Kenya Power’s cost structure weighs down its margins

Kenya Power reported its full-year earnings last Friday, and the impressive profitability numbers promptly caused the stock to jump two per cent.

The company posted a 55 per cent rise in pre-tax profits to Sh10 billion. Total revenues grew by 18.6 per cent to Sh105.4 billion, led by 30.6 per cent growth in electricity sales. Earnings grew by 88 per cent to Sh3.31 per share.

Questions over whether its recent tariff review would impact customer growth were answered as new connections came in well above expectations.

The company managed to connect 443,254 new customers during the year, the highest ever number connected in a single financial year, bringing the total number of customers to 2.7 million. This should begin to reflect positively on its top line in the medium term.

While I continue to believe that the company will see robust growth in its electricity sales business due to the increasing demand for connectivity, taming power purchase costs remains a key challenge for the company.

Year-on-year, power purchase costs were up Sh10.6 billion or 17 per cent and accounted for averagely 70 per cent of its total revenue. This high cost remains valid as it continues to hurt its free cash flow.

Re-calculated negative free cash flow stands at Sh18.86 billion, Sh10 billion more than reported. This means if the stock begins to trade on fundamentals like free cash flow then its year to date 10 per cent price rise looks unreasonable and should immediately trigger a trend reversal.

In addition to the negative free cash flow, Kenya Power continues to face significant finance costs. This cost burden accounted for 82 per cent of its non-operational expenses according to its recent full-year results.

Should these obligations get worse on the same operational efficiency, then both its return on equity (RoE) and return of assets (RoA), which currently stand at 18.8 per cent and 4.6 per cent respectively, could shrink if other factors remain constant.

Investors should take note that the company borrowed a further Sh25 billion in the reporting year slightly down from Sh29.9 billion borrowed in the previous year.

Nevertheless, given these funds are going into refurbishing and expansion of its network which include system automation, undergrounding of cables and upgrading and replacement of wooden poles with concrete ones, then perhaps the negative cash flow situation and the rising debt load should not be frowned at after all.

They could be excused for the sake of future enhanced system reliability (reduced outages), improving customer satisfaction, improving sales and yes better profitability.

The company intends to invest Sh14.3 billion by 2017 in its infrastructure under the 5,000+MW programme and to start with, it plans to connect a million customers per annum for the 2014/15 financial year, which, in my view, may be too ambitious.

It is clear that accelerated customer acquisition is a trend that is likely to continue in the foreseeable future seeing that Kenya Power’s market is far from saturation.

However if the company is unable to create operational efficiencies, then costs would continue to weigh on Kenya Power’s margins. The stock currently trades at 4.95 price-to-earnings ratio compared to the sector’s 7.7 P/E.

Mr Mwanyasi is an investment analyst