UTILITIES | 25 October 2009 INITIATION OF COVERAGE Saudi Electricity Co Neutral A monopoly undermined by margin pressure Price (SR) 11.30 12-month target price (SR) 11.9 Potential upside (%) ↑ 5.1 Growing revenue, high credit rating and constant dividends are positives that are undermined by margin pressure and negative free cash flows over 2009-12e due to high capital expenditure. We initiate coverage on Saudi Electricity with a Neutral rating and a 12-month price target of SR11.9 Stock details Financials 52-week range H/L (SR) 11.7/8.9 2007 2008 2009E 2010E 2011E Market cap ($mn) 12,572 Revenues SR mn 20,839 22,289 23,726 25,289 26,934 Shares outstanding (mn) 4,167 EBITDA SR mn 7,486 7,508 8,421 9,120 10,186 Listed on exchanges Tadawul Net income SR mn 1,413 1,104 1,416 1,014 981 Price perform (%) 1M 3M 12M Total debt SR mn 9,825 10,204 31,408 51,499 67,814 Absolute 10.2 20.2 13.0 Div per share SR 0.70 0.70 0.70 0.70 0.70 Rel. to market (0.2) 4.4 6.4 EBITDA margin % 35.9 33.7 35.5 36.1 37.8 Avg daily turnover (mn) SR US$ Net margin % 6.8 5.0 6.0 4.0 3.6 3M 32.2 8.6 ROE % 3.0 2.3 2.9 2.0 2.0 12M 23.7 6.3 Debt-to-capital % 17.0 17.4 38.9 50.8 57.4 Reuters code 5110.SE Source: Company, NCBC Research estimates Bloomberg code SECO AB Website www.se.com.sa Valuation multiples 08 09E 10E P/E (x) 42.6 33.2 46.4 P/B (x) 1.0 1.0 0.9 EV/EBITDA (%) 9.9 8.8 8.1 Div yield (%) 6.2 6.2 6.2 Source: NCBC Research estimates Share price performance - 2 4 6 8 10 12 14 16 18 Jan-07 Nov-07 Aug-08 Jul-09 - 2,000 4,000 6,000 8,000 10,000 12,000 14,000 SEC TASI Source: Bloomberg Ahmed Al Qahtani [email protected]Tel. +966 2 6907784 Please refer to the last page for important disclaimer • Stability and high credit rating: SEC has enjoyed predictable and stable revenue growth over the past decade and should continue to do so going forward. Moreover, majority ownership by the Saudi Arabian government ensures full government support and commitment to the company. As a result, SEC’s high credit ratings are equivalent to the sovereign rating of the Saudi Government. • Growing demand for power: A growing population, rising per capita consumption and increasing industrial activity led to growth in demand for power at 7.7% per annum over 2003-08. We expect these factors to continue to drive demand going forward; we estimate peak demand will grow at 6.4% per annum over 2008-16e. • Stable dividend per share: The government has recently extended its dividend waiver for a further 10 years until 2020. We expect dividends to remain at the SR0.7 level during this time. At the current price, the stock offers a dividend yield of 6.2%. Given the sovereign rating of the company, some investors view the stock as an alternative to Saudi sovereign debt, but with a much higher yield. • Extensive capital expenditure program: The aggressive capacity expansions will almost double generation capacity over the next decade. Over 2009-13e, the company plans to spend 118 times net income in 2008 which will pressure free cash flows. To finance that, SEC will have to rely on external debt and we expect debt-to-capital to increase from 17.4% in 2008 to around 50% over the long-term. • Steady EBITDA margin, but declining net income: We expect the EBITDA margin to stabilize around 35% over our forecast period, given SEC’s restructuring plans and tighter cost controls. Nevertheless, we expect net income to shrink over 2009-13e due to the expected rise in depreciation charges. However, beyond 2013e, as capital expenditure slows and income from equity investments improves, we expect income to start expanding • Tariffs reform could trigger significant upside: Despite our Neutral rating, the valuation is highly sensitive to a change in tariffs; a raise in tariffs by only 5% could lead to an increase in the valuation by 60%. Our base case assumes no tariff reform.
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Saudi Electricity Co · 2009. 10. 28. · Saudi Electricity Co Neutral A monopoly undermined by margin pressure Price (SR) 11.30 12-month target price (SR) 11.9 Potential upside (%)
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U T I L I T I E S | 2 5 O c t o b e r 2 0 0 9 I N I T I AT I O N O F CO V E R A G E
Saudi Electricity Co Neutral A monopoly undermined by margin pressure Price (SR) 11.30
12-month target price (SR) 11.9
Potential upside (%) ↑ 5.1
Growing revenue, high credit rating and constant dividends are positives that are
undermined by margin pressure and negative free cash flows over 2009-12e due to high
capital expenditure. We initiate coverage on Saudi Electricity with a Neutral rating and a
12-month price target of SR11.9
Stock details
Financials
52-week range H/L (SR) 11.7/8.9 2007 2008 2009E 2010E 2011EMarket cap ($mn) 12,572 Revenues SR mn 20,839 22,289 23,726 25,289 26,934 Shares outstanding (mn) 4,167 EBITDA SR mn 7,486 7,508 8,421 9,120 10,186 Listed on exchanges Tadawul Net income SR mn 1,413 1,104 1,416 1,014 981
Price perform (%) 1M 3M 12M Total debt SR mn 9,825 10,204 31,408 51,499 67,814
Absolute 10.2 20.2 13.0 Div per share SR 0.70 0.70 0.70 0.70 0.70Rel. to market (0.2) 4.4 6.4 EBITDA margin % 35.9 33.7 35.5 36.1 37.8 Avg daily turnover (mn) SR US$ Net margin % 6.8 5.0 6.0 4.0 3.6 3M 32.2 8.6 ROE % 3.0 2.3 2.9 2.0 2.0 12M 23.7 6.3 Debt-to-capital % 17.0 17.4 38.9 50.8 57.4
Reuters code 5110.SE Source: Company, NCBC Research estimates
Please refer to the last page for important disclaimer
• Stability and high credit rating: SEC has enjoyed predictable and stable revenue growth
over the past decade and should continue to do so going forward. Moreover, majority
ownership by the Saudi Arabian government ensures full government support and
commitment to the company. As a result, SEC’s high credit ratings are equivalent to the
sovereign rating of the Saudi Government.
• Growing demand for power: A growing population, rising per capita consumption and
increasing industrial activity led to growth in demand for power at 7.7% per annum over
2003-08. We expect these factors to continue to drive demand going forward; we estimate
peak demand will grow at 6.4% per annum over 2008-16e.
• Stable dividend per share: The government has recently extended its dividend waiver for
a further 10 years until 2020. We expect dividends to remain at the SR0.7 level during this
time. At the current price, the stock offers a dividend yield of 6.2%. Given the sovereign
rating of the company, some investors view the stock as an alternative to Saudi sovereign
debt, but with a much higher yield.
• Extensive capital expenditure program: The aggressive capacity expansions will almost
double generation capacity over the next decade. Over 2009-13e, the company plans to
spend 118 times net income in 2008 which will pressure free cash flows. To finance that,
SEC will have to rely on external debt and we expect debt-to-capital to increase from
17.4% in 2008 to around 50% over the long-term.
• Steady EBITDA margin, but declining net income: We expect the EBITDA margin to stabilize around 35% over our forecast period, given SEC’s restructuring plans and tighter cost controls. Nevertheless, we expect net income to shrink over 2009-13e due to the expected rise in depreciation charges. However, beyond 2013e, as capital expenditure slows and income from equity investments improves, we expect income to start expanding
• Tariffs reform could trigger significant upside: Despite our Neutral rating, the valuation is highly sensitive to a change in tariffs; a raise in tariffs by only 5% could lead to an increase in the valuation by 60%. Our base case assumes no tariff reform.
25 October 2009 SAUDI ELECTRICITY COMPANY - INITIATING COVERAGE 2
Contents
INVESTMENT SCENARIOS 3INVESTMENT VIEW 4
Downside risks 7
Upside risks 7
VALUATION 8
Cost of capital and terminal growth 8
Value of waived dividend 8
Discounted cash flow 9
Peer valuation 10
BUSINESS BACKGROUND 11
Corporate background 11
SEC’s operations 12
Business performance 14
INDUSTRY AND BUSINESS DYNAMICS 20
Demand-supply balance 20
Pricing 21
Privatization plans 22
FINANCIAL PERFORMANCE 23
Revenue 23
Profitability and margins 23
Capitalized interest 24
Dividends 25
Capital expenditure and financing 25
APPENDIX 26
SEC’s generation projects 26
FINANCIALS 27
25 October 2009 SAUDI ELECTRICITY COMPANY - INITIATING COVERAGE 3
Investment scenarios
Valuation can increase significantly with better tariffs
Historical and expected price performance (three scenarios)
We use DCF to arrive at our fair value of the company. We discount the FCFF over 2009-18e using our WACC, to arrive at EV, which we adjust by adding cash and equity investments and deducting debt. We then add our estimate of the value of the dividends waived by the government to arrive at our fair value estimate.
DCF bull case: SR 22.20
We assume the same electricity sales in Kwh as our base case, but we assume tariffs increase by 5% for all consumption categories. Moreover, we assume SEC will improve operational efficiencies more than what we factor in our base case.
DCF base case:SR 11.90
We expect revenue to grow steadily over our forecast period. We assume the electricity tariff structure to remain the same and the utilization rate to remain stable but low at 60%. We expect the company to improve cost management, which should positively impact margins. We use 7.0% as a discount rate.
• Continued monopoly: In 2008, SEC accounted for more than 87% of total power produced in Saudi Arabia; but 100% of power sold to end users. Despite plans to restructure the power sector and the company, SEC will continue to remain the monopoly provider of electricity to end users in the foreseeable future.
• Stability and high credit rating: Supply of electricity is an essential service and therefore its demand is insulated from business cycles. This has helped SEC register steady revenue growth. Moreover, full government support enhances the company’s credit ratings, bringing them on par with the Saudi Arabian government’s sovereign rating.
• Sustainable growth in demand: Peak power demand in KSA has grown at 7.7% per annum over 2003-08 and we forecast 6.4% annual growth over 2008-16e. Demographic factors such as a growing population, creation of households, rising per capita income, and rapidly growing industrial activity are the main drivers
• Significant capital expenditure requirement: SEC’s current capacity barely supports current demand. The company will have to enhance generation capacity to meet growing future demand. SEC has announced capital expenditure plans of SR130bn over 2009-13e to meet the additional demand.
• Steady EBITDA margins, but squeezed net margin: We project EBITDA to grow in line with revenue over our forecast period. However, we expect net income and net margin to decline over 2009-13e due to rising depreciation charges.
DCF bear case: SR 5.10
We assume revenue growth to be similar to our base case. However, we factor in lower levels of efficiency that will reflect in higher fuel, operating, and maintenance costs. Additionally, we increase our discount rate by 1% relative to the base case.
Potential catalysts Investment risks
• Tariff restructuring: Current tariffs are significantly low, which impact SEC’s profitability. An increase in electricity prices will have a significant positive impact on the company’s valuation.
• Rising consumption per capita: In our model, we have assumed per capita usage to grow marginally during the forecast period. Higher than expected growth in per capita consumption will have a positive impact on revenue and valuation.
• Change in customer mix: In our forecast, we assume residential consumption will grow more than other categories. Residential rates are the lowest amongst all categories. If growth in other categories is higher than our forecast, SEC’s revenue, earnings and valuation will be positively impacted.
• Rising cost of purchased power: The price of electricity that SEC purchases from IPP’s and IWPP’s is not linked to the price at which SEC sells to end-users. If prices of purchased energy increases more than what we expect, profits would be impacted negatively.
• Rising fuel costs: SEC purchases fuel from Saudi Aramco at a subsidized price. Although a change in electricity tariffs would accompany any change in subsidy, there is no guarantee that the increase in tariffs would be proportional to the increase in fuel cost.
• Difficulty mobilizing necessary financing: Given the company’s capital expenditure plans, SEC will have to rely heavily on debt in order to finance these expansions. If obstacles arise in securing the necessary funding, revenue growth would likely be impacted.
25 October 2009 SAUDI ELECTRICITY COMPANY - INITIATING COVERAGE 4
Investment view
INITIATING COVERAGE ON SEC WITH A NEUTRAL RATING AND A PRICE TARGET OF SR11.9
SEC is the only electricity seller to end users in the country, which has allowed it to capitalize on
the ever-growing demand for power. This factor also puts pressure on the company to increase
generation capacity, which will require significant investments over next few years. Such
expansion will be financed mostly through debt that will be raised from the market and/or the
government. The unlimited and unconditional government support has resulted in credit ratings
that are equivalent to the rating assigned to the Saudi government. Part of this support takes
shape in a dividend waiver, which, we believe contributes around 40% to SEC’s intrinsic value.
This support, however, comes at a cost. The Saudi government has set electricity tariffs at low
levels that results in low RoE for SEC relative to peers, globally and regionally. Going forward,
we expect profits to be squeezed despite rising revenue, led by higher depreciation charges due
to large capital expenditures.
CONTINUED MONOPOLY DESPITE PROPOSED RESTRUCTURING PLANS
The Saudi Electricity Company (SEC) is more than 80% owned by the government (directly and
indirectly). The company produced more than 87% of total power in Saudi Arabia in 2008.
Despite the rising proportion of power supplied by other producers, SEC is and will remain the
only supplier of power to end-users in the foreseeable future.
We believe that despite plans to restructure the industry and the company, SEC will maintain its
monopoly over the electricity generation, transmission and distribution businesses. The
company purchases power from the Independent Power Producers (IPPs) and the Independent
Water and Power Producers (IWPPs) through long-term contracts at an agreed rate and sells
electricity to end users at tariffs set by the government.
Recently announced plans to split SEC into several but similar companies would have a positive
impact on the company’s efficiency. However, this will not have any impact on the sector as a
whole since the competition between these companies will be confined to SEC.
STABILITY AND HIGH CREDIT RATING
SEC operates in the stable utilities sector, which has protected the company from earnings
swings that other companies have experienced. Thus, despite the global economic crises, SEC
has maintained steady revenue growth.
The government owns a more than 80% stake in the company. Along with this, the critical
importance of the electricity sector to the development of the wider economy engenders
unconditional government support to SEC. The credit rating agencies in 2008 increased their
ratings to factor in this support, bringing SEC’s ratings on par with the sovereign rating of Saudi
Arabia. These high credit ratings strengthen SEC’s credit and financial risk profile and allow it to
mobilize funding even during adverse economic conditions.
GROWING DEMAND FOR ELECTRICITY TO PUSH TOP LINE
Peak demand for power has been growing at 7.7% per annum over 2003-08 and we forecast
6.4% growth over 2008-16e. Demographic factors such as a growing population, creation of
households, rising per capita income, and growing industrial activity are driving this growth.
25 October 2009 SAUDI ELECTRICITY COMPANY - INITIATING COVERAGE 5
I NV ES T M E N T V I EW
This growth is expected to benefit the company’s top line. We forecast revenue to grow from
SR22.3bn in 2008 to SR35.1bn in 2016e (CAGR 5.8%). Most of the growth in electricity sales
will come from residential customers which have the lowest revenue per Mwh, which explains
the slower increase in revenue relative to consumption.
Exhibit 1: We expect electricity sales to grow at 5.9% per annum over 2008-16e
-
5,000
10,000
15,000
20,000
25,000
30,000
35,000
2008 Residential Commercial Government Industrial Others 2016E
SR m
n
Source: Company, NCBC Research estimates
STEADY EBITDA MARGIN, BUT DECLINING NET PROFIT MARGIN
SEC’s EBITDA margin has declined over 2003-08. However, we expect it to stabilize around
35%, driven by SEC’s restructuring program and cost control measures. These measures aim to
boost productivity and increase efficiency.
SEC receives fuel at a subsidized price from the government and we expect this to continue as
long as current tariffs are maintained. In 1999, the council of ministers issued resolution No. 169
that links any change in the existing fuel subsidy to a review of the structure of electricity tariffs.
Thus, in the unlikely scenario of the government changing the fuel subsidy, we believe this will
be coupled with a new tariffs structure that would at least partially offset the negative impact on
operating margins.
We forecast net profit margin, on the other hand, to decline significantly over 2009-13e, driven
by rising depreciation charges owing to increased capital expenditure. We estimate depreciation
expense will rise from SR6.7bn in 2008 (30% of revenue) to SR10.8bn in 2013e (36% of
revenue). Over 2014-15e, however, we expect net margin to recover, as depreciation expenses
would grow less than proportionately to revenue and EBITDA. Given the size of the depreciation
expense, this should have a sharp impact on the company’s net income.
25 October 2009 SAUDI ELECTRICITY COMPANY - INITIATING COVERAGE 6
When SEC was established, the Saudi Arabian government waived its rights to the company’s
dividends over 2001-09 (provided the dividends do not exceed 10% of par value). In 2009, the
government extended the waiver for another 10 years. This waiver by the largest shareholder in
the company has resulted in dividend per share (DPS) that exceeds earnings per share (EPS).
At the current price, SEC offers a 6.2% 2009e dividend yield.
SIGNIFICANT CAPITAL EXPENDITURE REQUIREMENT
SEC’s current capacity will not be sufficient to meet the expected growth in peak demand over
the coming years. In fact, the current capacity barely covers current peak summer demand,
leading to occasional power outages in various parts of the Kingdom. To meet this growing
demand SEC has outlined an expansion program involving significant expenditure of more than
SR130bn over 2009-13e. Our analysis indicates that the capacity expansion expected over the
next ten years is equivalent to the capacity added over the past 45 years. To put this into
perspective, the company’s planned capex over 2009-13e will amount to 118 times the
company’s earnings in 2008.
To finance this expansion, SEC will capitalize on its low leverage and full support and commitment
of the Saudi Government. We expect debt levels to increase from SR10bn in 2008 to SR52.5bn in
2016e. The Debt-to-capital ratio will increase from 17% at end 2008 to over 50%, through our
forecast period. We expect the company to maintain this leverage over the long term.
Exhibit 3: SEC will increase debt level in order to finance capital expenditure 2008 2009E 2010E 2011E 2012E 2013E 2014ECapex SR mn (22,154) (33,092) (32,222) (28,140) (24,625) (20,805) (16,855)
Capitalized interest It is important to note that SEC’s income statements do not show any interest expense as all
debt raised is used for capital expenditure; thus all interest charges are capitalized on the
company’s balance sheet. However, the company discloses the amount of capitalized interest
every year.
Interest coverage ratio is expected to decline sharply as debt levels rises significantly; hence
interest on that debt. However, the coverage is still at a reasonable level given the stability of
the business and the full backing the company has from the government.
Exhibit 30: Expected decline in interest coverage due to rising debt 2007 2008 2009E 2010E 2011E 2012E 2013EEBITDA SR mn 7,486 7,508 8,421 9,120 10,186 10,501 10,697
Interest on debt SR mn 634 613 1,541 1,805 2,367 2,741 3,129
EBITDA/Interest SR mn 11.8 12.2 5.5 5.1 4.3 3.8 3.4
Source: Company, NCBC Research estimates
Capitalized interest becomes part of the asset cost and is depreciated over the life of the asset.
Thus, part of the depreciation expense pertains to interest of previous years. Since depreciation
is a non-cash item, this interest does not have any impact on our FCF calculations; hence, it
would have no impact on our valuation. However, we adjust capital expenditure for the
capitalized interest, to avoid double counting, as the cost of debt is factored in our discount rate.
For financial forecasting, we do not adjust the capitalized interest; however, we present the
amount that we expect to be capitalized below the net income line (Please refer to the financials
section).
25 October 2009 SAUDI ELECTRICITY COMPANY - INITIATING COVERAGE 25
F I NA N CI AL P E R F O R MA N C E
Dividend The Saudi Arabian government has waived its rights to dividends from 2001 until 2009 and
extended the waiver in 2009 for another 10 years (provided dividends do not exceed 10% of
par). The company has maintained fixed dividends per share (paid to the public only) at SR0.7
over the past decade and we expect it to maintain the same level of dividends, going forward.
Capital expenditure and financing Due to rising peak demand in the Kingdom, SEC’s current capacity will not be sufficient to meet
the growing demand in future. As a result, the company has planned to expand its generation,
transmission and distribution capacities.
According to the company’s latest sukuk prospectus, SEC plans to spend more than SR130bn
over 2009-13e, mostly for generation projects, but also for transmission and distribution
projects.
To finance these projects, SEC has to raise external finance. In 2009, the company issued
sukuk, borrowed from banks and export financing companies, and received a loan from the
government (through the Public Investment Fund).
Exhibit 31: SEC will increase debt level in order to finance capital expenditure 2008 2009E 2010E 2011E 2012E 2013E 2014ECapex SR mn (22,154) (33,092) (32,222) (28,140) (24,625) (20,805) (16,855)
Overweight: Target price represents expected returns in excess of 15% in the next 12 months Neutral: Target price represents expected returns between -10% and +15% in the next 12 months Underweight: Target price represents a fall in share price exceeding 10% in the next 12 months Price Target: Analysts set share price targets for individual companies based on a 12 month horizon. These share price targets are subject to a
range of company specific and market risks. Target prices are based on a methodology chosen by the analyst as the best predictor of the share price over the 12 month horizon
OTHER DEFINITIONS
NR: Not Rated. The investment rating has been suspended temporarily. Such suspension is in compliance with applicable regulations and/or in circumstances when NCB Capital is acting in an advisory capacity in a merger or strategic transaction involving the company and in certain other situations
CS: Coverage Suspended. NCBC has suspended coverage of this company NC: Not Covered. NCBC does not cover this company IMPORTANT INFORMATION
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