ECM Libra Investment Research: Buy YTL Corp; target price RM2.44

ECM Libra Investment Research:  June 28, 2012

YTL Corporation Bhd
BUY
Current Price RM2.03
Target Price RM2.44

A regional powerhouse

After a lackluster performance in CY11, YTL Corporation’s stock hit an inflexion point at the start of this year, fuelled by the positive response from investors towards the recent privatisation of its subsidiary YTL Cement Bhd, which led to improved free float of YTL Corp shares and an increase in the stock’s weightage on the MSCI Asia ex-Japan Index to 2.2%. From a recent meeting with the management, we gather that it is in YTL Corp’s long-term agenda to progressively increase its stake in its key operatingsubsidiaries such as YTL Power International Bhd and possibly take some of them private. The key rationale behind this is to step up YTL Corp’s annual dividend inflow from its subsidiaries which would allow more room for the company to give more generous dividend payouts. Initiate coverage on YTL Corp with a BUY call and potential sum-of-parts target price of RM2.44.
 

YTL Corporation in a nutshell

• Founded in 1955 and listed on the Main Market of Bursa Malaysia in 1985, YTL Corporation Bhd (YTL Corp) has evolved from its humble beginning as a Pusat Khidmat Kontraktor (PKK)-registered Class ''A'' contractor to one of Malaysia’s largest non-Government linked conglomerates with a regional presence in United Kingdom, Singapore, Indonesia and Australia.
• Since 1993, YTL Corp’s core business has been in utilities and power infrastructure, parked under its 51%-owned listed subsidiary YTL Power International Bhd (YTLP).

Investment merits

• Post privatisation of YTL Cement Bhd (YTLC) by YTL Corp, it is possible that YTL Corp’s next target to be taken private is YTLP, given the disparity between YTLP’s FY13 PER of 10x and YTL Corp’s 15x FY13 PER. Our analysis shows that should a privatization offer be made via issuance of YTL Corp stock at an assumed price of RM2.00, it is in both YTL Corp management’s and the minority shareholders’ interests to take YTLP private at the current market price, which we assume to be RM1.77. Moreover in our view, this would result in a sum-of-parts based fair value of RM2.44 for YTL Corp’s share.
• The much talked about KL – Singapore high speed rail (HSR) link, once it materializes, is poised to be the YTL Corp’s next construction earnings kicker. As YTL Corp was the original proponent for the project, it would not be surprising if it bags a PDP role for the HSR. We estimate the civil engineering works portion to be close to RM7bn, comparable to the c.RM8bn price tag for the Gemas-Johor Bahru electrified double-tracking project, contributing c.RM150m in pretax profits (PBT) per annum over 5 years, translating to about 1.5x 9MFY12 annualised construction PBT.

Key risks

• YTLP’s existing Malaysian IPP power purchase agreement does not get extended.
• Delays in the implementation of the high-speed rail project.
• High leverage as reflected in YTL Corp’s end-3QFY12 1.3x net debt/equity ratio.

Valuation and recommendation

• Whilst the share price has rallied 50% YTD vis-à-vis a mere 4.6% gain in the benchmark FBMKLCI Index during this period, we believe the stock has more value to be unlocked as:- i) dividend yield and liquidity are likely to improve arising from the consolidation of YTL Cement’s profit effective March 2012; ii) more M&A activity may be in the pipeline.
•  Although our sum-of-parts valuation for YTL Corp as it stands is RM2.05, the potential privatization of YTLP could raise this to RM2.44 which we assign as our target price. Hence, we initiate coverage on YTL Corp with a BUY recommendation.

KL – Singapore high speed rail the next construction earnings kicker
 

It has been a while since YTL Corp has undertaken a high-profile construction job. The last time this happened was in 1997 - 2002, when its wholly-owned subsidiary Syarikat Pembenaan Yeoh Tiong Lay (SPYTL) teamed up with Siemens AG and Siemens Electric Engineering Sdn Bhd to build the Express Rail Link (ERL). SPYTL undertook the civil works portion (c.RM2bn) while Siemens was responsible for the trains and M&E portion of the RM2.4bn engineering, procurement and construction contract.

Measuring 57 km in length, the ERL is Malaysia’s first long standard gauge and electrified rail transport system linking Kuala Lumpur Sentral railway station at Brickfields, KL to Kuala Lumpur International Airport (KLIA) in Sepang. Built at a cost/km of RM35m, the ERL holds the record as the cheapest built high-speed line (HSL) in the world. Based on the current RM/EUR foreign exchange rate (RM4.00 per EUR), the ERL’s cost/km is only EUR8.75m (refer to Figure 5), with AVE Madrid-Lerida (Spain) and TGV Atlantique (France) being close matches to the former.

Currently, YTL Corp is in the midst of building a RM100m 2.2km ERL extension from the existing KLIA terminal to the KLIA2 airport, the new low cost carrier terminal, due to be completed by the end of this year. By our estimates, this is expected to more than double ERL’s annual ridership from 4m passengers as at end-2011 to 9m by 2013 once KLIA2 is up and running, assuming ERL’s ridership is pegged at about 11% of KLIA and KLIA2 airport passenger traffic, which we forecast to be 85m per annum comes 2013, based on press statements made by the Transport Ministry of Malaysia and Malaysia Airport Holdings Bhd.

A wild card that YTL Corp holds for its construction business is the implementation of the multibillion Ringgit KL - Singapore high speed rail (HSR) link which was first proposed by YTL Corp to the Malaysian government in the late 1990s but was put on ice due to the 1997 - 1998 Asian financial crisis. YTL Corp attempted a couple of times to revive the project but nothing took off. Then in September 2010, the HSR was unveiled as one of the entry point projects (EPPs) under the Greater KL/Klang Valley National Key Economic Area (NKEA) of the Economic Transformation Programme (ETP).

Following the completion of a pre-feasibility study conducted from June to August 2011, the Government gave the green light to the Malaysian Land Public Transport Commission (SPAD) to conduct a detailed feasibility study on the KL - Singapore HSR in two phases, to be concluded by the end of this year.

According to our checks with SPAD, if the HSR does get the go-ahead, then works on the HSR should begin by early 2014, assuming a 1-year window to obtain the necessary approvals, achieve financial closure, call for tender and award the turnkey contract to construct the link.

While we note the arguments both for and against the implementation of such a massive rail infrastructure project, we believe that, at least from a national welfare viewpoint, the pros of having the HSR outweigh the cons. For instance, a study by the Performance and Management Delivery Unit (PEMANDU) of the Government shows that travelling by HSR from KL to Singapore (and vice versa) would only take about 1.5 - 2 hours, thereby reducing door-to-door journey time (including time spent to check-in and check-out, especially in the case of air travel) between Southeast Asia’s two largest cities by an average of 3 hours (refer to Figure 6). Furthermore, the existence of a HSR could unlock economic growth in less developed areas in between major cities along the alignment as daily commuting by rail becomes more viable,  hich increases tourism activity in those areas.

Our back-of-envelope calculations using PEMANDU’s official forecast GNI impact of RM6.2bn per year, our estimated total project cost of RM13.5bn and expected construction duration of 5 years indicate that the GNI multiplier of the HSR is 2.3x (=5 x 6.2/13.5).

As YTL Corp was the original proponent of the KL – Singapore HSR, we will not be surprised if it is appointed as the project delivery partner (PDP), similar to Gamuda-MMC being the PDP for the Klang Valley MRT project. Apart from YTL Corp itself, it was reported that various railway builders including Hartasuma Sdn Bhd, M Rails International Sdn Bhd (a JV between Malaysia-based MRails and China’s CNR Tangshan Railway Vehicle Co Ltd) and China Railway Company have presented their proposals to the Government on the HSR, hoping to clinch the chariot master role for the rail project. While it is too early to gauge how much the actual project cost is, if we assume that the length of the entire KL – Singapore rail stretch is about 300km and factor in a cost/km of RM45m (based on the infrastructure cost/km of KLIA – KLIA2 airport ERL extension), this works out to a total estimated cost of RM13.5bn, which covers construction, land acquisition and rolling stock.

Supposing that YTL Corp undertakes 50% of the project for civil engineering works while the balance is subcontracted to other local and foreign parties, YTL Corp’s portion of the HSR is potentially worth RM6.8bn. Our projected cost for the HSR is close to the touted figure of c.RM8bn for Gemas – Johor Bahru double-tracking railway project (EDTP), where we expect the bulk of the cost to be for the rail infrastructure works. Assuming a 11% pretax profit (PBT) margin (comparable to that of the Gemas – Johor Bahru EDTP), YTL Corp would reap a PBT of c.RM150m per year from the HSR which is 1.5x YTL Corp’s annualised 9MFY12 construction PBT of RM102m.

ROS offers leveraged exposure to YTL Power
 

At the end of May 2012, YTL Corp announced a proposed renounceable offer for sale (ROS) of its holding of 2008/2018 YTL Power International Bhd (YTLP) warrants to entitled shareholders of YTL Corp at an offer price of RM0.20 for each warrant on the basis of 1 offer warrant for every 15 ordinary shares (RM0.10 par value) held by YTL Corp’s shareholders on the entitlement date. The exact entitlement date and number of YTLP warrants to be offered for sale will be determined by the board of YTL Corp and announced later. This exercise comes on the back of a bumper dividend declared in conjunction with the company’s 3QFYE June 2012 results, in the form of 2 sen interim cash dividend per share and 1 treasury stock for every 15 YTL Corp shares held. YTL Corp’s shares now trade ex the cash-cum-share dividends.

It is no doubt that YTL Corp’s core business to date is the Utilities division, parked under YTLP, which contributes about 74% of the group’s annual pretax profit (PBT), based on its 5-year trailing average. From a Malaysia-focussed independent power producer (IPP) company back in 1993 with its two maiden gas-fired combined cycle power plants with combined generation capacity of 1,212MW in Paka, Terengganu and Pasir Gudang, Johor (the first IPP in Malaysia), YTLP has grown its stable of utility assets outside of the country, through a series of M&A expansions ranging from the purchase of Wessex Water, UK from defunct Enron Corporation in 2002 to the acquisition of 100% equity interest in PowerSeraya Ltd, Singapore from Temasek in 2009.

Based on YTLP’s 9MFY12 financial results, YTLP’s Malaysian operations (represented by the power generation segment comprising the Paka and Pasir Gudang IPPs) only accounts for 15% of group PBT, adjusted for the 4G YES! WiMAX network start-up losses sustained by its 60%-owned subsidiary YTL Communications. However, the bulk of the PBT comes from its multi-utility business (PowerSeraya in Singapore, Jawa Power in Indonesia and ElectraNet Pty Ltd in Australia) and the water and sewerage businesses handled by its wholly-owned subsidiary Wessex Water in the UK. This illustrates how diversified YTLP’s utilities portfolio has become over the last two decades.

Based on the ROS offer price of 20 sen, YTLP’s warrants are offered at a 62% discount to the 5-day trailing VWAP (volume-weighted average price) of 53 sen, which offers YTL Corp shareholders an attractive leveraged exposure to the YTLP mother shares. Given the 1-for-15 warrant offer ratio for the ROS and 33 sen discount, this is equivalent to a dividend of about 2 sen per share. We use the sum-of-parts (SOP) methodology to arrive at a fair value of RM2.28 per YTLP share, potentially yielding 29% upside from the current stock price.

For the individual parts of YTLP’s SOP valuation, we apply the following: -

• Discounted cash flow (DCF) with 7.8% WACC to value its power generation business, ie YTL Power Generation Sdn Bhd, PowerSeraya Ltd and PT Jawa Power.
• 1.3x enterprise value/regulatory capital value (EV/RCV) to value Wessex Water, based on CY12’s UK water sewerage and treatment industry average multiple and CY12 RCV values issued by the United Kingdom Water Services Regulation Authority (Ofwat). End-FY12F book value to value ElectraNet, which is subject to RCV regulations by the Australian Energy Authority.
• We do not factor YTLP’s oil shale project in Jordan and YTL Communications’ YES! Network in our SOP valuation as both are fairly recent business ventures which are yet to make meaningful contributions to YTLP’s bottomline, particularly the latter which is currently incurring start-up losses.

Dividend stream to increase post privatisation of YTL Cement
 

Recall that on 19 December 2011, YTL Corp launched an offer to acquire all outstanding YTL Cement Bhd (YTLC) shares and irredeemable convertible unsecured loan stocks (ICULS) not owned by the former via issuance of YTL Corp stock at RM1.42 per share. The prices offered for the shares and ICULS of YTLC are RM4.50 and RM2.21 respectively, which translates to a share swap ratio of about 3.2x for the shares and 1.6x for the ICULS.

According to the filing made by YTLC with Bursa Malaysia on the privatisation offer date, YTL Corp held approximately 50% of the outstanding ordinary shares and 95% of the ICULS of YTLC. Based on our calculation, this implies that a total of about 788m shares was issued by YTL Corp to acquire the balance of the YTLC shares and ICULS it did not own. Although the deal does not appear to be that EPS- enhancing, owing to the increased share base of YTL Corp post the buyout of YTLC, both YTLC and YTL Corp stockholders benefited from the deal, as reflected in the share price performance of both YTLC and its parent company. Since YTLC was delisted last April, YTL Corp’s stock has soared more than 33% to date. Taking into account the RM4.50 offer price and 3.2x share swap ratio, this implies a 42% gain for YTLC shareholders that have accepted the offer and held on to their YTL Corp shares until now.

From YTL Corp’s viewpoint, one of the key benefits of taking YTLC private is having full access to the latter’s sustainable free cash flow to firm (FCFF) in excess of c.RM400m per year. As at FY11, YTLC’s FCFF stood at about RM428m. Consolidating YTLC’s operating profit into its parent company’s P&L and assuming that YTL Corp’s dividend payout ratio is pegged at the 5-year historical average of about 20%, we forecast YTL Corp’s cash dividend to double to RM344.7m by FY14 from RM179.6m in FY11. This comes on the back of our estimated 23% 2-year net profit CAGR from YTLC as we expect sales volume and selling prices of its cement products to improve significantly when major local infrastructure and property development projects such as the c.RM60bn Klang Valley MRT and c.RM26bn Kuala Lumpur International Financial District enter full swing. Our projected dividend payout across FY12-FY14 represents an average 12% increment above the dividend stream had YTLC not been taken private.

From a recent meeting with the management, we understand that the company’s long-term agenda to progressively increase its stake in its key operating subsidiaries such as YTLP and possibly take some of them private in order to step up the annual dividend remuneration from its subsidiaries in 5 years time. In our view, this should enable YTL Corp to pay more generous dividends.

YTLP’s existing Malaysian IPP power purchase agreement does not get Extended Earlier this year, the Government called on Tenaga Nasional Bhd (TNB) and Malaysia’s “first generation” independent power producers (IPPs) to bid via open tender for renewal of their existing power purchase agreements (PPAs), due to expire in 2015 – 2016, under the Track Two bidding process. The tender will close at the end of July and the winners announced this coming October. The “first generation” IPPs include YTL Power Generation Sdn Bhd, Genting Sanyen Power Sdn Bhd (the IPP utility arm of Genting Bhd), Segari Energy Ventures Sdn Bhd (a subsidiary of MMC Bhd), Port Dickson Power Bhd (an associate of MMC Bhd) and Powertek Bhd (recently acquired from Tanjong plc by 1Malaysia Development Bhd). Their combined daily power output is about 4,300MW, which makes up roughly half of Malaysia’s power requirements, whilst TNB supplies the rest.

YTLP’s 21-year PPA for its power plants at Paka and Pasir Gudang expires at the end of September 2015. Currently, YTLP is the only Malaysian IPP that has a “take-or-pay” clause embedded in the PPA, which obliges its key customer TNB to pay a flat 15.5sen/kWh tariff for a minimum purchase of 7,450GW per annum, regardless of whether TNB actually requires that amount or not.

It was reported in the press recently that only half of the existing PPAs will be extended by a period of about 5-10 years from the expiry date. Furthermore, under the “integrity pact” signed between TNB and the “first generation” IPPs, the IPPs had agreed to lower their rates for 48 months under their current PPA schemes, should they succeed in the bids. This is part of ongoing efforts by the Malaysian Energy Commission to make pricing of power supply in the country more competitive.

Like the rest of the “first generation” IPPs, YTLP faces the prospect of not having its PPA extended past 2015. However, we take comfort from the fact that as mentioned in our investment case earlier on, the Paka and Pasir Gudang power plant businesses contribute only 15% to YTLP’s bottomline. Given that YTL Corp’s utilities division PBT makes up roughly 65% of group PBT(Source: YTL Corp 2011 Annual Report), this means that the Malaysian IPP operations account for c.10% of YTL Corp’s PBT, which is not really significant. On the flip side of things, YTLP and its strategic partner Marubeni Corp of Japan are one of nine consortia and sole bidders prequalified to bid for the 1,000MW-1,400MW Combined Cycle Gas Turbine power plant in Prai.

According to news reports, the tender result will be out by end-October 2012. Should YTLP secure this project, the Prai power plant can then act as a buffer against any revenue shortfall if the group does not succeed in its PPA extension bid.