KAPCO – to cheer or not?

FY20 has been good for Kot Addu Power Company Limited’s (PSX: KAPCO) profitability as the company has seen its earnings for 1HFY20 rise by 86 percent year-on-year. KAPCO’s revenues during 1HFY20 remained flat, while 2QFY20 posted a decline of around 28 percent due to lower dispatches of electricity during the period. Growth in company’s bottomline stemmed primarily from significant improvement in gross margins with a shot from other income as well.

Improvement in gross margins in 1HFY20 emanated from lower dispatch of electricity by the IPP that also lowered the costs. At the same time, growth in other income was due to higher interest income in a higher interest rate environment.

Despite a sizable growth in KAPCO’s earnings, headwinds for growth for KAPCO come from the PPA expiration nearing. The IPP’s PPA is expiring in FY21, which means it needs to be revised as the plant still has some 10-15 years of life after expiration. The oil and gas based IPP has been facing lower dispatch levels due to the phasing out of furnace oil. While in the short term these lower dispatch levels have been able to help the IPP on the cost side, these have also resulted in significantly lower revenues.

A research note from AKD Securities comments that the company entered into a one-year GSA for LNG supply in Dec-17, which has been able to keep the IPP’s utilisation levels higher. That GSA ended in Dec-18 and was followed by no other. This is reflected in the decline in load factors for KAPCO in 2HFY19 and in 1HFY20.

This means that the long-term prospects of the company now depend on the revision of the power purchase agreement, and the subject has been picked up by the management and the government. So far, there is uncertainty regarding the details. AKD Research note further highlights that the PPA might go from the ‘Take or Pay’ mode to ‘Take and Pay’ mode, which will depend on actual dispatch of electricity but will also affect the dollar-hedged tariff component, and in turn affect the prospects of dividends going forward.