these plants capacity payments share from 21% to 4.1% (FY16 capacity payment charge for NTDC area was PKR230bn and we see additional capacity payments of PKR260bn for new additions). A relative reduction in capacity payments for these plants beyond FY21 drastically reduces the probability of complete halt in payments for NPL and NCPL.

Valuation: We maintain a BUY call for NPL based on a revised PT of PKR35/share after rolling over our valuation to Dec-18.This results in 27.7% total potential upside (including 10.1% leading dividend yield).

We also maintain our BUY call on NCPL based on a revised PT of PKR33/share after rolling over our valuation to Dec-18. This results in 25.0% total potential upside from last close (including 7.1% dividend yield).

We have incorporated a 1.0% risk premium above our CAPM based Cost of Equity on account of risks to capacity payments post plant closure.

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