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Tuesday, April 17, 2007

TENAGA - Quick Comments on Q2/07 Result

TENAGA posted its quarterly earnings results last night. PAT (Profit After Tax) for Q2/07 (Financial Year ending 31 Mar) was a mind-boggling $1.6B, compared to just $0.4B same period last year. On the surface, $1.6B is a huge number. For example, PBBANK reported a comparble $1.7B PAT but for the entire 2006 Financial Year, not 1 quarter. So, I suspect the market will react quite positively (perhaps irrationally) to cheer the latest TENAGA set of results, at least initially.

However, before we all rush out and buy TENAGA and its warrants, it is important to examine if these set of results are sustainable or not, whether the good results have been priced in fully (or not), and if not, what should be a reasonable long-term earnings and Intrinsic Value for TENAGA, based on what we know of TENAGA's business today. I am afraid this means that I need to pour some really cold water on TENAGA's latest hot, hot Q2/07 results first ...

1. Extraordinary currency gains. The $1.6B PAT includes approximately $430M of currency gains which requires some caution in interpreting. It is clear, this currency gain is not expected to be repeated perpetually in future. Yet, there is some expectation that going forward, at least for the next few quarters, that RM will continue to appreciate relative to USD, and TENAGA should be able to continue to benefit somewhat from this trend, due to its relatively high USD debt. For conservativeness, I think taking into account say 10% of the currency gain is probably a closer reflection to a reasonable PAT, than taking into account 100% of the currency gain.

2. Extraordinary tax write-back. In the last 2 quarters for FYE2007, TENAGA has written back approximately $170M worth of deferred tax to reflect the lower tax rates expected in FYE 2007 and 2008. Again, these are not expected to continue to benefit TENAGA perpetually in future, but has a very limited lifetime.

3. Tanjong Bin. The latest set of results, which ended 28 Feb 2007, has not yet reflected the recent commissioning of the second unit of the Tanjung Bin power plant on 28 Feb 2007. As stated in the news recently, we know that one of TENAGA's problems is its excess capacity payments to IPP. For FYE 2007, it is hard to put a precise figure on how much of Tanjung Bin's excess capacity could be actually utilized, but once the unit is commissioned, real costs can be expected to incur. TENAGA expects to incur costs of approximately $700M over the next 2 quarters. In terms of estimating future long-term earnings, it is not unreasonable to prudently assume a percentage, such as 50%-75% (say 67%) of that amount as being a true loss, as quite likely, it will take several years before TENAGA's present excess capacity can come close to being fully utilized in future. Note that 67% is just a rough and ready approximation, I expect the actual loss to be bigger in the immediate quarters (e.g. 100% on Day 1 of commissioning), and gradually reducing over time (e.g. 20%-40% after several years?).

4. Planned land bank sales, recovery of dilinquent accounts. At the start of the year, TENAGA announced that they planned to gain approximately $400M by FYE2007. For Q1/07, they gained $92M, close to $100M per quarter. I have not yet seen the figure for Q2/07. It is probably prudent to assume that there is some gains included in the latest set of results, leaving another $200M to be gained in the next 2 quarters. If it was nil in Q2/07, then, that should be a positive surprise. Again, it is unclear if these set of earnings are sustainable in the long term.

5. Potential additional revenue from 9MP, EGAT, etc. Higher electricity demand arising from the 9th Malaysia Plan projects as these continue to be rolled out. This is over-simplifying it, but steel companies are well known to consume huge amounts of energy in their manufacturing processes. It is hard to put a precise figure on the % increase in revenue that this would translate to TENAGA over the next year or two, but for the moment, it is probably enough to know that the potential additional revenue are more real than a dream.

So, what does this mean to TENAGA long-term sustainable EPS? Let's take a closer look at its historical results (in black). I have projected this to the end of 2007 FY, and the assumed inputs are in blue. In coming up with the projected values, I have tried to adhere to Buffett's principle that "it's better to be approximately right than precisely wrong" ... in other words, I know that my projections are precisely wrong, but the final EPS answer to be close enough to serve as a guide to TENAGA's intrinsic value.

A. Revenue.
It is comforting to see that TENAGA's revenue has been steadily increasing in the last 10 quarters, with a hike in Q4/06 (13%) due to the higher electricity tariff that came in at the start of the quarter. In the absence of fundamental changes (like tariff hike), a steady growth can be expected for TENAGA revenue due to natural GDP growth. So, for Q3/07, I would expect TENAGA revenue to continue to grow at a high rate (vs Q3/06). Then, for Q4/07, for the growth to slow down (as the impact of higher tariff rates are neutralized), but still slightly higher than past natural growth rates due to 9MP. So, I believe my projected revenue growth of 14% and 6% for Q3/07 and Q4/07 are not unreasonable.

Since the revenue for Q3/07 is close to Q2/07, I have made some adjustments to Q2/07 PBT to derive a suitable long-term, sustainable gross earnings, in order to value TENAGA's business more appropriately. Specifically, I have made adjustments to TENAGA's one-time forex gains and deferred tax write-back as noted in points 1 and 2 above, as well as Tanjung Bin's extra costs (as noted in point 3 above). More specifically, $860M = $1,651 - $430M (forex gains) - $170M (tax write-back) - $350M x 67% (Tanjung Bin loss) + $43 (10% forex gain). On the surface, this looks conservative since $860M is only a bit more than half of the recent fantastic result of $1.6B PBT ... but since our focus is on long-term sustainable earnings for TENAGA, I believe a figure like $0.9B-$1B is probably closer to the truth, than assuming the entire $1.6B PBT.
C. Tax rates.
We saw low tax rates for Q1/07 (7%) and Q2/07 (5%) due to the one-time deferred tax write-back. I am not an accountant by training, but I suspect, going forward, one can reasonably expect the write back to continue for the next 2 quarters. However, long-term, one should not expect future write-backs to continue perpetually. For Q2/07, I noted that tax was $242M, and write-back is $165M or approximately 2/3rds, i.e. if one strips out the write-back, the tax should be roughly 3 times bigger. So, I have assumed tax rates of 15% (= 3 x 5%). I use this instead of 27% (or 26%) tax rates as certain expenses incurred by TENAGA are probably tax deductible, and it is impossible for me as a lay person, to do a full estimation, and probably not worthwhile too. I suspect this assumption is quite debateable.
Based on the above methodology, I obtain an EPS of around $0.35 for H2/07 that factors in points 1, 2, 3, and some of point 5, and ignored point 4. Full year sustainable EPS is probably closer to $0.70, instead of $1.00 if one just adds up the full 2007 FY EPS.
Intrinsic Value Estimation.
To me, TENAGA is a consumer monopoly (no competitor) whose revenue, in normal circumstances, can be reasonably expected to grow at least, in line with GDP rates. Whilst it is a consumer monopoly, it is also a GLC, and it's ability to raise rates is somewhat limited, compared to a true consumer monopoly. Historically, its management calibre, rightly or wrongly, is also widely perceived to be below top corporates (e.g. the misjudgements made on the restrictive conditions set in the past limited-life IPP contracts). Nevertheless, I'm a believer that when average management runs an economically superior business, the economically superior business will eventually come out on top. Therefore, a P/E of 18 to 20 is not unreasonable for a business like this. Historically, I believe TENAGA has been rated at more than 20 times perhaps more often than not, and compared to its regional peers, perhaps even more, but I would feel somewhat uncomfortable personally to assume a P/E higher than 20, as the margin of safety then becomes smaller. Another way to view a suitable P/E is that with current 5 to 10 year government bonds running at 3.5% risk-free, it is probably safe (if one takes a long-term view) to assume that TENAGA's earnings should be valued at 5% interest rate from a security of earnings perspective. This also translates to an equivalent P/E of 20. So, a P/E of 20 looks about right.
This suggests an Intrinsic Value of $14, or maybe a bit higher.

Given the mind-boggling set of results announced last night, I expect the market to cheer TENAGA's share price initially. I would not be surprised if the cheering results in temporarily irrational prices. I will also not be surprised if the current bull run results in TENAGA euphorically shooting past $15 as it gather more pace. Still, the timing of the commissioning of Tanjung Bin power plant seems like a somewhat doubtful management decision (given the substantial excess capacity that remains unabsorbed), and one can name some other problems with TENAGA. However, bottom line is that it is widely expected that the 9MP and Malaysia's reasonable GDP growth (5%-6%) will continue to absorb some of the present excess capacity over time, which should be positive for its revenue and its earnings prospects, that some further upside from the current price of $12.1 can be expected. Technically however, there is a resistance at $12.5-12.6 from the last attempt in Feb. At $12.1, personally, I might consider buying some TENAGA (warrant) this morning if I can get it at the right price (and if I don't have any exposure yet), but I doubt I will be able to get it at an attractive price. Certainly, I don't recommend anyone to chase after a hot stock (especially for new investors who hasn't the experience). Given its doubtful track record in the past (e.g. past management decisions and GLC status), it might not be as attractive as some of the other better stocks to hold for the longer-term (e.g. PBBANK). However, I believe more experienced traders can benefit from playing this stock (and warrant) due to its large market cap and its consistently high liquidity, although there are also better stocks to play.
Disclaimer: As I am writing this in the early hours in the morning, it is possible that I might have missed something. If so, please don't hesitate to point out any factual errors so that I can make the necessary corrections. Thank-you in advance. Even though I tried to be as neutral and objective as possible, it is possible that I might not be completely neutral as I hold some TENAGA-CA warrants.

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