HK Electric:Expensive and vulnerable

The recent rise in HKE’s share price has been surprising and it is now, at18x PE with falling earnings, one of the most expensive utilities in Asia.This was probably caused by news reports that there is no need for a cutin permitted rate of return (RoR) following the release of results of thepublic consultation. We believe these reports are misleading. Proceedingsof the LEGCO meeting on this issue suggest that RoR is set to go down.Interest cost is also set to increase as short-term debt is replaced withlonger-term debt. The current share price can be justified only if weassume no cut in RoR and <3.5% interest cost to perpetuity. SELL.

Surprised by recent share-price increase

We have had a SELL on HKE since listing in Jan-14 at HK$5.45. The callworked in 2014 with stock down 6% but is up 19% in 2015 – which has beena head scratcher. Investment by two large investors – China’s State Grid andQatar Investment Authority – was probably a supporting factor in the past.One of the likely reasons for the recent rise in share price to over HK$6 wasnews reports hinting no need to cut ROR like this one - No need to cut profitsof Hong Kong power suppliers CLP Power and HK Electric, consultation finds.We believe the current share price factors in that ROR would remain at 9.99%and avg interest cost will be <3.5% till perpetuity – both risky assumptions.

Rate of return is set to go down

We believe the news report highlighted above is a bit misleading and ignoresthe discussion that took place in the LEGCO this issue (see video recording onthis link - Panel on Economic Development). To quote the Energy Secretary“Existing SoC will expire in 2018…. Taking into account the various viewsreceived…in terms of the permitted rate of return (RoR) it is necessaryto lower it… proposal will bring about changes in operations of powercompanies and negotiation process will be lengthy.” This in our viewleaves little room of doubt that RoR would go down. A govt consultant hadearlier suggested RoR of 6-8% and may revise it based on market conditions.

HKE’s interest cost would go up even if Fed rates remain unchanged

HKE’s current interest cost is under 2.5% because most of its debt is shortterm (HK$37bn maturing in Feb-17). Since a utility cannot perpetually fundfixed assets with lives as high as 100 years with short-term debt, the interestcost will go up as HKE is likely to start refinancing this debt in 2016. Thecurrent share price ignores these risks. Maintain Conviction SELL.