Toshiba's Fall And The Rise Of Korea's Nuke Biz

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Includes: TOSBF, TOSYY
by: Hyundai Motor Investment & Securities

Summary

Toshiba to sell NuGen which is currently building nuclear power plants in the UK.

Uncertain UK energy outlook opens opportunity for Korea to enter the UK nuclear sector.

Reshaping of nuclear sector to highlight the competitiveness of Korea and KEPCO.

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Major issues and earnings outlook

Thanks to Toshiba's (OTCPK:TOSBF) (OTCPK:TOSYY) financial and technical woes, which were triggered with the nuclear disaster at Fukushima, KEPCO is now the strongest candidate to buy NuGen in the UK. The company is now in talks to buy the company and if the deal goes through, KEPCO will be positioned to win the lion's share of nuclear orders in the UK. KEPCO is flush with cash thanks to the sale of real estate to Hyundai Motor Group and is the best positioned among nuclear power plant developers to expand its market.

KEPCO's competitiveness will be highlighted amid the mild competitive environment in the nuclear industry. We believe its presence as a nuclear power plant developer will strengthen.

KEPCO's biggest strengths are its strong financials and the successful track record of building Generation III nuclear power plants in the UAE.

We believe KEPCO is likely to buy part or all of NuGen to enter the UK nuclear power plant market to win additional orders in the country.

Toshiba's withdrawal from the nuclear business and EDF-AREVA's failure to complete the Olkiluoto unit three and Flamanville projects help raise KEPCO's status in the nuclear industry.

1) Korea's Shingori unit three is the first Generation III PWR-type nuclear reactor that is commercially on line. KEPCO boasts the most attractive track record in the industry due to its success in the UAE.

2) The EPC business requires massive funding and it takes time to recoup investments. Thus, KEPCO's strong financials and earnings structure stand out in the nuclear power plant construction industry.

3) China's rapid rise in the market is notable, but the nuclear business is politically touchy because it concerns energy security. In this regard, we believe the possibility of intense competition driven by China is limited.

KEPCO received a KRW54tn order to operate the UAE nuclear plants for 60 years. The relative revenue will increase from 2017 when the construction of the Barakah nuclear power plant unit one starts running.

The current inflationary environment makes KEPCO look like a less attractive investment. However, expectations for the company's strengthening fundamentals in the mid/long term are very much intact.

Toshiba to sell NuGen which is currently building nuclear power plants in the UK

Toshiba wrote off about KRW7tn for its acquisition of CB&I Stone & Webster due to huge cost overruns at US nuclear projects. It decided to withdraw from the nuclear power plant construction business. Along the way, the company is likely to sell a 60% stake in a UK subsidiary, NuGen, which currently plans to build three nuclear power plants in the UK. KEPCO is in talks with the company to buy a stake in NuGen.

Uncertain UK energy outlook opens opportunity for Korea to enter the UK nuclear sector

Power shortages are a chronic problem in Britain. The country's power production is declining and its base fuel generation capacity, which is composed of coal and nuclear power plants, is aging. The UK government has been working on building additional nuclear power plants but the crisis at Toshiba has cast a shadow over its nuclear projects. Besides, by 2025, most of its coal power plants currently in operation will be shuttered due to environmental concerns.

The ambiguity around the nuclear projects means uncertainty over the UK's energy policy. To ensure a stable energy supply, the British government has to move quickly given the time that it takes to build a nuclear power plant. Some argue that China will lend further support but we do not see this happening, given China's already deep involvement in the UK nuclear industry. This is the reason that we believe KEPCO (KEP, BUY) is an attractive option for UK decision-makers. If KEPCO manages to buy a stake in NuGen, it will receive additional nuclear orders from the UK.

Reshaping of nuclear sector to highlight the competitiveness of Korea and KEPCO

The AP1000 nuclear power plant designed and sold by Westinghouse, a subsidiary of Toshiba, is likely to lose ground. The EPR1600 reactor by AREVA (subsidiary of EDF) has also revealed serious problems such as construction delays, security issues and cost overruns in construction projects in Finland and France. Meanwhile, Korea has successfully built and operated its generation III nuclear reactor (Shingori #3).

The first Barakah nuclear power plant that it built in the UAE is by far the only generation III nuclear reactor built without a construction delay. As such, we believe Korea's strength in nuclear power plant construction will be highlighted further going forward. Along the way, KEPCO's competitiveness as a nuclear power plant developer will also grow.

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Britain seeks solutions in nuclear power

Britain turns to nuclear power

Britain was the first country to operate nuclear power plants in the world. Currently, 15 nuclear power plants are in operation, which account for 22% of the country's total electricity production. Of the nuclear plants currently in operation in the UK, 14 plants are advanced gas-cooled reactors (AGRS). These are aged reactors with an output of only 600MW. (Korea's oldest nuclear power plant, Kori unit one, has a 587MW output, and the third-generation reactors that are currently under construction boast outputs of 1,400 to 1,600 MW.) The average lifespan of these nuclear power plants is 32 years, with a utilization rate of 70.3%. About half of these nuclear power plants are expected to be shut down by 2025.

Britain also announced that it would shut down all of its coal power plants by 2025 to reduce carbon dioxide emissions. Most coal plants in the UK are more than 50 years old, and they account for about 26% of the UK's total electricity capacity.

There is speculation about the possibility of depletion in the North Sea oil fields. Some even predict that the North Sea oil fields will be depleted by 2020, because the British government and oil companies' efforts to locate large oil fields in the region have been largely unsuccessful. If there is no progress, Britain has to face the fact that its energy security is compromised.

With the decline in nuclear and coal power capacity, Britain's base fuel generation is about to drop. The country also has to tackle the energy security issue. As a way to overcome the power shortage that is likely to persist until 2025, London has chosen nuclear power. It plans to introduce 10 new nuclear power plants that generate 18GW by 2030, covering 60% of the 30GW base fuel generation shortage (nuclear 9GW and coal 21GW).

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UK, an importer of electricity

The UK's power supply has been steadily declining after hitting a peak in 2005. The power supply in 2005 was 398.4TWh, but by 2014, it fell by 17.8% to 338TWh. This has driven the UK to import 21TWh of electricity from France, the Netherlands, and Ireland. This is higher than the combined capacity of two new 1,600MW nuclear power plants (assuming a utilization rate of 80%). As such, in Britain, nuclear power should play a key role in stabilizing the supply of electricity.

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UK energy crisis opens a door for KEPCO

Toshiba's crisis could shake the overall UK energy policy

Britain is currently working to build nuclear power plants in six sites, including three new sites in Hinkley Point C, Wylfa, and Moorside. The first operation is scheduled to begin in 2025. The scale of the projects currently under progress is 18GW. The project that is progressing the fastest is the Hinkley Point C project. Being built by a French power utility company, EDF Energy and China General Nuclear Power Corporation, it is Britain's first nuclear power project in 30 years.

The Hinkley Point C project was delayed for several months due to Brexit-related uncertainties and the creation of the new government, but in September 2016, the Theresa May administration approved the project. However, there are still doubts as to whether the project will progress as scheduled, because the construction of EPR reactors by EDF in Finland and France, the same model as the Hinkley Point C project, was delayed for several years.

In addition, the Moorside project, which was anticipated to reach the final investment decision stage in 2018, is now in jeopardy as Toshiba's nuclear business, which owns 60% in NuGen, is facing a crisis. This wreaks havoc on the UK's energy policy too given that the country's base fuel generation capacity is likely to begin disappearing from 2025.

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KEPCO is an attractive option for the UK government

Toshiba is reportedly pursuing selling a 60% stake in Britain's NuGen, and Korea's KEPCO is being considered as a strong candidate to buy the company. We believe that KEPCO has the capacity to seal the deal and enter the UK nuclear power plant construction market.

We will explain it in more detail later, but there is no good alternative, and considering the period that it takes to build a nuclear power plant, there is a sense of urgency on the UK side. Although some predict that Chinese players will move forward to take the deal, we think chances are slim given China's already deep involvement in UK nuclear projects such as the Hinkley Point C and Sizewell C projects.

After the Brexit decision, the May administration suspended the signings related to the Hinkley Point C project to conduct a full-scale review of the project. The project was eventually approved in September 2016 but some view this hesitation as a sign of concern on the British side about China's deep involvement in the UK nuclear industry. From this point of view, KEPCO's participation in the UK's nuclear projects is welcoming news for the British government.

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NuGen acquisition to help explore more nuclear opportunities in the UK

The key is whether KEPCO will be able to introduce APR1400, the Korea-made nuclear reactor, when it acquires some or all of NuGen's stake from Toshiba. This is not easy because, in order to introduce a new model, it has to pass the generic design assessment (GDA) conducted by the UK Nuclear Regulatory Authority, which takes about four years. However, according to the Financial Times, there are voices expressing the need to change the UK's technological standards for its nuclear power plants, because the technological aspects of Westinghouse's third-generation nuclear power plant - AP1000 - are frequently called into question, with serious construction delays in China and the US.

There is an additional concern over equipment procurement and maintenance considering the delayed reactivation of nuclear power plants in Japan and Toshiba's faltering nuclear business. Because of these reasons, we believe there is a strong possibility that the UK will switch to APR1400.

The NuGen acquisition, if it happens, should open up additional opportunities for KEPCO to win other nuclear orders in the UK. Currently, London has confirmed eight nuclear sites, but only six sites are under construction.

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Low-margin orders unlikely since the UK's sense of urgency is strong

If KEPCO participates in the UK nuclear project, it will be the first nuclear project overseas since the USD18.6bn UAE Barakah nuclear order won in 2009. With the crisis at Toshiba slowing down the nuclear construction process in the UK, the sense of urgency at the British government is strong. The EPR nuclear reactors that France's EDF (AREVA) is building in Finland and France have been delayed for several years, resulting in huge losses.

As such, there are growing concerns over the Hinkley Point C nuclear project, which introduces the same model. Furthermore, there are also concerns over the financial state of EDF since its acquisition of AREVA. Hitachi-GE uses an unorthodox BWR method and is already booked for other nuclear projects. China's additional involvement in UK nuclear power projects is burdensome for the UK considering quality and politics.

Therefore, KEPCO, a state-run company with very healthy financials, must look very attractive to the UK government. Its UAE project was the only generation III nuclear project that was finished on schedule without cost overruns. We believe this increases the bargaining power of KEPCO when it enters the UK nuclear power plant industry.

Initially, London had qualms about injecting taxes into high-risk endeavors such as nuclear projects. As a result, individual companies have had to raise funds for themselves to participate in the UK nuclear projects. However, as the risks of nuclear power projects continue to rise, there is growing pressure on London to support the nuclear industry, which is an additional positive for KEPCO.

The UK government expects to recoup its nuclear investments through electricity bills. In the case of the Hinkley Point C project, London has guaranteed GBP92.5/MWh (about KRW130/kWh) for the project developers (EDF and CGN) over the next 35 years. The guaranteed price is about twice as high as the UK power wholesale unit prices, which range from GBP45 to GBP55/MWh. This is evidence of the urgency faced by the UK as it tries to tackle power shortages and ensure energy security.

In 2009, KEPCO won a USD18.6bn order to build four nuclear power plants in the UAE. The value of the Moorside project to build three nuclear plants is estimated to be KRW21tn (USD18bn), approximately 30% higher than the UAE project.

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Toshiba: how did this happen?

Westinghouse was a poison chalice for Toshiba

In 2006, Toshiba bought Westinghouse, which has its own nuclear technology. Toshiba's funding and construction capabilities and Westinghouse's nuclear technology were expected to generate great synergies. Toshiba was to become the only company with the ability to build a boiling water reactor (BWR) as well as pressurized water reactor (PWR). The merger had a significant impact on the nuclear industry, giving birth to the AREVA-Mitsubishi collaboration with an aim of developing a new PWR, and Hitachi-GE alliance for nuclear power projects.

Toshiba paid USD5.4bn for Westinghouse, which was twice as much as the market had originally expected. For this reason, some JPY500bn in goodwill was included in the Toshiba accounting report. At the time of the acquisition, expectations for the growth of the nuclear power plant industry were high. Nuclear reactors were gaining a lot of attention due to fossil fuel depletion and soaring natural resource prices, while expectations for a nuclear renaissance were growing. The US, which had not issued any permits to build nuclear power plants since the 1979 Three-Mile Island accident, deregulated the nuclear industry in 2005.

However, after the Fukushima nuclear disaster in 2011, many nuclear projects were buried or reconsidered resulting in the rapid contraction of the nuclear market. Whether Westinghouse was worth the value became a lingering question. In the end, in FY2015, Toshiba took a USD2.3bn write-down on its Westinghouse acquisition.

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The nightmare did not end there. In December 26, 2016, Toshiba's CEO Satoshi Tsunakawa issued a warning about the possibility of a huge loss at Westinghouse and wrote off JPY712.5bn (or KRW7tn) in goodwill related to S&W, which it bought in 2015. As a result, Toshiba is expected to report a loss of about JPY410bn (or KRW4tn) in FY2016.

Westinghouse bought CB&I Stone & Webster, a US construction company specializing in nuclear power plants in 2015 for USD230mn. When Toshiba acquired Westinghouse in 2006, a construction firm called Shaw, which is now a part of CB&I, acquired a 20% stake in Westinghouse. Shaw was the company that took on Westinghouse's US projects to build four AP1000 reactors (Plant Vogtle units 3 & 4 in Georgia and VC Summer units 2 & 3 in South Carolina). Soon, Shaw proved that it lacked the experience to build the nuclear power plants and was sold to a larger construction firm, CB&I, in 2012 for USD3.3bn.

To limit losses from the above projects, CB&I sold off Shaw's assets to Toshiba for USD230bn, less than 10% of the amount that it paid. In January 2016, at the close of the deal, Toshiba announced that it estimated the goodwill for the acquisition at USD89mn. However, four months later in April, Toshiba sued CB&I for underestimating the loss from the projects, and CB&I filed a lawsuit too. In this process, the scheduled operation date of the four US nuclear plants that was originally set for 2016 was postponed to 2019 and 2020.

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Toshiba-Westinghouse unlikely to rebound from the crisis

Toshiba is likely to withdraw from the nuclear business. It may still be involved in nuclear plant design and operation but its overseas business prospects are quite dim because the nuclear industry places a high value on trust and financing ability as a developer. This means that the AP1000, a Generation III nuclear reactor developed by Westinghouse, will lose considerable ground in the nuclear market.

From a broad perspective, Toshiba's monstrous loss in the nuclear business mainly stems from its lackluster risk management. It is hard to understand that it worked with Shaw, a relatively inexperienced nuclear player, to build nuclear plants. It is also unfortunate that it failed to fully take into account the possible cost overruns and schedule delays to be caused by tighter Nuclear Regulatory Commission (NRC) regulations.

Now, the market's confidence in Westinghouse's AP1000 reactor has plummeted. It is reported that its technological issues have been pointed out many times by the NRC.

Nuclear giants in jeopardy

Japan's nuclear exports in crisis

Due to the Toshiba-Westinghouse debacle, Japanese nuclear names' presence in the global nuclear market should is tarnished. Westinghouse, which owns the original technology for PWR, has a 50% market share in the nuclear power plant market. Among Japanese names, we believe only Hitachi-GE will be able to carry out nuclear projects overseas.

However, their Generation III advanced boiling water reactor (ABWR) has lost ground already since ABWR is based on the boiling water reactor (BWR) technology that was used at the Fukushima nuclear power plant sites. In the UK, four nuclear power plants are under construction using the ABWR method, which is raising concerns. In fact, the Wylfa and Oldbury projects in the UK are the only ABWR-based nuclear projects outside Japan.

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EDF-AREVA plagued by its own problems at home and overseas

AREVA has been building its new EPR nuclear reactors for the Finnish Olkiluoto nuclear project since 2003. However, the operation has been delayed by nine years and the construction cost ballooned to EUR8.5bn, nearly three times the initial estimate. The company looked like it was headed for bankruptcy but Electricite de France (EDF), an 85% state-owned company, came to the rescue and bought the nuclear business unit from AREVA, injecting EUR5bn in the process.

Still, the company is still in a legal dispute over the Olkiluoto project with the Finnish electricity company, TVO. TVO requested compensation of EUR2.6bn for the cost overruns by the AREVA-Siemens consortium, and AREVA also filed a lawsuit claiming EUR3.5bn in damages.

EDF also exceeded the planned cost by about EUR6bn, as the EPR reactor construction project in Flamanville, France, is expected to be completed by 2018 after a delay of five years. In particular, safety issues have emerged, and similar problems have occurred at the Taishan nuclear power plant in China. The plant is slated to start in early 2017, but it now looks increasingly uncertain if it will begin operation on schedule.

To sum up, safety issues and cost overruns have become frequent problems for the EPR projects run by AREVA-EDF. As a result, confidence in the nuclear power plants built by these companies is waning, and EDF's financials continue to deteriorate.

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Korea poised to lead in the nuclear space

World's only successful Generation III PWR is Korean-made

It should be noted that Korea's Shingori unit 3 completed last year is the world's only PWR-type Generation III nuclear power plant that has come on stream successfully. The Shingori nuclear plant is an APR1400 model developed by the country's own technology. The four nuclear power plants built by Korea in Barakah, the UAE, are also the same model.

The Barakah plants are the world's only nuclear power plants that were completed without a delay and are expected to begin commercial operation this coming May. In short, the APR1400 has become the most advanced model in the nuclear power plant industry while competing models such as the AP1000 and EPR suffer from frequent construction delays and cost overruns.

The Economist pointed out that the EPR and AP1000 reactors, despite being conceived at the beginning of this century, have not yet materialized. It also pointed out that the reason behind Korea's nuclear success is the continuation of partnerships with suppliers and construction companies. This makes the construction cost of the APR1400 far more attractive compared with competing models.

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Sound financials are KEPCO's biggest weapon

KEPCO's top-of-class financials should be of tremendous help as the company attempts to enter the global nuclear market. Most companies participating in nuclear power plant projects as developers are required to raise their own funds, although in most cases, it takes a long time for them to recoup their investments.

Therefore, healthy financials are the most important factor. Indeed, concerns about the UK Hinkley Point C project are mostly related to EDF's hefty debt ratio (over 400%). With the financials and profitability of Japanese nuclear exporters continuing to deteriorate, KEPCO's financial stability and recovering profitability are quite notable, since nuclear projects require large-scale funding and long-term management.

According to the press, if KEPCO is to take part in the nuclear power plant project by buying a stake in NuGen, it will need to raise about KRW10tn. This is not burdensome, given KEPCO's parent-based shareholders' equity at KRW55tn (KRW72tn on a consolidated basis) and debt-to-equity ratio at less than 90%. Furthermore, KEPCO's credit rating is Aa2 (Moody's) and AA (S&P), which tops global electricity companies.

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Nuclear biz contracting but will not disappear

Korea and China display stability in nuclear power plant construction

The nuclear renaissance of the past is unlikely to revive due to rising construction costs, lowered public acceptance toward nuclear power after the Fukushima disaster, and the declining generation cost of renewable energy. According to The Economist, when the nuclear business was at its apex in 1979, a total of 234 nuclear power plants were built across the world.

However, only 55 nuclear power plants are under construction currently, and of these, 35 nuclear reactors are experiencing construction delays. However, The Economist believes that large-scale nuclear power projects will still be feasible, as the construction of nuclear power plants by Korea and China are progressing well

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KEPCO's competitiveness as energy developer to gain attention

According to the World Nuclear Association, 447 nuclear plants are currently in operation, and 60 nuclear reactors are under construction. Although the number of nuclear projects has decreased considerably compared with the past, 164 nuclear power plants are still scheduled for construction, mainly in China, and 347 projects are being proposed.

With Generation I nuclear plants nearing their end, there could be more nuclear orders to come. The lifespan of the nuclear power plants built in the past is about 30 to 40 years. The construction of a nuclear power plant takes about eight years, so the nuclear new order and decommissioning markets are likely to expand further going forward.

The cost of renewable energy is falling and battery technology is advancing fast. However, nuclear and coal power still offer the most reliable source of stable power generation. That said, preference toward coal power is likely to decline further along with the efforts to reduce carbon emissions. Thus, there is a probability that nuclear power will gain more ground as base fuel.

The contraction of the nuclear power plant sector and the difficulties experienced by competitors could be an opportunity for the Korean nuclear industry to outshine. In addition to the UK nuclear sector, Korea's chances of winning nuclear orders from other countries will likely increase further. Furthermore, KEPCO's competitiveness as a nuclear energy developer could be highlighted too.

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UK entry to highlight value as developer

Investment highlights

KEPCO is a strong candidate to buy the UK's NuGen. If the deal goes through, KEPCO would gain an advantageous position to win additional nuclear orders in the UK.

As many entrenched players in the nuclear industry are facing difficulties, KEPCO's competitiveness should get highlighted amid the mild competitive environment. We believe its presence as a nuclear power plant developer will strengthen.

KEPCO's biggest strengths are its strong financials and the successful track record of building Generation III nuclear power plants in the UAE.

Major issues and earnings outlook

We believe KEPCO is likely to buy part or all of NuGen to enter the UK nuclear power plant market to win additional orders in the country.

Toshiba's withdrawal from the nuclear business and EDF-AREVA's failure to complete the Olkiluoto unit three and Flamanville projects help raise KEPCO's status in the nuclear industry.

1) Korea's Shingori unit three is the first Generation III PWR-type nuclear reactor that is commercially on line. KEPCO boasts the most attractive track record in the industry due to its success in the UAE.

2) The EPC business requires massive funding and it takes time to recoup investments. Thus, KEPCO's strong financials and earnings structure stand out in the nuclear power plant construction industry.

3) China's rapid rise in the market is notable, but the nuclear business is politically touchy because it concerns energy security. In this regard, we believe the possibility of intense competition driven by China is limited.

KEPCO received a KRW54tn order to operate the UAE nuclear plants for 60 years. The relative revenue will increase from 2017 when the construction of the Barakah nuclear power plant unit one starts running.

The current inflationary environment makes KEPCO look like a less attractive investment. However, expectations for the company's strengthening fundamentals in the mid/long term are very much intact.

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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.

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