Fitch Revises Tenaga's Outlook to Positive; Affirms at 'BBB+'

(The following statement was released by the rating agency) SINGAPORE, April 28 (Fitch) Fitch Ratings has revised the Outlook on Malaysia-based Tenaga Nasional Berhad to Positive from Stable, and affirmed the Long-Term Foreign- and Local-Currency Issuer Default Ratings (IDRs) at 'BBB+'. The agency has also affirmed Tenaga's foreign- and local-currency senior unsecured ratings at 'BBB+'. The Positive Outlook is driven by the improved financial profile following regular adjustments to its tariffs to take into account changes in generation costs over last four half yearly cycles (starting June 2015) as set out under the Incentive Based Regulation (IBR) framework. An upgrade of its standalone credit profile would, however, be contingent on a sufficient revision of the benchmark costs under the tariff framework for the second regulatory period (2018-20) and its consistent application, especially during the upcoming 12 to 18 months when we expect generation costs to rise beyond benchmark costs. Tenaga's standalone credit profile is assessed at 'BBB', which reflects its position as the owner and operator of Malaysia' s electricity transmission and distribution network, and its near 52% share of Peninsular Malaysia's power generation capacity. The IDRs incorporate a one-notch uplift to Tenaga's standalone rating, due to its moderate linkages to the government of Malaysia (A-/Stable), which effectively owns over 60% of the company. KEY RATING DRIVERS Regulatory Framework Intact: The government allows Tenaga to adjust its tariffs every six months to reflect changes in fuel and other generation cost relative to the amounts stipulated in the Imbalance Cost Pass-Through (ICPT) mechanism under the IBR framework, subject to the government's approval. The regular and appropriate implementation of the mechanism since June 2015 has further strengthened Tenaga's financial profile beyond the range for power producers with standalone profiles of 'BBB'. Consistent Application of ICPT Key: The regular and appropriate implementation of the framework benefitted from falling fuel and generation costs over the same period. However, Fitch expects generation costs to rise beyond stipulated benchmark costs in the near term while general elections are due in June 2018, both of which could test the government's commitment to implement the ICPT mechanism. An upgrade of Tenaga's standalone credit profile would be contingent on a sufficient revision of benchmark costs under the tariff framework for the second regulatory period and its consistent application, particularly when generation costs rise above the benchmark costs. For January-June 2017, Tenaga continued with a rebate of 1.52sen/kWh resulting in effective tariff at 37.01sen/kWh due to lower liquefied natural gas (LNG) price, higher utilisation of coal power plants and a reduction in the use of gas for electricity generation. The rebate also took into consideration higher piped-gas cost (MYR21.2/mmbtu) with effect from 1 January 2017 (July-December 2016: MYR19.7/mmbtu, ICPT framework: MYR15.2/mmbtu) as per the government's subsidy rationalisation plan. Higher-Than-Benchmark Costs Ahead: Fitch estimates Tenaga's fuel costs will be higher than the amounts stipulated in the current ICPT mechanism from the fiscal third quarter ending 31 May 2017 onwards. This will be mainly driven by higher prices for both coal and gas - piped natural gas as well as LNG. However, an increase in coal-fired electricity generation and the resultant reduction in reliance on expensive LNG will restrain growth in Tenaga's fuel costs. No Capitalised Capacity Payments: Tenaga's power purchase agreements (PPAs) with independent power producers (IPPs) include substantial fixed-capacity payments - about 15% of Tenaga's cash operating expenses in the fiscal year ended 31 August 2016 (FY16). Fitch partly capitalises these payments when calculating Tenaga's leverage ratios, with the amount capitalised representing the unutilised portion of the capacity contracted with IPPs. This added about MYR11 billion to Tenaga's unadjusted on-balance sheet debt of MYR34 billion at FYE16. However, Fitch will not capitalise these payments anymore because the unutilised IPP capacity has reduced significantly to a negligible amount as the increase in the country's peak electricity demand has outpaced the growth of its power generation capacity. The reserve margin has reduced from about 50% historically to around 25% - against a minimum reserve margin requirement of 20% - and is likely to remain at around these levels. As a result, the company's expected financial metrics will improve. The agency estimates that Tenaga would be able to maintain its FFO-adjusted net leverage comfortably below 3.0x - the level at which we may consider an upgrade - in the next two to three years (FY16: 3.0x). Uplift for State Support: The ratings incorporate a one-notch uplift to Tenaga's standalone rating due to its moderate linkages to the government of Malaysia, which effectively owns over 60% of the company, as assessed under Fitch's Parent and Subsidiary Rating Linkage Criteria. Tenaga is the owner and operator of Malaysia's electricity transmission and distribution network, and about 52% of the region's power generation capacity. The increase in electricity generation costs in FY11-13 due to natural gas supply disruptions and resultant reliance on oil and distillates was shared in equal proportions by the government, Tenaga and Petroliam Nasional Berhad (A-/Stable). High Capex, Overseas Acquisitions: Fitch expects Tenaga to have total capex of about MYR45 billion for FY17-FY20, mainly for increasing domestic generation capacity and maintenance. Tenaga plans to add 3.2GW by end-2019 to its domestic generation capacity of about 12GW at end-August 2016. The group also plans to pursue more international opportunities; Fitch expects Tenaga to take at least 30% stake in these acquisitions. Fitch has not factored in any acquisitions in its financial forecasts for Tenaga, and will analyse the impact if and when any materialise. Fitch expects Tenaga to generate cash flows from operations of about MYR14.5 billion per year, and to be able to fund the majority of the capex and investments through internal cash generation. DERIVATION SUMMARY Both Tenaga and Korea Electric Power (KEPCO, AA-/Stable) hold monopolies of their respective countries' electricity transmission and distribution sectors, and own and operate the majority of the installed generation capacity bases. However, Tenaga's expected financial profile is stronger than that of KEPCO, which has a standalone profile of 'BBB+'. Tenaga also has a much stronger credit profile, when compared to Indonesian state-owned utility PT Perusahaan Listrik Negara (BBB-/Stable, Standalone: BB+). We believe a two-notch difference in their standalone credit profiles is justified. Tenaga's financial profile is also stronger than its higher rated peers like Singapore Power Limited (SP, AA-/Stable, Standalone: A) and Vattenfall AB (BBB+/Stable). KEY ASSUMPTIONS Fitch's key assumptions within our rating case for the issuer include: - Annual electricity volume growth of around 3% - Cost of coal and oil (Brent) in line with our price decks; movement in cost of LNG in line with changes in oil prices - Coal-fired generation to increase to around 60% of total output by FY20 from about 51% in FY16 - Any excess or shortfall of fuel costs compared with benchmarks stipulated in the ICPT mechanism to be passed through to the customers - Capex of about MYR11 billion per year till FY20 - Dividend payout of 40% of net income RATING SENSITIVITIES Future Developments That May, Individually or Collectively, Lead to Positive Rating Action - Sufficient revision of benchmark costs for the second regulatory period (2018-2020) and consistent implementation of the fuel cost pass-through mechanism, especially in an environment of rising fuel costs. This while FFO-adjusted net leverage stays comfortably below 3.0x and FFO fixed-charge coverage above 4.0x, both on a sustained basis. At the same time, Tenaga's linkages with the state must remain intact. Future Developments That May, Individually or Collectively, Lead to Negative Rating Action - The Outlook may revert to Stable at the current rating if there is insufficient revision of benchmark costs for the second regulatory period or if there is inconsistent implementation of the fuel cost pass-through mechanism in an environment of rising fuel costs LIQUIDITY We expect Tenaga to generate cash flow from operations of about MYR14.5 billion a year over FY17-FY20. The company can very well address its investment plan and dividend payouts using internally generated cash. However, Tenaga may tap debt markets to raise US dollar borrowings for its overseas investments, and project-level debt for an efficient capital structure. Tenaga issued a USD2.5 billion multi-currency sukuk programme in mid-2016. It raised USD0.75 million under the programme in October 2016, which marked its return to the international debt capital markets after more than 10 years. According to press releases, the company will deploy the proceeds for its international ventures. We believe the company will continue to enjoy sound access to funding due to its strong business profile, strategic importance to the state and earnings potential. Contact: Primary Analyst Rachna Jain Associate Director +65 6796 7227 Fitch Ratings Singapore Pte Ltd One Raffles Quay South Tower #22-11 Singapore 048583 Secondary Analyst Isabelle Katsumata Director +65 6796 7226 Committee Chairperson Sajal Kishore Senior Director +612 8256 0321 Summary of Financial Statement Adjustments - 70% of the company's investments in unit trusts is considered as readily available cash Media Relations: Leslie Tan, Singapore, Tel: +65 67 96 7234, Email: leslie.tan@fitchratings.com. 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