Korea Electric: Rising Fuel Costs And Higher Electricity Tariff Pose Challenges

| About: Korea Electric (KEP)
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Summary

Korea’s state-owned electric utility company has slashed prices in response to social backlash regarding unaffordable electricity costs.

This coincides with a rise in natural gas and other imported fuel costs.

The decline has put an enormous amount of pressure on share prices.

Has the stock become cheap or is there more downside ahead?

Thesis

A combination of higher fuel costs and lower government-mandated electricity prices will contract KEPCO's margins through at least the next twelve months. If earnings fall low enough this can also imperil the dividend payment (a cut or outright suspension), which would spark further price depreciation. Despite the 30% fall since September, it's debatable whether KEPCO has become cheap or whether more pain for shareholders is on the horizon.

Overview

Korea Electric Power Corp (NYSE:KEP) (colloquially known as "KEPCO") is the largest electric utility in Korea and responsible for the generation and transmission of at least 93% of Korea's electricity. The company is state-owned, with the South Korean government owning a 51.11% stake (32.9% owned by Korea Development Bank and 18.2% owned by the central government).

In Korea, residential electricity consumption is priced based on a range of brackets (i.e., cost per kilowatt hour consumed) with increasing consumption subject to rising costs. Given KEPCO has monopolized the electricity market in Korea, any increases in electricity tariffs are positive to the company's earnings and cash flow from operations, while decreases in tariffs are negative. Last week, the Korean Ministry of Trade, Infrastructure and Energy ("MOTIE") recently decreased tariffs on residential electricity consumption by reducing the number of rate brackets and increasing their range. This move is hence a negative development for the company financially.

KEPCO has long been under fire for its electricity pricing among residential consumers. During the sweltering summer heat, affordability complaints and lawsuits filed against the company skyrocketed, pressuring the country to drop the progressive pricing scale. The former six-stage system charges 60.7 won (USD$0.051) per kilowatt-hour until 100 kWh are accumulated. The price more than doubles to 125.9 won between 100 and 200 kWh, and proceeds to run up to 709.5 won ($0.594) per kilowatt-hour after 500 kWh, or 11.7 times the minimum rate.

Korea's energy usage per capita came to 10,428 kWh in 2013, or 869 kWh per month. That level of usage would come to a few hundred dollars per month per household. However, the usage distribution is skewed right, as over 80% of households consume less than 500 kWh per month, and KEPCO isn't averaging the high unit cost associated with >500 kWh of monthly use.

This progressive scale applies only to residential customers despite their accounting of just 13.5% of Korea's electricity use. Industrial and commercial users are charged on a fixed scale and account for 57.1% and 19.9% of usage, respectively. Customers' frustration has led to the formation of 1,100 lawsuits demanding return of payment for the exorbitant fees. Consequently, the government reduced tariffs by what should come to around 11%-12% for residential customers and 20% within educational institutions.

KEPCO reduced the usage tiers down to three from its previous six and was retroactively enacted December 1. Each volume range has been expanded to 200 kWh tiers from its previous 100 kWh, which will help those in the lower- and mid-usage tiers from avoiding high bills especially. Also, the cost spread between the low and high tier will drop from an 11.7-to-1 ratio down to 3-to-1.

The changes are likely to decrease the company's earnings from a previously projected $7.1 billion (in equivalent dollar terms) to somewhere in the ~$4.0 billion range in 2017 as a combination of electricity price reductions and an increase in fuel import costs. (No sensitivity or conjecture is given to future capacity utilization, which normally hovers in the 80%'s.) The company's credit statistics (i.e., a measure of a unit of earnings or cash flow to a unit of debt or interest expense) will also worsen in conjunction. Since what was a temporary tariff reduction went into effect back in August, the stock has shed about 30% of its value, falling from $27 per share down to $19.

The past two years have been the best for the company since its run from mid-2004 to mid-2007. Froom 2008-2012, the company was unprofitable, before rebounding strongly in 2015 and into 2016 through a combination of low fuel costs and high tariffs that worked to expand margins on both ends. The company generated $12.0 billion in earnings in 2015 and will be primed for a little over $7 billion in 2016 as mentioned. However, a combination of higher fuel prices and lower electricity costs going forward will contract margins.

This lack of any real semblance of a cost pass-through mechanism represents the chief risk of investing in KEPCO. With many businesses, as the cost of a commodity increases, the company will simply pass off much of the price increase to customers. This is particularly true if a company operates within oligopolistic/monopolistic market structures, as KEPCO does.

However, given KEPCO is state-owned, electricity prices are often regulated as a means of directing macroeconomic specifics toward desirable outcomes, irrespective of what it might mean for the company's cash flow or other key operating metrics. For example, if the South Korean government wishes to keep inflation in check, higher fuel costs may actually lead to flat or even declining electricity tariffs. The positive effect of a decline in fuel costs from mid-2014 onward is receding and widespread concerns over electricity's effect in increasing cost of living are pressuring prices down in conjunction. The one main positive may be an increase in generation capacity as additional plants begin production.

Conclusion

Higher fuel input costs and reduced pricing from the government's response to public pressure will contract KEPCO's margins from both sides and lead to a decline in earnings through 2017. KEPCO has also traditionally been known for its generous dividend yield. However, with compressed earnings, that may also be cut or suspended, which would catalyze another downshift in price. For value-minded investors, it's largely a matter of assessing whether the stock's retracement represents an attractive entry point relative to future expectations under a renewed higher-cost/lower-tariff operating environment.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.