Power Play

As I mentioned at the start of the year, the key theme for 2007 is to overweight power/utility sector. Let me share with you some excerpts from the power sector report of Citiseconline.com. Both analysts - George Ching and Paul Lu got it all right. There is a clear paradigm shift in the industry that merits a second look.

Here are some highlights of the report.

1.) Power sector reform in place. In 2006, the government launched the Wholesale Electricity Spot Market (WESM) to create a competitive market for trading of electricity for the power sector. This will spur new investments, as the economics of the sector will move from regulatory bias to market driven parameters. Next step in the reform agenda is to move the pricing mechanism to Performance Based Regulation (PBR) scheme from the current Return or Rate Base (RORB). In simple terms, PBR will allow utility companies to charge rates based on their efficiency versus the current framework of charging based on a fixed return.

2.) Privatization play. Last year, Power Sector Asset Liability Management (PSLAM) was able to sell 472 MW of government owned power generation assets. In the next 3 years, the PSALM is looking to sell 5,580 MW of power assets. On top of this, is the pending privatization of TransCo.

3.) Electricity shortage. In the next 10 years, government estimates that additional 4,074 MW of installed power is needed to meet the country’s power demand.

Against this backdrop, I guess it’s a matter of time before power stocks become in vogue again. As I always say, buy when the writings are on the wall. So let me give you my take on how these factors can boost the sector.

1.) Go where the money is. As always – “show me the money”. Based on my estimate, proceeds from privatization and investments in new capacity will reach US$10.0bn in the next 5 years. The privatization of TransCo is expected to fetch US$3.0bn while the construction of 4,072 MW in new capacity will have an implied investment value of US$4.2bn based on US$1.2m per installed MW.

The power sector is in the same situation as the telco industry in the late 90’s. During that period, we saw a dramatic shift in sector fundamentals as the industry moved from landline to mobile and - from analog to digital/internet - thereby generating new wave of money. Note that shares of PLDT and Globe during that period were trading at 1/5th of their current value.

2.) Demand driven dynamics. Clearly, there is a looming power shortage. This means that power companies have the pricing advantage. As power generation is an incremental business, any increase in capacity utilization will go straight to bottom-line. Most power companies are still operating at slightly above 80% utilization. This means there is still upside for earnings expansion based on current utilization.

3.) Room for re-rating. Obviously, 2 stocks that come into play are First Generation Holdings (FGEN – P58.50) and EDC Energy (EDC – P5.90). FGEN is currently trading at 8.7x PER whilst EDC is valued at 10.0x PER. These valuations have not reflected the paradigm shift in the sector. So, I guess a re-rating to around 12.0x – 14.0x PER for both companies should generate at least 30-40% upside from current levels.

Even if we exclude the sector upside, FGEN and EDC are cheap since both companies are currently generating above market return on equity (ROE) of 17.1% and 54.7% respectively. So, in itself, both companies deserve to trade at a much higher valuation.

So, looks like another win-win scenario to boot.