Significant earnings potential in Hydro Power Free Lanka – JKSB

John Keells Stock Brokers (JKSB) has declared that Hydro Power Free Lanka (HPFL), which is coming out with an Initial Public Offering of 35 million shares at a price of Rs. 10 each, holds significant earnings potential in the medium term. This view is contained in a JKSB IPO update, excerpts of which are as follows:

Hydro Power Free Lanka Limited (HPFL), under the joint ownership of Pussellawa Plantations and Free Lanka Power Holdings (Pvt) Ltd., currently owns and operates two mini hydro power projects (MHP) in the region of Gampola, each with a capacity of 1.6 MWs.

Its existing power plants – Sanquhar and Delta – together generated 9,600 MWh in FY10 at a plant factor of 39%, the highest it has generated since inception. Both plants have been signed for a period of 15 years from the dates of commercial operation, which would mean that the agreements for Sanquhar and Delta would expire in August 2018 and April 2021 respectively.

The company expects to raise Rs. 350 million through the IPO which is to be utilised in stages to increase its capacity. HPFL hopes to construct four more MHP plants with a total capacity of 5.37 MW, which will increase the maximum capacity to 8.57 MW by April 2012.

The tariff structure applicable for its existing plants of Sanquhar and Delta would be standardised and non negotiable and is based on the avoided cost of the most expensive thermal unit displaced.

The tariff rates are revised annually and subjected to variations in dry and wet season. In the event of an increase in crude oil prices, the tariffs applicable to its existing plants would also see a rise, thereby benefiting its revenue growth.

However, the four new plants to be built will fall on to a different tariff system which would be cost based and technology specific. The new tariff system recognises the capital structure of the project, including construction costs, cost of capital and operational and maintenance expenditure thus extends more certainty to the future cash flows of the projects, unlikely avoided cost tariff, which hinges to a great extent on fuel prices and exchange rates.

Historically, the demand for electricity has grown over the years at an average rate of around 7%‐8% and has outstripped supply. Presently, despite the installed capacity of hydro power plants exceeding that of thermal power plants, thermal has become the dominating source of power generation contributing to 60% of the total energy generation.

With the revival of economic activity in the country we expect the gap between demand and supply to widen indicating the need for higher generation by the existing operators until such time that large scale investments such as the Norochcholai power plant join the network.

Outlook

Two of the four MHP projects planned are expected to commence construction by November 2010 utilising approximately Rs. 300 million to generate 1.77MW in total. These 2 projects are expected to commence commercial operations in November 2011. The remaining two projects to generate a total of 3.6MW at a cost of Rs. 505 million are expected to begin construction by February 2011 and will become operational by April 2012.

HPFL’s earnings have been boosted by its carbon credit income which forms a significant component of group revenue. Applications are currently being prepared to obtain Certified Emission Reduction (CER) approvals for the new MPHs to be developed by HPFL.

The company is issuing 35 million shares at a price of Rs. 10 each to raise funds for its expansion projects with the issue opening on 26 October 2010. The funds raised through the IPO will only be sufficient for the first two projects and the remaining two projects will require debt financing. We have assumed that of the total requirement of Rs. 505 million for the final two projects will be funded by both debt and internally generated funds in the proportion of 75:25.

For FY11E, HPFL will operate on its existing capacity of 3.2MW, on which we have conservatively assumed a plant factor of 37%. On the assumption of only a 5% increase in the tariff, we expect HPFL to post Rs. 64 million in earnings for FY11E. Although the two new plants to join the network in FY12E will be operational for only five months of the FY, it will contribute to an earnings growth of 13% as higher interest cost dilute earnings.

With its entire portfolio of MHP plants being operational by FY13, we expect HPFL to post over Rs. 178 million in earnings.

Based on FY11E earnings, HPFL trades in line with the sector valuations (Power and Energy – excluding LIOC) but exhibits significant earnings potential in the medium term.