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Elevator Pitch
I retain a Buy investment rating for Korea Electric Power Corporation’s (NYSE:KEP) [015760:KS] stock.
I discussed about “changes to energy policies that could be favorable for the company in the long-term” in my earlier April 18, 2022 update for Korea Electric Power.
This latest article focuses on the actions that the government and the company have taken which should act as catalysts for the stock. I have a positive view of recent developments for Korea Electric Power such as electricity tariff hikes and a change in the company’s fuel mix. As such, I leave my Buy rating for KEP unchanged.
Poor Quarterly Financial Performance Acts As A Catalyst For Change
As a start, it is relevant to review Korea Electric Power’s most recent quarterly financial performance as highlighted in the company’s 1H 2022 financial results presentation. KEP’s financial metrics for Q2 2022 offer an indication of the scale of the company’s challenges.
Korea Electric Power’s operating losses widened from -KRW765 billion in the second quarter of 2021 to -KRW6,516 billion for the second quarter of 2022. KEP’s most recent quarterly operating losses turned out to be worse than the sell-side’s consensus forecast of -KRW5,385 billion according to financial data sourced from S&P Capital IQ.
Specifically, a +15% YoY increase in Korea Electric Power’s revenue to KRW15,528 billion in Q2 2022 was more than offset by a +80% YoY jump in fuel cost. This explains why KEP suffered from greater losses in the recent quarter as compared to Q2 2021.
To make things worse, KEP’s financial leverage has been rising. The company’s gross debt-to-equity ratio increased from 123% as of the end of 2021 to 179% as of June 30, 2022.
But there is a silver lining here. Given that Korea Electric Power continues to be loss-making and its gross gearing keeps rising, this compels the government and the company to take the necessary steps to deal with KEP’s current woes.
Government’s Actions
In my prior update for KEP written on April 18, 2022, I mentioned that “electricity pricing that is aligned with market factors” will be a key catalyst for the stock. There are signs suggesting that positive change is finally coming.
On September 30, 2022, Korean local media Yonhap News Agency published a news article noting that the government has granted approval for a KRW2.5/kWh increase in “the adjusted unit fuel cost — a key part of the country’s electricity rates” for Q4 2022.
Earlier, KRW4.9/kWh and KRW5.0/kWh hikes were initiated for October 2022 and Q3 2022, respectively. In contrast, the “adjusted unit fuel cost” component of Korea’s electricity tariffs had remained unchanged for 1H 2022, which contributed to KEP’s continued operating losses in the recent quarter.
In other words, Korea Electric Power is now in a better position to mitigate the negative effects of a spike in fuel cost for the second half of 2022. More importantly, the change in the Korean government’s stance with respect to electricity tariffs will help to ease investors’ concerns that KEP’s interests will be sacrificed to please the public.
Looking beyond the short-term, it is reasonable to speculate that the Korean government might consider acquiring all of Korea Electric Power’s shares and nationalizing the company in the intermediate term if market conditions remain challenging. There is already a precedent for this; Reuters reported in July 2022 that France had decided to proceed with a “full nationalization of power utility EDF.” Similar to KEP, EDF was highly-leveraged and suffering from high energy costs.
Assuming that a fair price is offered to existing shareholders to buy over Korea Electric Power, this might be another re-rating catalyst for KEP in the medium term.
Company’s Actions
Korea Electric Power’s fuel mix is another major factor that has hurt the company’s bottom line.
According to the company’s disclosures in its 1H 2022 results presentation slides, the average unit fuel price for LNG (Liquefied Natural Gas) was KRW1.3 million per ton in 1H 2022, and LNG made up approximately 37% of its fuel cost during the same period. In comparison, coal’s average unit fuel price in the first half of this year was much lower at KRW250,000 per ton.
This implies that there is an opportunity for KEP to optimize its fuel mix to lower its overall fuel cost, and this is exactly what the company plans to do.
As indicated in an October 5, 2022 news article published by Korean media Pulse, Korea Electric Power is targeting fuel cost savings amounting to around “KRW1.6 trillion” with plans to “scale back LNG generation by 8 percent” and use coal as a replacement.
Valuations
Korea Electric Power trades at a 76% discount to the company’s tangible book value per share now according to S&P Capital IQ’s valuation data. In the last 15 years, Korea Electric Power has never traded below a price-to-tangible book value multiple of 0.16 times (or 84% discount to tangible book).
While it is uncertain if Korea Electric Power’s shares could still trade lower, it is clear that KEP’s valuations are approaching trough levels.
Closing Thoughts
My investment rating for KEP’s shares is a Buy. Recent news flow with respect to actions taken by the company and the Korean government is encouraging. I take the view that such actions will help Korea Electric Power to tackle rising fuel costs, and this should be positive for the stock.
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