We maintain our Neutral rating on SEC with a PT of SAR18.7 (downside of 4.6%). We expect SEC earnings to decline to SAR1.0bn in 2019f from SAR1.8bn in 2018 due to lower revenues on consumer rationalisation. However, lower capex and improved working capital is a key advantage. The stock is trading at 2019f EV/EBITDA of 9.6x, in line with the peer group average of 9.5x.
Weak earnings on lower sales: We expect SEC to report a net income of SAR1.0bn in 2019f vs SAR1.8bn in 2018. This is mainly due to lower revenues and margin contraction. In 2019f, we expect revenues to decline 5.5% yoy to SAR60.5bn due to consumption rationalisation in the residential and commercial segments (c60% of sales) following to the increase in tariff in 2018. Although the customer base increased 3.9% yoy to 9.59mn in H1 19, residential and commercial segment sales declined 7.6% and 3.0%, respectively. We expect revenues to grow by a CAGR of 1.0% between 2018-2023, while net income is expected to increase by a CAGR of 6.6%, mainly driven by population growth and gradual margin expansion.
Margins to remain weak despite lower fuel prices in 2019f: We expect gross margins to decline to 8.8% in 2019f from 9.2% in 2018 (13.2% in 2017) as lower fuel costs would be mitigated by higher depreciation expense. SEC is reducing the usage of fuel (c18% of COGS) by enhancing thermal efficiency, which is expected to result in a saving of c16% yoy to SAR6.4bn. Thermal efficiency has increased to 39.9% in 2018 vs 38.8% in 2017 and 31.3% in 2010. However, the substantial increase in capex over the past 5 years (average of SAR45.7bn) is expected to increase depreciation expenses by 12.1% yoy to SAR18.9bn. We expect gross margins to improve gradually going forward to reach 9.9% in 2023f. EBITDA margin is expected to improve to 39.4% in 2023f, from 36.3% in 2018.
Lower Capex and improved working capital to support FCF: SEC started to reduce capex in 2018, after an average annual capex of SAR45.7bn since 2013. Capex declined 34.3% yoy to SAR28.4bn in 2018 and stood at only SAR9.0bn in H1 19. We expect capex to be at SAR18bn (29.7% of sales) in 2019 and to remain broadly unchanged going forward. Moreover, working capital improved supported by lower receivable days, which declined from 213 in 2017 to 200 in 2018. This is expected to support FCF, which is expected to increase to SAR6.3bn in 2019 from a negative FCF of SAR64.6bn in 2018.
High debt level remains a concern: In 2018, SEC's total debt stood at SAR157.6bn (including government debt) with a net debt/EBITDA of 6.7x. The high debt is due to high capex requirement over the last five years. We expect the debt level to decline going forward supported by lower capex, with net debt/ EBITDA reaching 5.2x in 2023f.
Last year of fixed dividends policy: SEC has a 10-year fixed dividend policy of SAR0.7/share which will end in 2019. There is currently no clarity on the extension of the dividend policy. However, we expect that the policy will not be extended due to high debt levels. Any progress on extension of the dividend policy will be a key catalyst for the stock.
Remain Neutral with a PT of SAR18.7: We maintain our Neutral rating on SEC with a PT of SAR18.7. Lower revenues and weak profitability are concerns. However, lower capex and improved working capital are key advantages. Key catalysts going forward are: 1) dividend policy, 2) restructuring plans, and 3) tariff revision. The stock is trading at 2019f EV/EBITDA of 9.6x, in-line with the peer group average of 9.5x.