HSS Engineers’ 2Q18 result was within expectations. Revenue grew 33% yoy while core net profit grew 45% yoy in 1H18, mainly driven by higher progress billing for most of its major projects and maiden earnings contribution from SMHB’s operation. Both EBIT and PBT margin improved mainly arising from consolidation of SMHB’s earnings. We increase our FY18E-20E EPS target by 0.2-10.3% and raise our TP to RM1.08 based on higher FY19E PER of 22x. Maintain BUY.

1H18 Core Net Profit Jumped by 44.8% Yoy

Revenue increased by 32.7% yoy in 1H18 driven by progress billings for ongoing projects including (1) design contracts for East Coast Rail Link (ECRL) and West Coast Expressway (WCE) and (2) construction supervision contracts for Sungai Besi-Ulu Kelang Elevated Expressway (SUKE) and Maju Expressway extension to KLIA. In addition, SMHB Engineering has started to contribute in the 2Q18 to the group revenue, adding RM19.1m. 1H18 net profit was up by 26.9% yoy to RM7.8m, of which RM3.3m was contribution from SMHB. Excluding one-off RM2.5m corporate expense incurred for the acquisition of SMHB, its 1H18 core net profit improved by 44.9% yoy to RM10.3m, accounting for 48.6% and 45.9% of our previous and consensus forecasts, respectively. This is within our expectations as traditionally fourth quarter is the strongest quarter among the 3 quarters.

Margin Enhancement From SMHB’s Earnings Consolidation

EBIT margin was substantially higher at 20.9% in 2Q18 compared to 13.5% in 1Q18 and 14.2% in 2Q17 mainly due to consolidation of SMHB earnings. Despite higher interest expense of RM1.7m mainly arising from borrowings to partly fund the SMHB acquisition, PBT margin improved in 2Q18 to 18.1% compared to 6.3% and 11.9% in 1Q18 and 2Q17, respectively. For 2Q18, SMHB chalked up revenue and PBT of RM19.1m and RM4.5m, respectively, translating to 23.4% profit margin. HSS order book stood at RM630.8m, providing earnings visibility for the next 2-3 years.

Reaffirm BUY With Higher TP of RM1.07

We raise our FY18-20E earnings by 0.2%-10.3% as we expect stronger earnings in 4Q and we accelerate progress billings for existing projects given stronger 1H18. We reaffirm our BUY call with higher 12-month TP of RM1.18, based on regional peer’s FY19E PER of 22x, compared to RM0.78 previously (PER of 16x). We believe HSS is in a position to weather the expected slowdown in new contract awards given the EPS enhancement and better profit margin from the SMHB acquisition. HSS remains our top sector smallcap BUY.

Potential Increase in Government Capex for Water Infrastructure

The expected completion of the acquisition of water treatment concessionaire, Syarikat Pengeluar Air Sdn Bhd (SPLASH) by the Selangor state government coupled with potential water tariff hike will support government spending to upgrade water supply and distribution. Water-related contracts are likely to be rolled out next year after resolving the stalemate in the SPLASH acquisition. This is positive for HSS following its acquisition of SMHB Engineering, which is the largest local engineering consulting firm in the water sector.

Key Downside Risks to Our Call

Key risks to our BUY call: (1) mergers and acquisition execution risks; (2) higher financing costs; (3) earnings lag due to the timing of contract wins; (4) execution risks involved in its expansion plans; and (5) a slowdown in the award of construction contracts.

Source: Affin Hwang Research - 16 Aug 2018