VSH [M-PF 2.1%] – Huge growth potential on the horizon but low ROE

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Administrative Decisions of Tax Authorities

September 28, 2015

Vinh Son Song Hinh Hydropower (VSH), Electricity generation

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– We initiate on VSH with a 10.0x PER-derived TP of VND13,700 (TSR 2.1%) and M-PF rating. VSH possesses good hydropower assets totalling 136MW which has delivered highest utilization rate relative to peers, EBITDA margin and dividend yield among domestic peers. It is constructing Upper Kon Tum project (220MW) to double its capacity by 2020.

– Gloomy return on equity outlook of less than 10% in the next five years and risk of losing VND600b erases all VSH’s attractiveness.

– Key catalysts: we will upgrade VSH whenever there is one among the following events: 1) Much better output than expected; 2) Significant increase in CGM volume; 3) Upper Kon Tum progress speeds up.

VSH is the most efficient hydro power plant listed, with the best utilization rate, delivering the highest EBITDA margin and highest dividend yield:

  • VSH’s utilization rate is 30% higher than standard level of hydro power plants and 22% higher than domestic relevant peers. Consequently, VSH delivered the highest EBITDA margin vs. its relevant peers (79.9% vs. 74.5%) and highest dividend of 7.3% vs. 5.9%.
  • VSH benefits the most from competitive market. Their CGM price is twice of their PPA. CGM volume accounts for 17% in 2014 and will rise to 30% in the future.
  • Upper Kon Tum is one of the few good hydro resources left in Viet Nam which has a promising IRR of 12.7%, NPV of VND542b and PBP of 8 years. Once coming on-stream, it will drive VSH’s EPS growing at double-digit rate in the first 5 years of operation.

Nevertheless, poor return on equity and risk relating to the Upper Kon Tum project make VSH unappealing:

  • VSH’s return on equity is expected to remain very modest in the next five years, averaging at less than 10% due to large equity base mobilised to develop Upper Kon Tum since 2009 and subsequent project delays for 5 years.
  • VSH is exposed to the risk of losing VND600b in ongoing litigation with ex-contractors (Chinese ones) of Upper Kon Tum project.

Please refer to our Power Generation Sector for more information.

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Financial Statements

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Quarter Results

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P&L Forecast

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VSH’s assets

VSH was established in 1991 with seed asset of Vinh Son plant (66MW). In 1999, VSH received its second plant – Song Hinh (70MW) from Vietnam Electricity Group (EVN). VSH equitized from 2005 and was listed on the Ho Chi Minh Stock Exchange the year after.

Vinh Son and Song Hinh are good plants using turbines and generators manufactured in G7 countries. They also have big reservoirs (132-323m m3) which help them to store water for several months. This is extremely meaningful in the Vietnam context and operation of the Competitive Market Generation (CGM) as VSH can reserve water for the dry season when price on CGM is high.

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Once Upper Kon Tum goes into operation, VSH will become the biggest hydro power plant listed with total capacity of 356MW. In addition, VSH also has two more projects, Vinh Son 2 (100MW) and Vinh Son 3 (30MW), under feasibility study.

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Management & shareholders

  • VSH’s management are from EVN. VSH’s chairman is a person with accounting background while the CEO is extremely well versed in technical matters. Both of them have individually devoted over 20 years to the company and are EVN Genco 3’s representatives in BOD.
  • VSH has a quite independent Board of Director. BOD comprises of five members with three of them being non-EVN representatives. Mr Tran Manh Huu represents for State Capital Investment Corporation (SCIC) and Mr Nguyen Hong Son represents for VIAC Ltd (an Oman fund). Mr Phan Hong Quan is an independent member who has no stake in the company. We think this structure on one hand will help to control the cost of Upper Kon Tum project (revised investment capital will only be approved once all of BOD’s member unanimously agree); on the other hand, it will help VSH to have more bargaining power in the CGM in the long run. However, the control of EVN at this moment is still very substantial as they are the only buyer and possess ample expertise in power plant construction.
  • VSH’s shareholders are mainly institutional investors. Retail investors account for 5% stake only. SCIC has registered to sell 49.5m shares (24% stake) with starting price of VND18,300 in May 2015. If SCIC succeeds in selling their whole stake, VSH

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Central Viet Nam has the biggest rainfall

VSH has consistently maintained average utilization rate of 60% over the past 15 years, 30% higher than the standard level for general hydro power plants (46%). This is thanks to its location in the Central Viet Nam where rainfall is highest at 2,800m p.a.

We compared VSH’s utilization rate with other power plants whose historical utilization rate data for 10-20 years are also available and see that VSH’s utilization rate surpasses both SJD and TBC while just nominally lower than TMP. Compared to these three companies, VSH’s utilization rate is 22% higher.

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Volume sold to competitive market is increasing

According to the management, VSH’s contract volume (Qc) was set at 563m kWh for 2015, down 2% vs. 2014. This implies volume sold to CGM market (Qm) of 112m kWh or 17% of commercial output. We expect that the portion of CGM volume will increase gradually per annum to reach 30% by 2019. Of note, this is still lower than the cap, guided at 40%, as we think the liberalization in the sector will not happen overnight but will improve slowly so as to allow the Government to control inflation.

We assume that VSH’s commercial output will arrive at 675m kWh for 2015, the same as 2014. This assumption is a nominal 2% lower than the management guidance. 1H’s volume of 363m kWh was down 11% vs. 1H14A but according to the management there is amply capacity for catch-up, especially in Q4, as Q3 is lowest season for VSH. As of 15 September 2015, VSH’s output reached 467m kWh, completing 69% of our full year forecast.

From 2016 onwards, we suppose volume will revert to the mid-cycle level of 694m kWh observed in VSH’s 15-year operation. While we expect that rainfall will be back to up-cycle after three year’s drought, 2014 El Nino (coming in the second year of the three year drought) has been very complicated and might last until Spring 2016, becoming the most severe one over the past 65 years. Of note, commercial output is ~1% lower than production output due to internal use & loss.

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Competitive market helped ASP increase by 40%

Average selling price (ASP) of VSH in 2014 has reached VND672/kWh, up 40% vs. the average price in the past five years thanks to the newly signed PPA contract in November 2014. This new PPA contract was effective from 2014 onwards and has no specific ending year, which suggests this will last for the remainder of project life cycle (25 years more).

Such high ASP in 2014 was explained by the CGM, as even though PPA (inclusive of resource tax & forest fee) is set at just VND547/kWh, the price on the CGM is nearly double that of the PPA. We expect CGM price will increase further by 2% p.a., helping to lift up VSH’s ASP gradually and reach VND753/kWh by 2019, up 12% from current price.

A new PPA will be negotiated in case VSH has a major upgrading project or when Ministry of Industry & Trade approves the new designed output for VSH based on the regulation of reservoirs operation on the same river (Decision 1077, dated 7 July 2014 of the Prime Minister). According to this regulation, a portion of VSH’s reservoir must be saved for agriculture. Therefore, this regulation when applied will lower VSH’s commercial output. However, in return, VSH’s designed output (which is at 638m kWh at the moment) will also be reduced and results in higher PPA to offset for the decline in volume which ensures the same regulated return for VSH.

In addition, VSH also announced that they have finalized the PPA framework for the 2010-2013 period. Previously, VSH had to book a temporary PPA assumption every year whereas these agreed terms set the official price lower than temporarily-booked price for 2010-2012 but higher for 2013. Netted off, VSH booked VND98b retrospective profit for historical years.

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VSH delivered the best EBITDA ratio among domestic peers

VSH delivered the best EBITDA margin in the past five years even though it receives a lower PPA price vs. its peers and had to deal with a delayed PPA until November 2014. TMP’s PPA is 4% higher than VSH while TBC and SJD’s PPA is from 30% to 60% higher than VSH’s PPA. Its peers also received confirmed PPA pricing every year whereas VSH was given tentative PPA pricing. Low price is mostly due to EVN’s monopoly power when purchasing VSH’s large output while long-lasting negotiation process is partly due to independent directors having fought very hard to bargain with EVN.

Such high EBITDA margin was explained by its high utilization rate and good cost control (maintenance cost, labour cost and admin cost).

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Upper Kon Tum hydro power projects

One of the few remaining good hydro resource in Viet Nam

Upper Kon Tum is being developed on the Sesan River, the third biggest river in Viet Nam in terms of hydro resource capacity (1,768MW). On the Sesan River, there have been five hydro power plants constructed so far in which Ialy is the biggest one with capacity of 720MW. Upper Kon Tum is the last dam to be developed on this river. According to management, Upper Kon Tum’s location has an ideal natural altitude of 1,170 meters above sea level, the physics of which is a big advantage in developing a hydro power plant.

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Reasonable investment capital despite a five-year delay

In 2015’s AGM, VSH gave guidance about revised investment capital of Upper Kon Tum at VND7.1tn, up 24% vs. previous budget of VND5.7t. We estimate that investment capital for one MW is VND32.3b, in line with other recently built hydro power plants in Vietnam such as Dak Dring (VND24b), DaM’bri (VND29.2bn), Song Bung 4 (VND31.6bn) and Dong Nai 2 (VND53b).

The increase in the investment capital is 90% due to soaring construction costs and 10% from remaining items:

  • Construction cost – up 50.7% vs. original budget as a result of rising expenses relating to the cancellation of HydroChina Huadong Engineering Corporation contractor, changes in digging methodology of water irrigation tunnel as well as inflation
  • Land clearance expense budget was revised up by 164% while management fees and consultant fees also rose.

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Financing structure

VSH has used its equity so far to finance the project with VND2.1t having been spent as of June 2015. VSH plans to use 30%-70% equity and debt structure for Upper Kon Tum so it needs to raise VND500b convertible bond in the future to maintain the desired financing ratio.

Additional debt financing includes:

  • Firstly, VSH has secured an export credit agreement of USD 27.1m & EUR 3.0m with Raifeisenlandesbank (Republic of Austria) at 6 Month Libor + 3% to pay for Austrian turbine and generator.
  • Secondly, they need to raise VND1,000b straight bond
  • Thirdly, VSH has secured commitment from VCB, BIDV and ACB to finance the remainder (VND2.9t). However, these will be based on 12-month deposit rate + 3.5%, which is not very favourable.

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Upper Kon Tum project current construction status suggests commercial operation from 2020

Upper Kon Tum project broke ground from 2009 but after five years, VSH has just completed 15% of the workload. The projects comprises of eight main items as listed below, the biggest item being a tunnel which is 16,893 meters long running through complicated terrain. Revised schedule suggest that VSH will run generator 1 & 2 in 2018 and 2019, respectively, therefore we expect commercial operation will start from 2020.

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The main reason for such bad performance is due to the EPC contractor. In 2010, VSH’s management was happy to announce that EPC package was signed at VND2,154b, 10% under their budget with HydroChina Huadong Engineering Corporation and China Railway 18th Bureau Group. The Chinese bid, at $77 million, was half the price of other contractors (ie CMG, Cavico and No 3 Power Engineering Consulting JSC–PECC3).

These contractors failed to stick to the agreed schedule of work and stopped on 18 July 2014 after 40 months of construction but fulfilled only 24% of the contract value and 15% of the workload while they should have completed the entire project by September 2014.

The Chinese firms said they had failed to recruit local workers for the construction site due to the difficulty in obtaining the necessary permits and additional difficulties included heavy rain as well as East sea dispute. Moreover, the Chinese contractors have asked for USD$38m of additional costs that are not included in the EPC contract.

The 2015 AGM pushed to overturn this stalemate and approved the No 47 Construction Company (Ticker: C47), Robbins (USA) and Song Da No 10 to replace the aforementioned contractors. We think the capabilities of these contractors are quite reliable for the following reasons:

  • C47 is a construction company with 35 years of experience, based in Binh Dinh with expertise in building hydro projects and some residential projects;
  • Song Da 8 has experience in building the 520 MW Huoi Quang hydro power project; and
  • Robbins Company is the world’s foremost manufacturer of advanced, underground rock boring machinery (TBM – Tunnel Boring Machine) with 60 years experience

Project’s PPA & IRR guidance

According to the management, the draft PPA for Upper Kon Tum was set under two scenarios: 1) 4.5 USDcents or VND970 (under the old feasibility study) and 2) 6.5 USDcents or VND1,400 (based on Circular 41). Based on this, the project’s IRR is guided at 13.6% and 20.5%, respectively. Using the same PPA, we estimate lower projected IRR, at 10.8% and 16.7%, respectively.

The main reason for lower profitability ratios are higher interest rate (we assume 10% while VSH assumes 8.5%) and higher discount rate. Of note, we also assume that Upper Kon Tum will run at average utilization rate of 57% as per guidance, 3% lower than Vinh Son and Song Hinh plant given the same weather and rainfall in that location.

We think the finalised PPA for Upper Kon Tum might be in the middle of the above two figures to settle at VND1,100/kWh as USD4.5cent is absurdly low for VSH whereas USD6.5cent is probably too expensive for EVN (a cost of electricity that is equivalent to cost paid to old thermal power plants). Based on this PPA, Upper Kon Tum is expected to deliver NPV of VND542b and IRR of 12.7%.

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We estimate that upon the start of Upper Kon Tum production in 2020, this project will generate VND1,192b in revenue and VND242b in NPAT. Bottom line will increase 14% p.a to crest at VND709b in 2029 when it runs out of interest expense.

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1H15A recap

VSH’s 1H15A revenue and NPAT soared by 16% and 84% vs. 1H14, respectively, despite sales volume decline of 11% as ASP has risen by 31% to VND747/kWh from VND572/kWh (booked under old PPA). VSH has just started to apply its new PPA in its P&L since 4Q14. Of note, VSH generated VND271b in revenue and VND173b in NPAT for 1H15A.

Earnings & ROE outlook

VSH has set 2015’s sales volume at 691mn kWh, up nominally by 2.5% vs. 2014. However, we see that VSH’s 1H sales volume is 363m kWh, down 11% vs. 1H14A, therefore, we estimate a sales volume of 675m kWh, the same as last year.
Despite this difference, we estimate nearly the same revenue (VND460b vs. VND465b guided) and the same NPAT (VND284b vs. VND283b guided) for 2015.

For 2016, we anticipate that VSH’s NPAT will increase by 10.1% with a 3% rise in sales volume as drought has taken place for almost three years and 2016 is expected to be back to up-cycle. Going forward, VSH will generate stable profit before getting a boost from Upper Kon Tum in 2020.

VSH’s return on equity is expected to be still very modest in the next five years, averaging at less than 10%. The delay is Upper Kon Tum project has deteriorated VSH’s ROE badly since 2009 given a large equity base was mobilised to finance for the project as well as another 4 years in our forecast period.

Nevertheless, once it commences operation, Upper Kon Tum will drive VSH’s earnings at double-digit growth rate until it doubles in 2024 while elevating ROE to 14.1% in the first five years of operation.

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Risks

Risk of losing VND600b in legal dispute with Chinese contractors

On August 2014, the Chinese contractors commenced litigation at the Viet Nam International Arbitration Center (VIAC) for the sum of VND1,035b and USD11.9m representing its contract value. VSH counter-sued and claimed damages of VND1,317b. So far, VSH has paid VND450b to the contractors for the amount of work already completed and have outstanding VND50b for the work not yet clarified and agreed by both parties. Of note, on 29 July 2014, a Chinese bank transferred back to VSH VND428b (the whole amount of a Bank guarantee for contract’s performance as well as advances).

According to one member of VSH’s BOD, the amount of loss in case of failure in this court case might reach VND600b. If this happened, Upper Kon Tum’s investment capital cost will inflate by another 10%, which will lead to lower profitability for the project.

Further delay for Upper Kon Tum

VSH’s management targets to resume the project within 6 months since April AGM, but at this time, there is no information about the project’s progress. Should the project meet further delays then further cost overruns are possible.

Weather

VSH’s output is completely dependent on rainfall. In 2005, VSH’s output plunged to 474m kWh, 30% lower than the average level due to drought. El Nino, La Nina, climate change and global warming, etc are key risks to electricity output.

VSH’s dividend yield in comparison with other power plants

Despite having an unfinalised PPA with EVN in 2010-2013 period, VSH paid out cash dividend VND1,000 for each year although the payment was quite delayed. Given its low share price, it has delivered the highest yield (average at 7.3%) compared to its peers (average at 5.9%), surpassing even SJD – a notable cash cow in the sector.
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Valuation

P/E valuation

We use P/E method to derive valuation for VSH as VSH’s free cash flow is negative in the next five years due to huge capex financing for Upper Kon Tum project.

A target PER of 10.0x (based on observed PER of regional peers) suggests VSH’s target price of VND13,700 (+2.1% TSR) which indicates a Market Perform rating. Of note, equally-weighted average using three methods (PER, Gordon growth model and replacement cost) also results in the same target price (VND13,712).

Replacement cost method results in fair value of VND19,031 for VSH, which implies upside of 32% and illustrates VSH’s cheapness vs. recently built power plants. However, using a Gordon growth model, we see that such cheapness does not result in a high share price due to dividend cap of VND1,000/share. Fair value of VND8,403/share by this method is a strong counterweight to the replacement cost method.

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Replacement cost valuation

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Gordon growth method

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Appendix

There are 28 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 pricier the ratios are. The first quartile is trading at FY15E P/E and P/B of 10.4x and 1.6x, respectively, with median market cap of USD 2.2b. Meanwhile, the third quartile is trading at FY15E P/E and P/B of 33.0x and 3.0x, respectively, with median market cap of USD 547m.
  • 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 of 2.3% and highest return on equity of 14.9%.
  • We use first quartile group to do P/E valuation for VSH

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VCSC Information

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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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