Investment Highlights

• We keep our earnings forecast for FY18F but cut those of FY19-20F by 14% and 15% respectively. We trim our FV by 4% to RM1.25 (from RM1.30) but maintain our HOLD call for Hock Seng Lee (HSL).

• The FY19-20F earnings forecast downgrade is largely to factor in a lower assumption for job wins of RM250mil annually (from RM400mil previously) during our forecast period.

• Our new FV is based on 10x revised FY19 EPS, from 9x previously, in line with our widened benchmark forward target P/E of 7-10x for small-cap construction stocks (from 7-9x previously) to reflect the slight improvement in the sentiment towards small-cap construction stocks of late.

• During a recent visit to HSL, the company acknowledged that similar to its peers in Peninsular Malaysia, contractors in East Malaysia are not spared the weakened prospects for job wins over the short term as the government cuts back on public projects on grounds of fiscal prudence.

• However, the fact remains that East Malaysia is still falling far behind Peninsular Malaysia in terms of infrastructure development. As such, once the dust settles, the rollout of public infrastructure projects in East Malaysia is likely to resume. HSL holds that view that given the budgetary constraints, the government is more likely to focus more on smaller-scale/value-for-money basic infrastructure projects.

• We believe these could include road upgrading, bridges, schools, drainage, smallish water supply and sewerage schemes (but certainly not the RM10.8bil Kuching LRT project). As the size of these projects only ranges from RM30-50mil on one end, to less than RM100mil on the other, they are uneconomical to the peninsular boys whose operations in East Malaysia generally carry much higher fixed overheads.

• We believe HSL is very well positioned to benefit from the rollout of these small-scale public infrastructure projects in East Malaysia over the medium to long term given:

1. Its competitive local workforce (vs. the costlier one — “imported” from West Malaysia — for the peninsular boys);

2. Its better control over raw materials, both in terms of supply and pricing (HSL sources aggregates from privately-held sister companies which offer reliable supply at competitive pricing, and sand from local suppliers with business relationships going back decades who could therefore offer HSL below-market rates; and

3. HSL’s niche strength in ground treatment and land reclamation (infrastructure projects in Sarawak are normally preceded with ground treatment and land reclamation, given the generally low-lying and swampy nature of the land located in the fast-developing coastal areas).

• Meanwhile, the progress on HSL’s key construction jobs has finally gathered momentum, after overcoming the initial hiccups such as the delays in obtaining the necessary approvals from various authorities as well as vacant possession of project sites. At present, the completion stands at:

1. 30% for the RM1.2bil work package for the Pan Borneo Highway (total value for the work package is RM1.7bil, HSL has a 70% share);

2. 18% for the RM333mil Miri Wastewater Management System; and

3. 5% for the RM563mil Kuching City Central Wastewater Management System (Phase 2) (total contract value is RM750mil, HSL has a 75% share).

• Collectively, these three jobs make up two-thirds of HSL’s currently outstanding construction order book of RM2.5bil.

• In conclusion, we are still cautious on the outlook for the local construction sector. As the government scales back on public projects, local contractors will be competing for a shrinking pool of new jobs in the market. Severe undercutting among the players will result in razor-thin margins for the successful bidders. On the other hand, the introduction of a more transparent public procurement system under the new administration should weed out rent-seekers, paving the way toward healthier competition within the local construction sector.

• We believe HSL will be able to ride out the current downturn in the local construction sector relatively better than its peers, given its substantial order backlog that should keep it busy over the next 3-4 years, coupled with its ability to compete under an open bidding system.

Source: AmInvest Research - 30 Jul 2018