1QFY18 earnings of RM3m (+40% QoQ, -51% YoY) were below our expectations and consensus. This was due to higher steel and labour cost impacting its building type jobs (80% of orderbook). Slowdown in government jobs could intensify bidding competition for private sector jobs where Pesona largely participates in. Cut FY18-19 earnings by 38% and 22%. Downgrade from Buy to HOLD with lower TP of RM0.28 (from RM0.52).

Below expectations. Pesona reported 1QFY18 results with revenue coming in at RM170.6m (+89% QoQ, +6% YoY) and earnings of RM3m (+40% QoQ, -51% YoY). This was below expectations with 1Q earnings only accounting for 11% of ours and consensus full year forecast. The key culprit for the disappointing results was higher than expected material and labour cost.

Topline recovers but... Recall that last quarter (4QFY17), Pesona experienced delays on several projects, namely, iCity Mall (design changes by client), West Coast Expressway (WCE) (land acquisition issues) and UniZA Hospital (delay in obtaining development order). With the exception of WCE, management guides that the delay issues on the other 2 projects have been resolved and works have picked up. This is evident by the 104% QoQ surge in construction revenue.

…higher cost hits hard. Construction PBT margin for 1QFY18 was thin at 1.8%. While this is a slight recovery QoQ (4QFY17: 0.6%), it is still much lower YoY (1QFY17: 6.3%). The thin margin was largely attributed to increase in material (i.e. steel) price and labour cost. Management shared that most of their building related jobs were hit by the higher steel price. We estimate that 80% of its orderbook comprises building type jobs.

Healthy orderbook level. Pesona managed to secure RM378m worth of new jobs YTD (FY17: nil), bringing its orderbook to RM1.7bn. This implies a healthy cover of 3.3x on FY17 construction revenue.

Cautious on job flow outlook. Following the change in government post GE14, we have turned cautious on the overall macro job flow outlook for the construction sector. The new administration has stated that it will put all mega projects under review to ensure that the terms are fair to the government and country. We feel that this will result to project award delays (as they are reviewed) or in the worst case, an outright cancellation.

Higher competition for private sector jobs. Pesona has traditionally relied more on private sector developers for jobs as opposed to the public sector. Nonetheless, we with the potential scaling back of government spending, we feel that competition for private sector jobs could intensify as other contractors start bidding within this space.

Forecast. We cut FY18-19 earnings by 38% and 22% respectively as we price in lower construction margin to account for the higher cost environment.

Downgrade to HOLD. Apart from the earnings reduction, we also cut our P/E target from 15x to 12x to reflect the uncertain macro job flow outlook. Effectively our SOP based TP is reduced from RM0.52 to RM0.28. We downgrade our rating to HOLD as its weak near term earnings outlook coupled with an uncertain sector outlook, no longer warrants a Buy.

Source: Hong Leong Investment Bank Research - 28 May 2018