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Elixir Securities Limited – Elixir Insight

Karachi, January 05, 2018 (PPI-OT): Lalpir Power Limited – Furnace Oil Demise is a Boon

We Initiate coverage with a Dec-18 PT of PKR35/share offering 72.6% total potential upside from last close (including 10.4% leading dividend yield) at a 14.5% cost of equity.

LPL has historically suffered fuel losses of 160% of reported earnings over 2013-16. This has resulted in 6.7% average ROE which is expected to rise to 15.5%.

We see reduction in utilization rate from the historical average of 58% over 2013-16 to 25% post 2023, with drastic reductions in utilization during 2017-2022. This could potentially reduce average fuel losses by 56%.

Due to a scheduled outage in October and industry wide furnace oil plant closure in November, we expect utilization rate for 4Q2017 to average 20% at best. This would result in 81%YoY increase in 4Q2017 earnings to PKR1.1/share.

Going forward dividends are expected to increase. The 1994 Power Policy guarantees fuel supply from PSO which reduces working capital constraints for the company.

Capacity payments remain an issue if utilization levels fall. We have conservatively assumed 30% of capacity payments each year get delayed till 2028 resulting in PKR15.6bn in additional receivables by 2028.

We have also assumed that the plant sells for 75% of its book value by 2028 due to technological obsolescence.

Fuel losses have eroded profits in the past; the future will likely be different: Lal Pir Power (LPL) has historically been plagued by fuel losses. The company reported PKR8.6/share in cumulative earnings over 2013-16 and lost PKR14.3/share in fuel losses. Resultantly the company’s ROE over this period averaged a meagre 6.7% compared to ~30% ROEs for Nishat IPPs and HUBC. We see the company’s ROE increasing to 12.6% in 2018 and stabilizing at ~15.5% thereafter till PPA expiry in June 2028.

The demise of furnace oil is a boon for Lalpir: We expect furnace oil based power plants capacity utilization rates to drop drastically by 2020. Of these, the most inefficient plants, inclusive of LPL and Pak Gen Power (PKGP) are expected to fall to 1.7% utilization by 2020 owing to 14,118MW of capacity additions into the grid between FY16-19. To remain conservative we have stabilized capacity utilization rates at 25% post 2023 rather than shutting the plant down. In comparison the plant averaged 58% utilization over 2013-16. Resultantly we expect average fuel losses over 2018-21 to decline by 56% over those realized from 2014-17.

4Q2017 earnings to increase 81% to PKR1.1/share: Lalpir Power’s plant remained closed in October due to a scheduled outage. The company is undergoing a Productivity Enhancement and Performance Improvement (PEPI) program which is expected to reduce fuel losses, according to the company. We believe that this is unlikely in the worst case and may be marginally beneficial in the best case (though still immaterial in the big picture). However plant closure in October due to the outage and plant closure in November due to industry wide furnace oil plant shutdowns, has resulted in no utilization over this period.

Assuming a very conservative 60% utilization rate during December still results in 20% average utilization over the quarter. As a result we expect earnings to increase 81.4%YoY to PKR1.1/share. This would result in 20.0%YoY earnings growth in 2017, however dividends are expected to remain flat at PKR2.0/share owing to circular debt constraints.

Fuel supplier and power policy matters when it comes to dividends: Lalpir Power has a 30 year fuel supply agreement with Pakistan State Oil (PSO). Under the 1994 Power Policy, the GOP guarantees performance of the fuel supplier provided that the fuel supply agreement is with a public sector organization. In comparison, Nishat IPPs have their fuel supply agreements with Bakri Trading, therefore fuel supply is not guaranteed. Due to this anomaly, from a working capital perspective, LPL/PKGP are superior to NCPL/NPL.

Capacity payments remain an issue: Reduced reliance on furnace oil will reduce RFO plants’ importance in terms of payment clearance from the Central Power Purchasing Agency (CPPA). This could result in severe capacity payment delays for LPL. We see several safeguards against this issue. Firstly, as pointed out in our report “What Lies Ahead for IPP’s, OMC’s and Refineries” on November 27th 2017, the power tariff is unlikely to increase with new capacity additions, therefore the impact of the burden on the government is overestimated. Secondly, we have assumed 30% of capacity payments each year to get delayed till 2028, which results in an additional PKR15.6bn in receivables on which we have assumed no penal income.

LPL’s PPE book value unlikely to be realized: In addition to building in capacity payments delays, we have also assumed that the company recognizes a ~75% loss on the book value of the plant as of 2028 when the PPA expires. This accounts for the event that the plant does not sell for its depreciated book value owing to technological obsolescence and fuel inefficiency.

Valuation: To account for the inherent risk in the company’s cash flows we have built in an additional 2% risk premium which takes our cost of equity to 14.5%. We Initiate coverage on LPL with a Dec-18 PT of PKR35/share resulting in 72.6% total potential upside from last close (including 10.4% leading dividend yield).