HK Electric Investments Lumpy Maturity to be Supported by Visible Earnings

17 May 2016

Credit Brief

HK Electric Investments           

Lumpy Maturity to be Supported by Visible Earnings

Key Credit Highlights                                                                     

¨     Transparent, regulated and mature electricity industry in Hong Kong. Electricity consumption in Hong Kong has been flat at 43.9 TWh p.a. for the past four years, though sales has increased to HKD52.3bn in 2015 (8y-CAGR of 3.4%) due to gradual tariff increases. Meanwhile, peak demand in Hong Kong declined to 10,009 MW (from a 10y average of 10,225 MW) while generating capacity was little changed at 12,625 MW (Fig 3), leading to wider reserve margins of 26% (versus 10y average of 23%). Hong Kong power companies (CLP Power and HKE) are monitored and regulated through a Scheme of Control Agreement (“SoC”) with the government, which transparently specifies the cost pass-through mechanism and Permitted Return for both companies. The first SoC was signed in 1964 between CLP Power, Castle Peak Power Co (“CAPCO”), and the government; while the current SoC came into effect around end-2008 and will expire in 2018 (subject to a 5-year extension by the government). HK electricity sector customer mix consists of 66.1% commercial, 26.6% residential, and 7.3% industrial

¨     Growth is limited by geographical constraint. HKE’s electric unit sales has been stagnant at around 10.9 TWh p.a. (25% of Hong Kong’s electricity demand), with 10y-CAGR of 0.3% due to geographical concentration as the sole supplier of electricity to Hong Kong Island and Lamma Island, while the remainder of Hong Kong is accounted for by CLP Power. HKE is exposed to site concentration risk from Lamma Power Station which is their only generation facility. HEC has generating capacity of 3,737 MW with new 350MW gas-fired plant (“L10”) that will commence construction this year, for commissioning in 2020, to replace old 3 coal- and 1 gas-fired plants from next year. The new plant has a budgeted CAPEX of HKD3.0bn, as originally slated in HKE’s 2014-2018 Development Plan with a total budget of HKD13bn.

¨     Uncertainty of Permitted Returns after expiry of SoC in 2018. HKE’s earnings are susceptible to changes in the SoC which expires in 2018 (or 2023 at the government’s discretion), as the agreement allows the company to recover operating costs through a tariff setting mechanism and earn a Permitted Return of 9.99% of average net fixed assets. Notwithstanding, material changes seem unlikely at this juncture given that a majority of the respondents to a public consultation in Nov-2015 were in favor of continuing the current SoC mechanism, while the government will negotiate the level of Permitted Return with power companies during 2016-2018.

¨     Earnings to remain stable under the SoC mechanism. HKE’s earnings performed better than peers in FY15 (Fig 5) as revenues rose 6.7% YoY to HKD11.2bn while EBITDA margin remained robust at 71.7%, albeit a slight decline from 73.3% a year ago. We expect revenues and PBT to remain stable around HKD11bn and HKD4bn respectively due to the SoC mechanism (Fig 6); and further buffered by surpluses in the Fuel Clause Recovery account of HKD2.28bn and Tariff Stablisation Fund of HKD204m, accumulated from tariff revenues in excess of fuel costs and Permitted Returns in prior periods. As such, we expect the decrease in average net tariffs by 1.1% (or approximately 1.5 cents) to 133.5 cents per kWh effective 1 Jan 2016 to have a neutral impact on earnings while passing lower fuel cost benefits to consumers. Separately, Permitted Returns could increase following the completion of L10, though impact to bottomline in the short term may be offset by higher depreciation and interest. We presume the L10 project to have an IRR of c.18.7%, assuming HKD600m p.a. CAPEX through 2020, followed by HKD750m p.a. cash inflow for 30 years through 2050.

¨     FFO interest cover pressured by hefty maturities at higher refinancing rates. HKE has a short maturity profile with a weighted average duration of 3.8 years as 65% of existing debts are due in the next 12 months (Fig 7), namely HKD900m at 4.45% in 4Q16 and HKD37bn at an estimated 1.7% in 1Q17. HKE has tapped the market for HKD7.23bn YTD ahead of the maturities but at a higher rate of 2.87% on average versus S&P’s estimate of 2.5% for the HKD37bn refinancing. Assuming the remaining HKD30bn is refinanced at current rates, we anticipate that FFO/interest could drop as low as 5.1x in FY16 and 4.9x in FY17 (from 5.8x in 2015), below S&P’s estimates of 5.6x-5.8x in FY17, while average cost of debt would rise to 2.23% in FY16 and 2.69% in FY17 from 2.17% in FY15. HKE may utilise a portion of its HKD6.2bn cash balance and HKD1.0bn undrawn banking facilities, while operating cash flows are anticipated to be fully utilised for CAPEX (HKD2.4bn maintenance and estimated HKD600m for L10 construction in 2016) and distributable income to Share Stapled Unit (SSU) holders. Free cash flows (FCF) have averaged HKD5.4bn since 2014, though we expect a reduction to around HKD4.8bn through 2020 during the construction of L10.

¨     Leverage to remain within rating and covenant thresholds over 12-18 months. Debts could rise 12% YoY to HKD5.3bn (based on HKD7.2bn raised YTD less HKD900m maturities) in FY16 mainly to prefund 2017 maturities, which results in higher debt/EBITDA of 6.6x in 2016 (from 5.9x in 2015) before easing to 5.7x in 2017, remaining within the loan covenant of 7.0x or equivalent to HKD3.3bn of headroom and S&P’s estimate of 5.6x-6.0x in 2017. Similarly, FFO/debt is projected to drop to 12.0% in 2016 and 12.4% in 2017 (from 12.5% in 2015) – which remains conservatively above S&P’s downgrade trigger of 9.0%; while debt-to-equity could rise to 1.10x (from 0.97x), which is well below the covenant of 2.5x.