Elixir Securities Limited – Elixir Insight

Karachi, January 12, 2018 (PPI-OT): Hub Power Company Limited – Laying Addressing Concerns on Utilization and Shariah Compliance

Based on our discussions with the management we believe all planned overhauls at Narowal for FY18 have been carried out in the first quarter. Earnings are expected to normalize going forward. A PKR5-5.5bn additional debt facility has also been arranged for expansion projects.

Capacity additions to the grid may lead to HUBC’s utilization levels on furnace oil dropping to 30.1% by FY20. This would reduce HUB plant’s bonus, reduce O and M savings and fuel losses. We expect the net impact to be immaterial.

However if operating costs remain sticky, EPS may decline by ~PKR1.0/share in FY18/19.

HUBC is expected to remain shariah compliant despite pick up in borrowing. However circular debt pay off could cause non-compliance as 54% of total assets are receivables from WAPDA and NTDC.

We maintain our BUY call on HUBC with a Dec-18 PT of PKR145/share resulting in 66.1% total potential upside (including 8.2% forward dividend yield).

Management Guidance on Recent Events: 1QFY18 consolidated earnings for Hub Power Company (HUBC) came in below street expectations. Based on our discussions with the management we believe the drop was due to overhaul of 3 engines at Narowal. The company had already overhauled 8 engines in the preceding year (out of a total of 11), with the remaining overhauls planned for FY18. These have been carried out resulting in Narowal’s operating costs (Cost of Sales – Fuel Cost – Insurance – Depreciation) increasing from PKR167mn in 4QFY17 to PKR513mn in 1QFY18. Narowal’s segmental profit resultantly dropped 43%QoQ to PKR462mn. Going forward we expect Narowal’s profits to normalize at PKR750mn/quarter for the remaining year.

The company has also secured additional borrowing of PKR5-5.5bn. This takes aggregate borrowing for new projects to PKR26-26.5bn resulting in a PKR4-7bn financing gap which will be bridged by internal sources. In light of this we maintain our call of flat dividend payout for FY18 and FY19 at PKR7.5/share.

Lower Utilization on Furnace Oil will Impact Three Variables: The seasonal closure of furnace oil plants in November has raised concerns for IPPs. Due to capacity additions into the grid, we expect utilization levels for HUBC’s base plant to drop to 30.1% by FY20 vs. previous estimates of 67.9% (which were in line with the historical average utilization). We expect a similar decline for Narowal with utilization levels falling to 30.1% by FY20. Over the longer term we have maintained utilization levels at 20.0% for both Hub and Narowal plants.

The drop in utilization levels will impact three variables O and M Savings/Losses, Fuel Savings/Losses and Hub plant’s Bonus. While it is impractical to estimate fuel savings/losses by plant due to lack of disclosures, on an aggregate basis the Hub and Narowal plants suffer fuel losses. We attribute these to the Hub plant due to its aging.

Impact on Fuel Losses to be Immaterial: On an aggregate level (Hub and Narowal), the plants suffered PKR1.4/share of fuel losses in FY17. These have come down significantly from PKR5.0/share of fuel losses in FY13 due to boiler rehabilitation works at the base plant and consistent maintenance of the Narowal plant by the new management.

Hypothetically assuming zero utilization would lead an incremental earnings of PKR1.4/share, however zero utilization would also result in reduced bonus from the Hub plant. The net impact on earnings would be around PKR1.2/share. Since we are assuming plant utilization to fall gradually over a period of years, we do not expect the positive impact of reduced fuel losses to be material on a consolidated level.

Impact on Operating Costs is Uncertain: From a financial modelling perspective we assume O and M costs vary with O and M revenue. However drastic reductions in O and M costs (due to reduced generation) could take time to achieve if costs are sticky (such as if majority employees are on a full time basis). For the moment if we assume that costs do in fact fall with the drop in revenue, the impact on O and M savings would be minimal. On an aggregate basis, we expect O and M savings in FY20 to drop from PKR1,690mn to PKR1,317mn due to the change in utilization level. This has a PKR0.3/share negative impact on earnings.

In the worst case scenario where O and M costs do not drop at all despite the drop in O and M revenue, we expect a PKR0.9/share negative impact in FY19 and a PKR1.1/share negative impact in FY20.

Overall Impact on Earnings will be Immaterial: We believe due to HUBC’s significant diversification, the impact of lower utilization on earnings will be immaterial. Slight changes in earnings are not likely to impact dividends significantly as these are already expected to remain flat at PKR7.5/share for FY18-19. However there is some risk of earnings dipping by PKR0.5-PKR1.0/share if operating costs remain sticky.

Shariah Compliance Could be an Issue if Circular Debt is Paid: Shariah compliance requirements dictate a 37% threshold for Debt / Total Assets. HUBC’s Debt / Total Assets is currently at 34.3% as of FY17. We do not expect additional borrowing for new projects to elevate this significantly as additional borrowing will raise both debt and assets. However we highlight that an unexpected circular debt pay off similar to 2013 could cause the Debt / Total Assets ratio to jump. The ratio jumped from 26.5% to 39.1% between FY12-13 when HUBC’s receivables dropped by PKR125bn. These were used to pay for PKR93bn payables and PKR15bn of short term borrowing.

As of FY17, HUBC’s receivables comprise 54% of their total assets. Retirement of these receivables could cause non-compliance with Shariah rules.

Valuation: We maintain our BUY call on HUBC with a Dec-18 PT of PKR145/share resulting in 66.1% total potential upside (including 8.2% forward dividend yield). While market has concerns over timelycapacity payments to FO based IPP’s, we opine that HUBC has a much higher bargaining power due to its foray in coal based generation. In addition, HUBC has the flexibility to delay payments to Pakistan State Oil, as dictated by its Fuel Supply Agreement.