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Investment Recommendation Report – KenGen


Faida Research - January 23, 2021 - 0 comments

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We recommend a LONG-TERM BUY on KenGen. The counter is currently trading at a trailing P/E multiple of 3.87x (at a price of KES 4.64 as at 22nd January 2021).

KenGen recently released its 1H2019/2020 results showing a 98.1% y/y growth in after tax profits to KES 8.2 bn. The jump in after tax profits was predominantly due to a tax credit of KES 1.9 billion occasioned by capital allowances following the commissioning of 165 MW Olkaria V.
Our recommendation is based on the following factors.

Investment Considerations
Capacity expansion:
KenGen is actively pursuing its Revamped Horizon III Good-to-Great (G2G) Strategy that is largely focused on geothermal capacity expansion (totaling 439 MW). KenGen benefits from plant commissions through tax credits (during the financial years in which they are commissioned), increased capacity revenues (accounting for a larger share of electricity revenues at 72.2% — as at FY2017/2018) and the potential to increase energy revenue (through energy sales). The following is a brief description of pipeline projects according to the company;
o 83.3MW Olkaria 1 unit 6 plant is in the advanced stages and is expected to be commissioned in 2021
o Contract processes for the 140MW Olkaria VI plant and Olkaria I Rehabilitation (from 45MW to 51MW) are at advanced stages

Direct electricity sales:
With the introduction of the Energy Act 2019 (which allows other players other than Kenya Power to sell electricity to consumers), KenGen has the ability to pursue direct energy sales. According to media reports, KenGen is currently seeking the approval of the Energy and Petroleum Regulatory Authority (EPRA) to sell electricity directly to flower firms and large industrial investors in the proposed Naivasha Industrial Park. If approved, this would enhance KenGen electricity sales and open the door for similar direct sales especially for companies in the Special Economic Zones.
Revenue diversification:
The company is also actively pursuing a revenue diversification strategy. Some of the initiatives include:
o Consultancy and drilling services; in 2019 KenGen was awarded a KES 5.2 billion tender to drill geothermal wells in Ethiopia and is reportedly currently pursuing geothermal infrastructure tenders in nine African countries
o KenGen recently entered into an agreement with Nairobi County to generate electricity from garbage
o KenGen announced plans to set up electric car charging infrastructure

Key Risks
Reduced tax credits:
With the review of tax allowances from a maximum of 150.0% to 50.0% of capital investment, going forward KenGen may not benefit as much from tax credits as it did it in the past from the commissioning of new plants as it did it in the past.

Regulatory risks:
Owing to the negative impact of the coronavirus (COVID-19) pandemic (reduced electricity demand), there has been a lot of uncertainty as to whether Kenya Power will honor existing power purchase contracts from power producers. The Ministry of Energy had earlier announced (June 2020) that it will invoke the force majeure clause in wholesale power generation contracts. The invocation of the clause indicates that Kenya Power will not be obliged to fulfill the payment of existing power purchase contracts from power producers. The nature of the contracts generally requires Kenya Power to purchase a set amount electricity while also compensating power producers for electricity availability/capacity.

The declaration of force majeure implies Kenya Power will not be obliged to pay for excess power i.e. the difference between the power consumed and the power acquired from power producers (“take or pay” model of power purchase agreement (PPA)). At present, it remains unclear as to whether the force majeure affects only the payment of unused electricity or also electricity capacity. KenGen generates electricity revenues from both sources – energy revenue and capacity revenue. If the force majeure affects electricity capacity as well this will significantly affect KenGen financial performance in FY2020/2021. However, since this is still unclear, we expect more clarifications going forward.
Furthermore, with the easing of COVID-19 restrictions, we expect rising electricity demand to potentially reverse the invocation of the force majeure clause.

Conclusion
Whilst we expect the reduction in tax allowances to weigh down profitability in commissioning years, we believe that the capacity expansion initiatives and the revenue diversification initiatives have the potential to anchor growth for the company — especially in the long-term thus we recommend a LONG-TERM BUY on KenGen.

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