• We are surprised by the S$158m impairment for Sembcorp Industries’ UK Power Reserve (UKPR), with the group blaming changing market conditions since the acquisition in May 2018.
• All in, Sembcorp Industries guided for S$165m in impairments in 4Q19F, including S$87m in impairments for Chile and China utilities assets. No impairment for India.
• Management strategy execution hiccups and unclear growth outlook from core markets (Singapore, UK, India) limit catalysts. Downgrade to HOLD with SGD2.13 target price.

What Went Wrong With the UKPR Acquisition?

• Recap: Sembcorp Industries (SGX:U96) acquired UK Power Reserve (UKPR) in May 2018 at £216m (S$385m), comprising a cheap-to-build, quick-to-fire-up mini power plants in the UK.
• We had expected the acquisition (valued at 10x FY3/18 P/E then) to add S$17m p.a in profit to Sembcorp Industries’ earnings from FY19F. However, UKPR was then affected by the European Court of Justice’s ruling to suspend capacity market payments after Tempus Energy’s appeal on the auction process in late-2018. That led the UK government to not issue capacity market payments to generation companies or hold auctions to secure additional power capacity for the winter of 2019, and resulted in UKPR’s losses in 2Q-3Q19.
• In Oct 19, the European Commission approved the UK market capacity scheme and UKPR had expected to recognise S$15m of payment that it missed since the suspension.

Market Conditions Changed, Reducing Demand for Flexible Energy

• A string of reasons were given for the impairment, including
  1. oversupply of energy capacity,
  2. reduced demand due to energy efficiency and reduced industrial production,
  3. mild and windy winters, and
  4. improved forecasting by the National Grid Electricity System Operator in Great Britain.
• These caused flexible energy generation operators, such as UKPR, to be utilised less frequently to balance the electricity market.
• We now expect minimal earnings contributions from UKPR in FY20-21F.

Chile and Nanjing Assets Impaired; No Impairment Needed in India

• There was a S$64m impairment from a divestment of non-core water assets in Chile, sold at S$49m to be completed in 2020. The impairment stems from higher opex and regulatory costs, and deterioration of Chile’s economy and currency.
• S$23m was provided for Nanjing wastewater treatment plant for failing to meet the new and more stringent effluent discharge standards in Jiangsu.
• Management also carried out a review of its Indian assets but no impairment is required for now.

Downgrade to HOLD From Add , Lower SOP Target Price

• Our EPS is cut by 4-57% for FY19-21F to factor in the profit guidance (4Q19F: net loss for utilities). We also lower our UK and China earnings growth for FY20-21F.
• On a positive note, the impairment exercise could pave the way for potential future M&As, in our view.
• We think Sembcorp Industries needs to rebuild investment confidence with a consistent earnings trend in its utilities amid the challenging operating environment in its core markets - India, Singapore and UK.

Source: CGS-CIMB Research - 6 Feb 2020