Hong Kong Power Sector

HK utility companies have on average outperformed the Hang Seng Index by 31% year to date as investors have become more risk averse amid the global financial crisis. We agree HK power companies are highly defensive with their profits protected by the Scheme of Control (SOC) regulatory regime. Possible deflationary pressures in FY09E would mitigate their operating cost pressure and improve their chances of making their maximum permitted return without the need for tariff hikes.

Nevertheless, the utility stocks' P/Es are well above the historical average after the recent outperformance, and hence we would advise selectivity in the investment decision. Among the HK utility companies, we prefer CKI and HKE in FY09E for they have low gearing (net debt to equity ratios of below 5%) and thus have the financial resources to make overseas acquisitions that would be EPS-accretive. Recent share price weakness for CKI owing to a forex loss in 2H08E from US$ appreciation against other major currencies offers a good buying opportunity, in our view.

Hong Kong power companies generate profits in Hong Kong based on a Scheme of Control (SOC) agreement that sets a permitted ROA. Under the new agreements signed in 2008, CLP and HKE are allowed 10% ROAs (from 13.5% previously) effective from 1 Oct 2008 and 1 Jan 2009, respectively; the agreements are for 10-year periods, with the Hong Kong government having an option to extend them for another five years.

Easing inflation and possible deflation in Hong Kong in FY09E would be positive for CLP and HKE, as reduced cost pressures would make it more likely that they achieved the maximum permitted SOC returns in Hong Kong without the need to raise their basic tariffs. Additionally, if they need higher basic tariffs to achieve the maximum permitted SOC return in FY09-10E, it is possible to transfer some fuel clause charge to basic tariffs amid declining fuel costs without the need to increase total tariffs. Any hike in total tariffs would face major local resistance at a time of unfavorable economic conditions; in the early 2000s, as a reminder, HKE was not able to achieve the maximum permitted return due to inadequate basic tariff hike.

Meanwhile, any persistent deflation would likely trigger populist pressure on CLP and HKE to cut tariffs in FY09E. We believe a special rebate from the surplus of their development fund might be distributed; but this would not affect their ability to make the maximum permitted return.

HK-based utility companies are expanding overseas as the local market is mature. Financially, they are well positioned to do so, given their strong recurrent cash inflow from Hong Kong. In 1H08, profits from overseas as a proportion of total profits were 28% for CLP, 13.4% for HKE, 56.7% for CKI and 19.8% for HKCG. Geographically, their overseas expansions are located primarily in the Asia-Pacific region for CLP, English-speaking developed countries (e.g., Australia, New Zealand, the UK and Canada) for CKI and HKE, as well as mainland China for HKCG.

Among the Hong Kong based utility companies, HKE and CKI would be the prime beneficiaries of overseas expansions; they are financially robust and are interested in brownfield acquisitions that would generate profits shortly after acquisition.

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