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Morningstar, Inc.

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Equity Bottom-Up

HK Electric Investments / Equity Bottom-Up

We are initiating coverage on narrow moat-rated <a href="https://www.smartkarma.com/entities/20985" target="_blank" data-smartkarma-citation="entities:20985:1">HK Electric Investments (2638 HK)</a>, or HKEI, with a fair value of HKD 5 and a 1-star recommendation. Our fair value of HKD 5 represents a fair distribution yield of 7.5% and enterprise value/EBITDA of 10.6 times. We apply weighted average cost of capital of 5.6%, which is at the low end of peers within our global utilities coverage.Our 1-star recommendation is based purely on valuation grounds as we view the vertically integrated electricity operator's assets as high-quality and possessing efficient scale, underpinning its narrow economic moat. Electricity generated from its predominantly coal and gas-powered power plant on Lamma Island is distributed to the Hong Kong Island through its difficult-to-replicate transmission and distribution network, which is mostly underground. The underground network minimizes vulnerability to weather conditions and underpins HKEI's high reliability rating. We also like the consistent and favorable regulatory regime in Hong Kong, allowing HKEI to earn reasonable returns and underpin its steady distribution payout.While investors continue to favor yield-plays such as regulated utilities in this ultra-low interest rate environment, we expect investor interest in HKEI to wane as U.S. policy rates normalize in the medium term and the U.S. Federal Reserve begins to unwind its balance sheet. Given the fixed exchange rate system in Hong Kong, the Hong Kong Interbank Offer Rate, or HIBOR, should move in line with the U.S. depending on the level of liquidity in the system. Short-term HIBOR edged higher post the Fed's meeting last week but three-month and six-month rates held steady at 0.76% and 0.96%, respectively. We believe the normalization of U.S. interest rates is the main driver for the trust's unit price to converge toward our fair value.With the rate of return of 8% locked in from fiscal 2019 for the next 15 years, the main driver of profit and distribution is the level of capital expenditure and increase in its regulatory asset base. Over the next two years, we expect HKEI to spend the remaining HKD 6.6 billion of allocated capital expenditure in the 2014 to 2018 Development Plan. Current run rate is tracking slightly below with close to HKD 7 billion incurred since 2014. We estimate the slightly higher capital expenditure in fiscal 2017 and 2018 should see its Scheme of Control asset base increase by 2% annually in the two years. Post 2018, the next Development Plan for 2019 to 2023 will encompass HKEI's long-term return. With the number of domestic households in Hong Kong increasing steadily at a slow pace of 1.1% annually and both total electricity demand and peak demand largely flat over the last 10 years, capital expenditure will be underpinned by maintenance expenditure for the transmission and distribution electricity network and increments driven by the replacement of coal-fired generating units to gas fired units.HKEI currently earns a predetermined permitted return on average net fixed assets of 9.99%, but the regulator has lowered the permitted return to 8% from 2019 onwards, for 15 years. However, HKEI will continue to earn return on invested capital of 5.8% and above its weighted average cost of capital of 5.6%. The difference between the permitted return and return on invested capital is due to the asset base of the company, which was revalued higher at the time of listing. The regulator did not account for the revaluation in assessing HKEI's regulated asset base and the company's returns are calculated off this lower asset base. However, we forecast HKEI's return on invested capital to increase towards 8% over the medium term as ongoing capital expenditure will lift the regulated asset base towards the accounting asset base. We estimate the decline in permitted return in 2019 should lead to a 18% decline in distribution in fiscal 2019 to HKD 0.31 and be sustained at this level going forward.Analyst: Michael Wu, CAIA

We are initiating coverage on narrow moat-rated HK Electric Investments (2638 HK), or HKEI, with a fair value of HKD 5 and a 1-star recommendation. Our fair value of HKD 5 represents a fair distribution yield of 7.5% and enterprise value/EBITDA of 10.6 times. We apply weighted average cost of capital of 5.6%, which is at the low end of peers within our global utilities coverage.Our 1-star recommendation is based purely on valuation grounds as we view the vertically integrated electricity operator's assets as high-quality and possessing efficient scale, underpinning its narrow economic moat. Electricity generated from its predominantly coal and gas-powered power plant on Lamma Island is distributed to the Hong Kong Island through its difficult-to-replicate transmission and distribution network, which is mostly underground. The underground network minimizes vulnerability to weather conditions and underpins HKEI's high reliability rating. We also like the consistent and favorable regulatory regime in Hong Kong, allowing HKEI to earn reasonable returns and underpin its steady distribution payout.While investors continue to favor yield-plays such as regulated utilities in this ultra-low interest rate environment, we expect investor interest in HKEI to wane as U.S. policy rates normalize in the medium term and the U.S. Federal Reserve begins to unwind its balance sheet. Given the fixed exchange rate system in Hong Kong, the Hong Kong Interbank Offer Rate, or HIBOR, should move in line with the U.S. depending on the level of liquidity in the system. Short-term HIBOR edged higher post the Fed's meeting last week but three-month and six-month rates held steady at 0.76% and 0.96%, respectively. We believe the normalization of U.S. interest rates is the main driver for the trust's unit price to converge toward our fair value.With the rate of return of 8% locked in from fiscal 2019 for the next 15 years, the main driver of profit and distribution is the level of capital expenditure and increase in its regulatory asset base. Over the next two years, we expect HKEI to spend the remaining HKD 6.6 billion of allocated capital expenditure in the 2014 to 2018 Development Plan. Current run rate is tracking slightly below with close to HKD 7 billion incurred since 2014. We estimate the slightly higher capital expenditure in fiscal 2017 and 2018 should see its Scheme of Control asset base increase by 2% annually in the two years. Post 2018, the next Development Plan for 2019 to 2023 will encompass HKEI's long-term return. With the number of domestic households in Hong Kong increasing steadily at a slow pace of 1.1% annually and both total electricity demand and peak demand largely flat over the last 10 years, capital expenditure will be underpinned by maintenance expenditure for the transmission and distribution electricity network and increments driven by the replacement of coal-fired generating units to gas fired units.HKEI currently earns a predetermined permitted return on average net fixed assets of 9.99%, but the regulator has lowered the permitted return to 8% from 2019 onwards, for 15 years. However, HKEI will continue to earn return on invested capital of 5.8% and above its weighted average cost of capital of 5.6%. The difference between the permitted return and return on invested capital is due to the asset base of the company, which was revalued higher at the time of listing. The regulator did not account for the revaluation in assessing HKEI's regulated asset base and the company's returns are calculated off this lower asset base. However, we forecast HKEI's return on invested capital to increase towards 8% over the medium term as ongoing capital expenditure will lift the regulated asset base towards the accounting asset base. We estimate the decline in permitted return in 2019 should lead to a 18% decline in distribution in fiscal 2019 to HKD 0.31 and be sustained at this level going forward.Analyst: Michael Wu, CAIA

Initiating Coverage on Narrow-Moat HK Electric Investments with HKD 5 and 1-Star Rating