Following our report on 31-Oct-17: Equity issuance details released, HSS is expected to complete the 100% acquisition of SMHB by 1Q18. Factoring in SMHB’s 2Q-4Q18 contributions, we expect FY17-19E EPS to increase by 1-6% on a fully-diluted basis. FY18E PER of 16x postexercise (based on theoretical-ex-all price [TEAP] of RM1.29) is attractive relative to peers’ average of 20x. We raise our target FY18E PER to 20x and TP to RM1.60 given the immediate EPS enhancement, stronger long-term growth prospects, profit margin improvement and high ROE post-exercise. Maintain HSS as our top sector pick.

Combined Group Advantages

We believe HSS’ current order book/potential new contracts per annum will increase by 86%/67% to RM734/RM250m with the acquisition of SMHB. SMHB should enhance HSS’ profitability given the former’s high average net margin of 32% compared to the latter’s 9% in the past 3 financial years. We estimate group EBIT margin will increase by 12ppts yoy to 28% in FY18E by reaping merger synergies. HSS’s capabilities should expand given SMHB’s 50-year strong engineering consultancy experience in the water sector.

Earnings Adjustments

The combined revenue/core earnings will jump by 58%/174% yoy to RM214.4/RM41.1m in FY18E upon factoring i) SMHB’s current order book (RM343m) and potential new contracts per annum (RM100m); ii) one-off corporate exercise expense (RM7m); and iii) higher interest expense (RM5m) due to RM85m in new borrowings to partly fund the acquisition. Management intends to repay this debt within 5 years.

Post-warrant Conversion in Our Maximum Case Scenario

We believe the proposed SMHB acquisition will be earnings-accretive even in our maximum dilution scenario. We estimate HSS’s FY18/19E EPS will be enhanced by 1.3%/6.1% assuming rights issue price of RM1.08 (15% discount to TEAP) private placement price of RM1.15 (9% discount to TEAP) and warrant exercise price of RM1.45 (14% premium to TEAP). We estimate that fully-diluted core EPS will increase 63% yoy in FY18E despite the enlarged share base (76% increase in share capital) post-exercise.

Reaffirm BUY With a Higher TP of RM1.60

We reaffirm our BUY call with a higher 12-month TP of RM1.60 based on regional peers’ average FY18E PER of 20x. We raise our target FY18E PER from 17x previously, given 1) our expectation of stronger long-term earnings growth; 2) higher average net margin post-acquisition of 19% in FY18-19E versus local peers such as AWC and UEM Edgenta of 5% and 10% respectively in FY11-16; and 3) high ROE of 21% CY18E post-acquisition.

Source: Affin Hwang Research - 14 Dec 2017