HK Utilities:New SoC return of 8%in-line

8% return under new Scheme of Control….

    CLP (2 HK, Hold) and Hong Kong Electric (2638 HK, Not Rated) announced after market close on 25 Apr that they have reached a new agreement with the HK government regarding the Scheme of Control (SoC). Returns under the SoC will be 8%, governing about 15 years for both CLP (from 1 Oct 2018 to 31 Dec 2033) and Hong Kong Electric (from 1 Jan 2019 to 31 Dec 2033). There is no distinction for permitted return for renewable energy investments and other investments under the new SoC.

    …and some other minor changes.

    Other changes under the new SoC include: Fuel Cost Adjustment (FCA) will be revised more frequently, new terms and initiatives will be introduced to promote the development of renewable energy and encourage energy saving with enhanced efforts; stringent operational performance targets including supply reliability and customer services will be set for power companies.

    New return in line with DB expectation .

    We think the 8% return under the new SoC is in line with consensus (also with DBe) and we expect minimal earnings implications from others changes in the SoC. SoC earnings represents ~73% of earnings for CLP, ~18% for PAH (6 HK, Hold) and ~5% for CKI (1038 HK, Hold), through their holdings of Hong Kong Electric. Hong Kong SoC represents ~68% of our valuation for CLP, ~4% for CKI and ~18% for PAH.

    Prefer CLP.

    Although all Hold-rated, we have a relative preference for CLP over CKI/PAH. The settlement of post-2018 SoC and also CLP’s large exposure to SoC means that CLP now offers higher earnings certainty versus peers. In addition, we see upside risk from CLP’s Australia business given the high power prices. Lastly, CLP looks more attractive than its peers on PE vs. earnings growth and P/B vs. ROE and has the greatest flexibility to increase the dividend (if needed), given its lower payout ratio.

    Valuation and risks .

    We base our valuation of CLP on a sum-of-the-parts analysis with DCF (WACC of 4.6%) for HK SoC business and DCF and multiple-based approaches in valuing non-SoC businesses. We value CKI and PAH's existing assets using a sum-of-the-parts approach based on DCF for the key assets and the remaining assets using various multiple-based approaches. Key risks for CLP: performance of overseas businesses; US rate hikes; and key risks for CKI and PAH are failure/success in making value-accretive acquisitions, higher/lower bond yields, and currency risks.