KEPCO: Lower SMP And Fuel Costs, Better Generation Mix

About: Korea Electric Power Corporation (KEP)
by: Hyundai Motor Investment & Securities

Earnings at their mid/long-term lows, accordingly slated to improve going forward.

Tariff hike is uncertain, but stabilizing costs to boost earnings.

Raise target price to KRW44,000 based on an upgraded target P/B of 0.4x.

Investment highlights

The system marginal price (SMP) is expected to fall from 2Q19 on falling oil prices and a change in the LNG taxation structure. Costs should continue to stabilize as coking coal prices remain stable. The Shin Gori unit #4 recently received permission to begin operations. Three more nuclear power plants will come online by 2020, suggesting an improvement in the generation mix. The prospect of a tariff hike is uncertain, but stabilizing costs are expected to boost earnings.

KEPCO's (NYSE:KEP) earnings are at their mid/long-term lows, meaning they are slated to improve going forward. We raise our target price to KRW44,000 based on an upgraded target P/B of 0.4x.

Major issues and earnings outlook

4Q18 results will likely miss consensus due to cost increases (power purchase and fuel costs) and lower coking coal plant utilizations. We forecast KRW14.9tn in sales (-4.2% YoY) and KRW964.9bn in operating loss (remain in the red YoY). In February, SMP slipped KRW16.4 MoM to KRW93.5/kWh. Despite seasonality (e.g., Lunar New Year holiday), LNG prices and SMP are expected to post significant declines, following oil price corrections.

Following the decline in oil prices, LNG import prices fell too, and we believe fuel costs will follow suit. From April, a new LNG tax structure should send LNG prices down by KRW68,400/tonne, which could lead to an additional decline in SMP. Also, the increased use of LNG for domestic power plants should help reduce LNG unit prices despite a higher LNG supply cost at KOGAS. This is also a factor that could drive SMP lower. A KRW1.kWh decrease in SMP will help KEPCO (KEP) to save KRW150bn per year. Considering the sharp pullback in oil prices recently, the scale of SMP decline may surpass our expectations. Even in a conservative scenario, we expect the power purchase cost to fall by more than KRW10/kWh.

The Shin Gori unit #4 is now ready for operation. Barring any unexpected events, it will start commercial operations in September. Construction of the Shin Hanul units #1 and #2 are likely to be completed in 2020 too. The three new nuclear power plants should help improve KEPCO’s generation mix.

We expect the generation cost gap between LNG, coking coal, and nuclear to narrow through the recognition of social cost in the long term. Environmental dispatch may drag down coal plant utilizations but the opportunity cost of choosing LNG/nuclear over coal should gradually decrease. Our earnings forecasts are based on the assumption that there will be no tariff hike in 2019. While we do not expect to see many changes from the new power tariff scheme to be announced in March, we find it positive that there are many discussions under way regarding power tariffs.

A tariff increase could boost valuation multiples greatly, but even if we assume no tariff hike, we believe KEPCO will grow its earnings continuously through a better power mix, lower energy prices, and LNG tax structure changes.

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.

Additional disclosure: Hyundai Motor Company is a passive shareholder in our bank.