Elevator Pitch

I assign a Neutral rating to South Korea’s largest electric utility Korea Electric Power Corporation (KEP) [015760:KS].

This is an update of my initiation article on Korea Electric Power published on September 21, 2019. Korea Electric Power’s share price has increased by +6% from KRW20,500 as of September 18, 2019 to KRW21,700 as of December 2, 2020, since my initiation. Korea Electric Power trades at 0.20 times P/B and 9.4 times consensus forward FY 2021 P/E, and it offers a consensus forward FY 2020 dividend yield of 3.1%.

The progress on Korea Electric Power’s tariff rate adjustment has been much slower than expected, with the company only expected to submit its tariff rate adjustment proposal to the South Korean government by the end of this year. Also, rising environmental costs could be a drag on the company’s bottom line going forward, if Korea Electric Power can’t meet the renewable energy mix targets set by the government.

On the positive side of things, Korea Electric Power is likely to resume dividend payments this year as it returns to profitability, and the company’s actual FY 2020 dividend payout ratio could be higher than what the market expects.

I will consider raising my rating for Korea Electric Power to Bullish, if there is more clarity on future changes to South Korea’s power tariff rates and system.

Readers have the option of trading in Korea Electric Power shares as ADRs on the New York Stock Exchange with the ticker KEP, or on the Korea Exchange with the ticker 015760:KS. For those shares listed as ADRs on the New York Stock Exchange, average daily trading value for the past three months is decent at $1 million, but lower than that for the Korea-listed shares.

For those shares listed in Korea, there are limited risks associated with buying or selling the shares in terms of trade execution, given that the Korea Exchange is one of the major stock exchanges that is internationally recognized, and there is sufficient trading liquidity. Average daily trading value for the past three months exceeds $65 million, and market capitalization is above $12.6 billion, which is comparable to the majority of stocks traded on the US stock exchanges.

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Institutional investors who own Korea Electric Power shares listed in Korea include The Vanguard Group, BlackRock Institutional Trust Company, Samsung Asset Management, Mirae Asset Global Investments, and Baillie Gifford, among others. Investors can invest in key Asian stock markets either using U.S. brokers with international coverage, such as Interactive Brokers or Fidelity, or international brokers with Asian coverage like Hong Kong’s Monex Boom Securities and Singapore’s OCBC Securities.

Tariff Rate Adjustment

In my initiation article on Korea Electric Power published on September 21, 2019, I highlighted that the company did not have its tariffs adjusted since 2016, and it has plans to submit an application to the South Korean government for a tariff hike. As a result of low tariff rates, Korea Electric Power was loss-making in FY 2018 and FY 2019.

The challenging operating environment for utility companies in South Korea such as Korea Electric Power is further supported by research published by Fitch Solutions. Fitch Solutions’ Q1 2021 South Korea Power Report highlights that “power prices (in South Korea) have been below generating costs, causing major financial problems for utilities” and “South Korea’s electricity prices remain relatively low, and operate under a merit-order dispatch system driven by cost.”

This is the key reason for Korea Electric Power’s depressed P/B valuation multiple of 0.20 times.

Unfortunately, the progress on Korea Electric Power’s tariff rate adjustment has been much slower than expected. The company disclosed at its recent 3Q 2020 results briefing on November 12, 2020 that “the tariff updates are currently being reviewed, and we are leveraging our expert panel as well as our civic organization to consult them (the South Korean government)”. More importantly, Korea Electric Power revealed that “we have not started discussion with the government yet” and “we are currently reviewing and finalizing our proposal (for the government).”

Korea Electric Power only expects to finalize its tariff rate adjustment proposal and submit to the South Korean government by end-2020. Also, there is no guarantee that the government will approve a direct tariff rate hike for the company. A September 3, 2020 Business Korea article quoting research from NH Investment & Securities highlighted that “even if the cost pass-through system is introduced, the possibility of a related electricity price hike is limited”, as “revisions to the electricity rate system will focus on cutting any unnecessary rate benefits or irrationalities.”

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Environmental Costs

Korea Electric Power reported the company’s 3Q 2020 results on November 12, 2020, and its financial performance in the third quarter of this year was much better than expected. Korea Electric Power reversed from a net loss of KRW932 billion in 3Q 2019 to a net profit of KRW1,508 billion in 3Q 2020. The company benefited from lower fuel costs and power purchase costs, which fell by -16.5% and -11.6% YoY, respectively in the third quarter of FY 2020.

Notwithstanding the good financial performance in 3Q 2020, it is noteworthy that Korea Electric Power’s environmental costs increased significantly on a YoY basis in the most recent quarter. The company’s renewable energy certificate costs rose +26% YoY to KRW559.6 billion in 3Q 2020. According to research by Fitch Solutions, South Korea introduced the Renewable Portfolio Standard in 2012 which requires “power companies to increase their renewable energy mix at a mandated target a year”, and power companies like Korea Electric Power need to purchase renewable energy certificates (which adds to their operating expenses) if they cannot fulfill the Renewable Portfolio Standard.

If Korea Electric Power is unable to meet the renewable energy mix targets set by the government, environmental costs such as renewable energy certificate costs could continue to increase going forward. On the flip side, a cost pass-through system (as highlighted above) might be implemented for the Korean power sector in the future, and this could possibly include renewable energy certificate costs.

Resumption Of Dividend Payments

Korea Electric Power offers consensus forward FY 2020 and FY 2021 dividend yields of 3.1% and 2.3%, respectively.

The company omitted dividend payouts for FY 2019 due to losses. But sell-side analysts see Korea Electric Power resuming dividend payments this year, given expectations of positive earnings in FY 2020. Market consensus expects Korea Electric Power to pay out dividends per share of KRW680 and KRW500 for FY 2020 and FY 2021, respectively.

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At the company’s 3Q 2020 earnings call on November 12, 2020, Korea Electric Power guided for a FY 2020 dividend payout ratio of 40%. This is higher than the market’s expectations of a 30% dividend payout ratio for the current fiscal year.

Valuation And Risk Factors

Korea Electric Power is valued by the market at 0.20 times P/B based on its share price of KRW21,700 as of December 2, 2020, versus its five-year and 10-year average P/B multiples of 0.34 times and 0.38 times, respectively. The stock also trades at consensus forward FY 2020 and FY 2021 P/E multiples of 9.2 times and 9.4 times, respectively.

Korea Electric Power’s depressed valuations are justified, if one considers the company’s consensus forward FY 2020 and FY 2021 ROEs of 2.2% and 2.1%, respectively.

The key risk factors for Korea Electric Power are a longer-than-expected time taken for an increase in tariff rates to be approved by the South Korean government, rising environmental costs, and lower-than-expected dividends going forward.

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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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