Pha Lai’s Power Plants Generating Energy Success

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August 20, 2015

Pha Lai Thermal Power (PPC), Electricity Generation

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– We initiate on PPC with M-PF rating & DCF-derived TP of VND20,600. The granddaddy of listed power producers will see significant bottom line improvement in the next two years thanks to fully depreciated assets in 2016 and 95% jump in contribution from associates during this period. In 2016 we see PPC’s PER move to 6.6x on an expected ROE 16.2% and est. dividend yield 10%. This coupled with PPC’s EV/MW 55% discount compared to its domestic peers makes it compelling.

– Nevertheless, PPC’s capped top-line dulls this excitement, in part due to oversupplied situation in the North and in part because of its current inability to independently pursue earnings enhancing M&A. Power Purchase Agreement (PPA negotiations for Pha Lai 1 (PL1) looms with a counterparty not incentivised to be generous, old operating assets hinders outperformance and CGM prices remain relatively unattractive.

– PPC is trading at PER of 10.4x on our FY15E EPS forecast, representing a 22% discount compared to its regional peers and on paper ostensibly cheap given projected average ROE of 14.2% over the next 5 years.

PPC is an old coal thermal power plant in Northern VietNam. Its PL plant (440 MW) is 30 years old while Pha Lai 2 (PL2) (600MW) is 15 years old.

25% stake in Hai Phong power plant (HPPP). HPPP is a newly constructed coal thermal plant (1,200MW) using Japanese made turbines & generators. It has been fully online since May 2014 and since operated stably. HPPP’s profit is calculated to soar by 25% & 76% respectively in FY15E & FY16E given stable utilization rate and full booking of forex loss under construction period.

Old asset requires new capex with PPA re-negotiation. PL1 needs to be upgraded, its current PPA will expire in 2016 and the new PPA will depend on the upgrade capex. (which we do not include this in our model due to no disclosure).

Northern Viet Nam is in oversupplied situation. According to EVN, the North currently has 30-40% excess capacity. We estimate that power supply in the North will grow by 18% and 21%, respectively, in the next two years. Hence, we expect that PPC’s utilization rate will drop to 62% in 2016, down from 65% in 2015.

Bad corporate governance is unlikely to change in the short term. PPC has consistently allocated approximately 20% of its assets to lend to EVN. It also does not have any independence in investing in or acquiring new stakes in other power plants and instead leaves significant cash on hand. Such policies acts to depress ROEs.

Company At A Glance

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Financial Statements

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Quarter Results

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P&L Forecast

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Company description

  • PPC used to be the biggest coal thermal power plant and a primary power supplier in the North before 2009. The company was established more than thirty years ago (since 1982) with the target of constructing two plants – PL1 and PL2. PL1 (440MW) has four generators (4×110 MW) and went into operation in 1984 while PL2 (600MW) has two generators (2x300MW) and was put into commercial operation in 2001.
  • PPC has one subsidiary (Northern Power Maintenance Services Supply JSC), various associates including Hai Phong thermal power plant (HPPP) and Quang Ninh thermal power plant (QNPP) and nominal stakes in various electricity-related companies (listed below).
  • Both HPPP and QNPP are newly constructed plants, which are controlled by EVN’s Genco 2 & 1, respectively. In HPPP, EVN’s Genco 2 has 51.7% stake while SCIC, TKV and Bao Viet Holdings have passive stakes.

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Good assets but they are getting very old

Pha Lai 1 & 2 is getting old

Even though Pha Lai 1 & 2 was built 30 years and 14 years ago, respectively, they both use machinery and equipment of developed countries (Russia, Britain and the US). This is one of the reasons why they can still operate until now. However PL1 will need substantial capex for upgrading to continue operating reliably and more efficiently.

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Hai Phong power plant is good but PPC has limited stake

Both HPPP and QNPP were just recently built but they still use sub-critical technology, the same as Pha Lai 1 & 2 (see Appendix page Error! Bookmark not defined. for the difference between supercritical and sub-critical coal thermal power). We see sub-critical technology is popular in Viet Nam and almost all coal thermal power plants use this technology except recently-developed Mong Duong 2 power plant.

HPPP use both Chinese and Japanese machinery and contractors while QNPP heavily relies on Chinese contractors and equipment. According an industry player, this is one of the reason why HPPP operates quite smoothly since coming on-stream while QNPP has been through a series of shut- downs due to machinery & equipment break-downs.

We would be happy if PPC can increase its stake in HPPP further with its enormous cash on hand, especially when the State Capital Investment Corporation (SCIC) is expected to auction their 9% stake in the near future. As far as we know, it seems that Genco 2 has a preference to ask PPC to lend them more rather than allow PPC to acquire more stakes.

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Northern Viet Nam’s power capacity is oversupplied

According to EVN, the North currently has 30-40% excess capacity. We estimate that power supply in the North will total at 15,655 MW as the end of 2015 and rise to 18,905MW by 2016, equating a to 18% and 21% supply growth, respectively, for the Northern market.
PPC’s low cost competitive edge vs. new power plants is expected to reduce due to oversupplied situation, especially when large-scale hydropower projects including Huoi Quang and Lai Chau come on-stream in 2016.

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  • Mong Duong I: The unit 1 of the plant has successfully synchronized to the national grid since January 2015 and unit 2 is expected to be put into official operation in 3Q2015.
  • Mong Duong II: The Unit 1 with a capacity of 560MW has officially been grid-connected since March 2015. After completion of construction activities in the second half of 2015, Mong Duong II will produce an estimated 7.6 billion kWh per year and will be transferred to the Government of Vietnam after 25 years under BOT scheme.

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We expect that PPC’s utilization rate will reduce to 65% in 2015. In the first six months of this year, PPC’s sales volume has achieved 3.1b kWh, -4.1% vs. 1H14A. According to PPC, this decline is due to various factors including machinery break-down, oversupplied situation when Mong Duong 1 & 2 came on-stream as well as better rainfall for hydro power plants.

We expect PPC’s 2015’s sales volume will decline by 6.1% vs. 2014 due to some impact from record floods in July 2015. Heavy rains during 26-31 July in Quang Ninh province (where Viet Nam’s biggest coal reserves are located) flooded many coal mines. So far, Mong Duong coal mine suffered the biggest damage. PPC uses coal from Hon Gai and Mao Khe and has stored 200,000 tons of coal for one-month of operation. In addition, 300,000 tons of additional coal is also available if necessary to feed another month of operation.

For 2016, PPC is anticipated to operate at a utilization rate of 62% given rising new supply from the above-mentioned hydro power plants overwhelming expected stronger electricity consumption nationwide in 2016. One notable reason for the heightened rise in demand for electricity in 2016 is the completion of the Samsung Hightech Complex in Thai Nguyen – Phase II (SEVT2). PPC’s utilization rate is expected to stabilize at 65% from 2017 onwards when oversupplied situation relieves.

Regarding HPPP, we anticipate that it will run at average utilization rates of 65% and 62% in 2015 & 2016, respectively, for broadly the same reasons that we have laid out for PPC. Of note, HPPP’s third and fourth generators has started operation since February and May 2014. Beyond 2016, HPPP is anticipated to run at a stable utilization rate of 70% as its new machinery is more reliable than PPC’s.
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17 Year PPA for PL2 but PPA for PL1 up for negotiation from 2016

Before 2014, the PPA for PPC was negotiated every year and in reality it was subjective to EVN’s decision-making, based on total generation cost plus whatever rate of return. This is the main reason why PPC’s gross margin fluctuates significantly in the 2010-2013 period.

In 2H14, PPC signed two PPA contracts with EVN in which PL1 was locked in at VND1,434/kWh for two years (2014 & 2015) while PL2 secured a 17-year contract (2014-2031) at VND1,233/kWh.

PL1 will need to undergo major overhaul after 30 years in operation and the upgrade is likely to require substantial capital expenditure, as such; any new PPA will depend on this capex figure.

Basically, these PPAs have two components:

  • Fixed component is the price derived backwards from a discounted cash flow model, based on assumptions of investment capital, project life cycle, depreciation policy, labour, maintenance expense, loan & interest rates, CIT and utilization rate.
  • Variable component includes coal, other fuel costs and coal transportation fee, etc which will all be passed through to EVN.

PL1’s PPA is 16.3% higher than PL2’s PPA, even though the former’s fixed component is 24.5% lower than the latter, as it consumes 32.0% higher coal per kWh than PL2.
HPPP’s PPA is also 16.7% higher than PL2 because of its high depreciation expense as a result of having just come on-stream since 2013.
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Competitive Generation Market (CGM) participation a negative for PPC at the moment

PPC has joined CGM since July 2012 and currently its CGM price is 12% and 24% lower than PL2’s and PL1’s PPA, respectively. We expect that from 2020 onwards, CGM price will turn into a premium vs. PL2’s PPA but will remain at discount compared to PL1’s PPA due to PL1’s high production cost.

In 2013 and 2014, CGM volume ratio was 9% and 15%, respectively. We estimate that for 2015, CGM volume ratio will reduce to 8% (equivalent to 451m kWh), though at the same time EVN is expected to protect PPC from financial downside by setting contract volume (Qc) at 4,897 m kWh for PPC in 2015 (vs 4,867 m kWh for 2014). Going forward, we estimate CGM volume ratio will be maintain at 5% despite rising at its peers as PPC’s utilization rate is forecasted to remain low.
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Gross margin will increase thanks to fully depreciated assets

We estimate that PPC’s gross margin will go up to 8.8% in 2015 from 6.6% in 2014 as depreciation expense is expected to reduce from VND110/kWh in 2014 to VND70/kWh in 2015 though this gain is chipped away by rising maintenance expense of 12% and coal price also up 6% from 1Q15. Gross margin will continue to rise moving into 2016 to 13.8% by which time PPC has fully depreciated its assets.

In the past years, PPC’s gross margin was decreasing from 29.0% in 2009 to 6.6% in 2014, mainly due to two factors:

  1. Regulated Return per kWh: which was VND174/kWh in 2009 but that 4-year PPA expired in 2010 and EVN reduced this return to VND101/kWh as PPC’s depreciation decreased from VND141/kWh to VND127/kWh. During 2010-2013, this return was subject to EVN’s annual revaluation. In 2014, the regulated return was derived from a discounted cash flow model to come up with a regulated return of ~10-12% on equity and arrived at VND79/kWh. Going forward, this regulated return per kWh will increase as PPC runs out of depreciation expense largely from 2016 onwards.
  2. Coal price: Coal price increase is completely passed to EVN, however, arithmetically it will lower the gross margin for PPC as the weight of coal cost in comparison with ASP will rise accordingly.

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Increasing maintenance expense for the old asset

Maintenance expense (major & frequent) at the moment accounts for 8% of PPC’s cost structure and nearly the same as depreciation expense. We estimate that this expense will rise further in following years as PPC’s assets are old which will need more out of schedule repairs.

In 2014, its major maintenance expense fell by 26% vs. the previous year as PPC has not maintained its assets as scheduled due heightened demand from the National Load & Dispatch Center. Therefore, PPC will execute these maintenance activities this year, as such; we estimate maintenance expense will rise by 12% vs. 2014 to VND588b in 2015.

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2014 recap and 2Q15A result

2014’s recap: PPC reported revenues of VND7.4tn (+13.6% vs. FY13) and NPAT of VND1.0tn for FY14A (-32% vs. 2013). The increase in revenues is mainly due to increase in coal price which PPC was able to pass through to EVN. In the meanwhile, the substantial decline in NPAT is owning to 40% drop in forex gain.

Resilient 1H15A result due to contribution of HPPP:

  • PPC announced 1H15 result with core NPAT of VND438b, +9% vs. 1H14A mainly due to jump in income from its associated company of HPPP (95b vs. 35b). Gross profit was flat thanks to 4% increase in ASP as it achieved better bidding price on Competitive Generation Market (CGM) despite 4% slide in output.
  • PPC’s robust sales volume in 2Q has helped 1H15A output achieving 3.1b kWh, a decline of only 4% vs. 1H14A. Of note, 1Q15A sales volume decreased 8.4% vs 1Q14A.
  • In terms of reported NPAT, PPC generated VND368b, up 135% vs. 1H14A as it realized forex translation loss of only VND77b in 1H15A, a third of 1H14A’s loss.
  • In 1H14, coal price has increased by 6% and this was passed through to EVN.

Earnings outlook

HPPP’s earnings outlook

For 2015, the HPPP is estimated to generate revenues of VND8.8t (+5.9% vs. 2014) and NPAT of VND412b (+25% vs. 2014):

  • Sales volume will increase by 5.9% with four generators in full operation for the entire FY15 (the third and the fourth generator came on-stream in Feb & May 2014, respectively).
  • The jump in reported NPAT is due to sales volume’s rise as well as expected lower allocation of forex translation loss in construction period (VND196b).
  • From 2017 onwards, HPPP will no longer suffer from forex loss associated with construction and profit is estimated to soar by 76% accordingly.
  • PPC will receive VND93b income from HPPP in 2015.

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PPC’s consolidated earnings outlook

We expect that PPC’s adjusted NPAT in 2015 will increase by 33% due to circa VND250b drop in depreciation expense and VND93b contribution from HPPP. For 2016, depreciation expense will decline by a further VND368b and expected doubling of contribution from HPPP will lift up PPC’s NPAT further by 50%.

Beyond 2016, HPPP will increase its role in PPC’s earnings profile while PPC’s profit from production of electricity will reduce as preferential CIT of 7.5% will expire from 2017.

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We see a reasonable return on equity for PPC from its core business which will average at 14.2% over the next five years. The return spikes in 2016 when PPC runs out of depreciation and contribution from Hai Phong climbs, nevertheless, this rate will then be on declining trend again if PPC does not use its amble cash more wisely as its tax holiday expires, equity base expands and maintenance, labour & other fixed expenses keeps rising.

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Risks

Lower PPA for PL1

PPC must re-negotiate its PPA for PL1 in 2016 and there is a possibility that EVN’s GENCO 2 still wants to lower regulated return of PL1 to reduce generation cost for EVN Group as GENCO 2 has no countervailing priorities as its equitization timeline is beyond 2016.

Lower sales volume risk

PL1 is relatively old and prone to unexpected machinery break-downs and recovery time can be increasingly hard to predict and this volume risk is exacerbated by oversupplied situation in the North.

Competitive market risk

PPC’s CGM price is from 12%-24% lower than its PPAs. If EVN sets higher CGM volume for PPC, profit margins will be hurt materially.

Weak corporate governance

EVN’s Genco 2 has a controlling stake in PPC and has taken advantage of the company’s huge cash resource. We see that PPC has consistently allocated approximately 20% of its assets to lend to EVN (on both a short-term and long-term basis). The short-term lending is for mixed purposes with a portion via power of attorney form to BVFMC for money management purposes however this latter purpose remains insignificant.

Another aspect is the fact that PPC has no independence in growing the business further by proactively investing in or acquiring more stakes in the new power plants but is instead expected to leave ample cash on hand in deposit form. Should it use its cash smartly, it could generate much better return on equity for shareholders.

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Dividend payment capability

PPC’s dividend payment is highly dependent on EVN’s preferences and forex gains/losses. For 2015, EVN’s Genco 2 set a dividend target of VND2,000 but we estimate 2015’s DPS will be VND1,500 (a 78% pay-out ratio) based on our forecast NPAT of VND628b and assuming JPY does not change much in 2H15A.

PPC paid a VND2,000 cash dividend for 2014. Noted that this is the highest dividend which PPC has paid over the past five years. In 2010 & 2011, forex losses resulted in no accounting profit for PPC and negated any scope to pay dividends.
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We estimate that from 2016 onwards, PPC will be able to pay stable dividend of VND2,000 p.s, yielding 10.0% return if JPY does not appreciate significantly above 10.0% p.a and if PL1’s new PPA does not change significantly.
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Valuation

DCF valuation

We derive a target price of VND20,600 (10.5% TSR) for PPC using WACC of 10.3%. Such a low discount rate is owing to a low interest rate ODA loan. Of note, PPC’s tax holiday will expire from 2017 and current 7.5% tax rate on electricity business will increase to 20%.
Our DCF valuation is backed up by a multiples valuation. With target P/E of 10.0x, PPC’s fair value is derived at VND21,100 for 2015, 2% higher than DCF-based target price.
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Multiple valuation

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Replacement cost valuation

We estimate PPC’s power capacity of 1,196MW with its different stakes in HPPP and QNPP. In deriving this capacity number, as PL1 is already 30 years old, we treat it as a disposal asset by allocating a weight of 20%.
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PPC looks very cheap in terms of replacement cost valuation. Its EV/MW is just VND9.2b, 49% discount compared to its peers. Such discount, in our opinion, is subject to PPC’s poor return on equity and weak corporate governance that has no signs of improving in the near term.
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Appendix

There are 31 utilities companies in Asia Pacific region (emerging markets) which can be classified into four groups by market cap:

  • The lower the market cap, the more pricey the ratios are. The first quartile is trading at P/E FY15E and P/B of 14.1x and 2.5x, respectively, with median market cap of USD 2.3b. In contrast, the third quartile is trading at FY15E P/E and P/B of 27.9x and 4.8x, respectively, with median market cap of USD 373m.
  • The first quartile, which has an average market cap of USD2.7b and less concentration of China stocks, offers the most meaningful multiple valuation comparisons.
  • The first quartile also offers highest dividend yield and highest return on equity.
  • We use first quartile group to do multiples valuation for PPC.

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VCSC Information

VCSC Rating System & Valuation Methodology

Absolute, long term (fundamental) rating: The recommendation is based on implied total return for the stock defined as (target price – current price)/current price + dividend yield, and is not related to market performance. This structure applies from 27 May 2015.
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Valuation Methodology: To derive the target price, the analyst may use different valuation methods, including, but not limited to, discounted free cash-flow and comparative analysis. The selection of methods depends on the industry, the company, the nature of the stock and other circumstances. Company valuations are based on a single or a combination of one of the following valuation methods: 1) Multiple-based models (P/E, P/cash flow, EV/sales, EV/EBIT, EV/EBITA, EV/EBITDA), peer-group comparisons, and historical valuation approaches; 2) Discount models (DCF, DVMA, DDM); 3)Break-up value approaches or asset-based evaluation methods; and 4) Economic profit approaches (Residual Income, EVA). Valuation models are dependent on macroeconomic factors, such as GDP growth, interest rates, exchange rates, raw materials, on other assumptions about the economy, as well as risks inherent to the company under review. Furthermore, market sentiment may affect the valuation of companies. Valuations are also based on expectations that might change rapidly and without notice, depending on developments specific to individual industries.

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