Adeel Ahmed

Internal Document – Annual Review of HUBCO (FY 2010) To : The Investment Committee (IC) From : Adeel Ahmed Date : 7 January 2011 Subject : Annual Review of HUBCO (FY 2010) Purpose: The purpose of this memo is to update the IC members on the financial numbers of HUBCO as of 30 June 2010. We recommend that the approved fair value of Rs. 46 per share to be maintained. The recommended fair value of Rs. 46 per share implies a P/E multiple of 9.7x, FV/ EBITDA of 9.9x and dividend yield of 10.9%. FV/EBITDA is higher than P/E because of substantial increase in long term debt for financing of expansion projects. However, EBITDA from these projects is currently zero as these projects have not commenced commercial operations yet. Secondly, the interest on debt taken for expansion projects is being capitalized. This policy has an inconsistent impact on P/E and FV/EBITDA resulting in a very small difference between the two ratios. The P/E is lower because interest on expansion related debt is not reflected in the income statement whereas FV has increased by the full amount of debt thereby increasing FV/EBITDA ratio. Section 1 – Business Update of HUBCO (FY 2010): During the review period FY 2010, the Company generated net sales of Rs. 99.7 bn (as compared to Rs. 82.8 bn). The incremental sales were a net effect of increasing furnace oil prices as well as higher load factor demanded by WAPDA. Since FY 2005, the Company is generating higher net sales as a consequence of higher load factor and rising fuel costs. Please see the following table for net sales, annual increase in sales and electricity sold (load factor) over the previous 6 years: Period (30 June) Net Sales (Rs. in mil) FY 2010 99,694 FY 2009 82,784 FY 2008 62,435 FY 2007 44,131 FY 2006 27,911 FY 2005 16,978 Growth Rate(s) 20.4% 32.6% 41.5% 58.1% 64.4% 6.1% Electricity Sold (GWh) 8,337 8,257 7,205 7,214 3,930 1,975 Load Factor 79.3% 78.5% 68.4% 68.6% 37.0% 18.8% The gross profit showed a robust increase of 26.1% in FY 2010 on the back of PKR devaluation against the USD, higher production bonus and thermal efficiency gains. Page 1 of 7 Internal Document – Annual Review of HUBCO (FY 2010) Due to the inherent u-shaped tariff structure of HUBCO, the gross profit declined from Rs. 9.8 bn (FY 2002) to Rs. 4.2 bn (FY 2007). However, gross profits started improving since FY 2007 as the tariff started riding on the upward curve. It is expected that this trend will continue and gross profits will further improve going forward. The u-shaped structure had a higher frontend load (due to long term debt for the development of Company’s infrastructure and property, plant and equipment). Over the years (since FY 1997), the tariff structure gradually declined (as per the PPA) as the Company’s long term debt was paid off. The tariff reached its bottom in FY 2007 and is now gradually increasing again with the incursion of long term debt for the expansion projects. Please see the table below for the Company’s gross profit and underlying growth rates since FY 2005: Period (30 June) Gross Profit (Rs. in mil) Growth Rate(s) FY 2010 7,688 26.1% FY 2009 6,097 28.4% FY 2008 4,750 14.1% FY 2007 4,164 (4.5%) FY 2006 4,358 (39.1%) FY 2005 7,157 (9.4%) The power purchase agreement (PPA) with WAPDA is for a period of 30 years. The agreement will expire in year 2027. Section 2 – Balance Sheet (30 June 2010): We present and analyze below the fixed assets, long term debt, leverage and cash cycle figures of the Company since FY 2005. 1. Fixed Assets and Long Term Debt The Company is going through an expansion mode since FY 2008 and resultantly its long term debt has increased from Rs. 7.3 bn (FY 2008) to Rs. 25.5 bn (FY 2010). This increase in long term debt is purely for the financing of the undergoing expansion projects of Narowal and Laraib Energy Ltd. The cumulative long term debt incurred till 30 June 2010 for these projects amounts to Rs. 20.1 bn. The major portion of this financing went to the Narowal project, which is expected to commence operations by March 2011. The Narowal project is expected to contribute an EBIT of Rs. 1.0 bn and an EBITDA of Rs. 2.5 bn approximately from FY 2012. The related interest expense of this long term debt is being capitalized as per IAS 23R, which now requires firms to defer the interest cost of such projects till the time their commercial operations commence. As such, the enhanced long term debt would not have any bearing on the firm’s net profitability till FY 2012. The capitalized interest would then be expensed out in the form of depreciation. 2. Leverage HUBCO’s Net Debt has increased from Rs. 15.9 bn in 30 June 2009 to Rs. 33.9 bn in 30 June 2010. Consequently, Net Debt/ EBITDA has increased from 2.2x (30 June 2009) to 3.8x (30 June 2010). Despite this increase, the ratio is quite in line with the average Net Debt/ EBITDA ratio of regional peers, which ranges from 3x to 7x. The additional debt has been incurred for expansion projects. Page 2 of 7 Internal Document – Annual Review of HUBCO (FY 2010) The short term borrowing of HUBCO has increased from Rs. 3.6 bn in FY 2009 to Rs. 6.7 bn in FY 2010. This increase was purely due to the circular debt issue, which resurfaced again in FY 2010. However, this increase is not expected to have material impact on the financial cost or overall profitability of the firm. The financial cost borne by the Company due to overdue payments is passed on to the customer. The overdue amount carries a mark-up at SBP’s discount rate plus 2% per annum compounded semi annually. The TIE ratio has been improving since FY 2008 due to stable financial cost and increasing operating profit (EBIT). Please see the following table: Period (30 June) FY 2010 FY 2009 FY 2008 FY 2007 FY 2006 FY 2005 Net Debt (Rs. in bn) Net Debt/ EBITDA (x) Time Interest Earned (x) 33,855 15,917 21,598 11,340 7,424 7,568 3.8 4.0 2.2 2.7 3.5 2.3 2.0 2.8 1.3 2.6 0.9 3.9 3. Cash cycle Cash cycle has increased from 1 day on 30 June 2009 to 10 days on 30 June 2010 as the Company’s receivables increased more than its payables over the year. Although the cash cycle has increased but only to a partial extent because of the Company’s capacity to put major portion of its payables to PSO on hold once the payment of its receivables are delayed by WAPDA. Please see the table below for Company’s cash cycle numbers since FY 2005: Cash Cycle (30 June) Days Inventory Days Receivable Days Payable Cash Cycle FY 2010 FY 2009 FY 2008 FY 2007 FY 2006 FY 2005 - - - - - - Section 3 – Income Statement (30 June 2010): 1. Sales Sales have been growing on a compounded annual growth rate (CAGR) of 42.5% since FY 2005 mostly on the back of currency devaluation, higher tariff profile and higher generation bonus in recent years. Period Net Sales (Rs. in mil) Growth Rate(s) FY 2010 99,694 FY 2009 82,784 FY 2008 62,435 FY 2007 44,131 FY 2006 27,911 FY 2005 16,978 20.4% 32.6% 41.5% 58.1% 64.4% 6.1% 2. Cost structure There are three main costs items - cost of sales, administrative expenses and financial costs. Page 3 of 7 Internal Document – Annual Review of HUBCO (FY 2010) During the review period, cost of sales increased by Rs. 15.32 bn (20%) mainly due to rising energy costs and PKR devaluation. Administrative expenses increased marginally by Rs. 0.07 bn (17.1%). Although leverage has increased from Rs. 15.9 bn (FY 2009) to Rs. 33.9 bn (FY 2010), the financial cost has decreased by Rs. 0.3 bn (14.2%) over FY 2009. This decline in financial cost occurred as more than Rs. 20 bn of net debt is being availed for the power expansion projects. Accordingly, the capitalized interest was a substantial amount of Rs. 2.8 bn in FY 2010 against Rs. 1.32 bn in the comparable 9 month period of FY 2009. As discussed above, this additional interest is expected to be expensed out starting FY 2012. 3. Profitability The gross, operating and net margins showed improvement in FY 2010. Till FY 2009, margins were showing a declining trend. This was because absolute profitability either declined or improved marginally while sales grew at a fierce pace. It is expected that the rising tariff will improve absolute profitability, however margins would remain stagnant within their current range of 5% - 8%. Additionally, we have projected pro forma income statement figures of FY 2011. Following the growth trajectory due to rising u-shaped tariff structure, predictable variable costs and stable fixed costs over the prior years have enabled us to determine gross, operating and net profits for the next year. Please see the table below for profitability figures since FY 2005: Period FY 2011E 117,639 FY 2010 99,694 FY 2009 82,784 FY 2008 62,435 FY 2007 44,131 Gross Profit (Rs. in mil) 8,700 7,688 6,097 4,750 4,164 4,358 7,157 Gross Margin (%) 7.40% 7.71% 7.36% 7.61% 9.44% 15.61% 42.15% EBIT (Rs. in mil) 8,100 7,202 5,682 4,461 3,911 4,078 6,963 EBIT Margin (%) 6.89% 7.22% 6.86% 7.15% 8.86% 14.61% 41.01% Net Profit (Rs. in mil) 5,900 5,469 3,717 2,601 2,654 2,768 5,385 Net Margin (%) 5.02% 5.49% 4.51% 4.17% 6.01% 9.92% 31.72% Sales (Rs. in mil) FY 2006 27,911 FY 2005 16,978 A projected net profit of Rs. 5.9 bn in FY 2010 translates into an EPS of Rs. 5.10 per share. The stock is currently trading at Rs. 38 per share (as of 7 January 2011). Assuming a DPS of Rs. 5 for the FY 2011, the dividend yield (at the existing market price) equates to 13.2% approx. Section 4 – Valuation 1. DDM We have used single stage DDM model with the following assumptions: 1. The ROE is assumed to range between 20% to 25%. The tangible book value per share was Rs. 24.80 as of 30 June 2010, which implies an EPS range of Rs. 5.0 to Rs. 6.2 per share. Page 4 of 7 Internal Document – Annual Review of HUBCO (FY 2010) 2. Aggregate cash dividend for FY 2011 is assumed to be Rs. 5 per share. The cash dividend for the FY 2010 was also Rs. 5 per share. 3. The forecasted dividend for FY 2011 implies retention ratio to range between 0% to 19.4% and translates into a growth rate range of 0% to 4.8%. 4. We have assumed an expected return of 15%. Tangible Book Value Per Share (Rs.) ROE EPS (Rs.) Dividends (Rs.) Retention Ratio Growth Rate (without PKR devaluation) Expected Return Implied Value Per Share (Rs.) Downside Base Case Upside 24.8 20.0%-% 33 24.8 24.8 22.5%-% 2.4% 15.0% 40 25.0%-% 4.8% 15.0% 49 The above growth range is further boosted by PKR devaluation as the negotiated power tariff has an inbuilt dollar based ROE of 12% under the PPA agreement (not guaranteed). The impact of this devaluation on the implied value per share is as follows: 1. The average PKR devaluation rate since July 1991 till June 2010 has been 7%. 2. We have assumed 3 devaluation rates of 3%, 4% and 5% respectively in coming years. Adding each of these assumed devaluation rates to the above growth rate range provides us with 3 new valuation range(s), given below: Growth Rate (Devaluation rate 3%) Implied Value Per Share (Rs.) Downside 3.0% 42 Base Case 5.4% 52 Upside 7.8% 69 Growth Rate (Devaluation rate 4%) Implied Value Per Share (Rs.) 4.0% 45 6.4% 58 8.8% 81 Growth Rate (Devaluation rate 5%) Implied Value Per Share (Rs.) 5.0% 50 7.4% 66 9.8% 96 2. FV/EBITDA We have also attempted a valuation using FV/EBITDA methodology (range of 5.0x to 10.0x). Previously, the Company’s FV/EBITDA was as low as 3.4x (FY 2000) and as high as 9.7x in (FY 2007). The normalized EBITDA is assumed to be Rs. 11,000 mil. A FV/EBITDA multiple in the range of 6x to 8x is ideal for companies like HUBCO and KAPCO. The earnings of these IPPs remain insulated to macroeconomic shocks such as international fuel price Page 5 of 7 Internal Document – Annual Review of HUBCO (FY 2010) variability, exchange rate depreciation and inflationary pressures. These companies naturally have good prospects for growth (for long term investors) even without any specific project in the pipeline. We would like to point out that power utilities in developed markets where growth prospects are low trade at FV/EBIDTA multiples of 4.5x to 7x. In emerging markets like China, India and Malaysia, similar companies are trading at an average range of 6.4x to 20.7x. Please see the following table: FV/EBITDA EBITDA (Rs. mil) FIRM VALUE (Rs. mil) Net Debt (Rs. mil) Minority Interest (Rs. mil) Implied Equity Value (Rs. mil) No. of shares Implied Value per share (Rs.) 5.00 11,000 55,000 (33,855) (357) 20,788 1,157 18 6.00 11,000 66,000 (33,855) (357) 31,788 1,157 27 7.00 11,000 77,000 (33,855) (357) 42,788 1,157 37 8.00 11,000 88,000 (33,855) (357) 53,788 1,157 46 9.00 11,000 99,000 (33,855) (357) 64,788 1,157 56 10.00 11,000 110,000 (33,855) (357) 75,788 1,157 66 The Net Debt of the Company increased by more than 100% over the year due to the expansion projects. Additionally, these projects have not started commercial operation hence contribution to EBITDA from these projects is zero. Consequently, the FV/EBITDA ratio is coming a tad higher than the P/E ratio. Once these projects commence commercial operations, EBIT and depreciation from these projects will increase the EBITDA in the range of Rs. 13,500 to 14,000 approximately, bringing the FV/EBITDA multiple to a normal range of 6x to 8x. 3. Free Cash Flow Analysis: On an aggregate basis, free cash flow has been Rs. 56.0 bn for the period FY 2000 – FY 2010. The aggregate cash dividend paid during this time period was Rs. 46.8 bn. Please see the following table for aggregate numbers: FY 2000 – FY 2010 NOPAT Investment in working capital Investment in fixed assets Depreciation & Amortization FCFs Change in Net Debt Interest Cost Other Income Cash dividend paid Aggregate Numbers (Rs. bn) 76.3 (11.4) - (26.4) (4.7) 46.8 Although cash dividends paid have been less than the free cash flows, higher interest cost and negative other income forced the Company’s leverage to go up in the respective period in addition to the circular debt issue and enhancement of fixed assets. Page 6 of 7 Internal Document – Annual Review of HUBCO (FY 2010) Recommendation: We recommend that the approved fair value of Rs. 46 per share to be maintained because: 1. The implied value per share range calculated through DDM model turns out to be Rs. 33 to Rs. 49 (without PKR devaluation rate). The midpoint of this range turns out to be Rs. 41 per share. This method ignores growth in EPS and dividends due to PKR devaluation. 2. The DDM model incorporating the PKR devaluation rate of 3% widens the implied value range to Rs. 42 to Rs. 69 respectively. The midpoint of this range turns out to be Rs. 56 per share. 3. A FV/EBIDTA multiple in the range of 6x to 8x implies a value per share in the range of Rs. 27 to Rs. 46 for HUBCO. The midpoint of this range turns out to be Rs. 37 per share. 4. The average value turns out to be Rs. 45 per share taking into account the above 3 midpoints. Page 7 of 7