HSS Engineers’ reported 9M18 results were within our expectations but slightly below market expectations. Revenue grew 37% yoy to RM142.9m, boosted by the 6-month contribution from SMHB’s operations. Net profit jumped 89% yoy to RM16.9m in 9M18 on the better performance of HSS’ existing operations and the maiden contribution from SMHB. We expect a weaker 4Q18 result qoq due to the amortisation of goodwill on the acquisition of RM4-5m to be recognised. HSS remains our top small-cap sector BUY with a target price of RM1.18, based on FY19E PER of 22x.

Within Expectations

Net profit of RM16.9m (+89% yoy) in 9M18 comprises 73% of the consensus full-year forecast of RM23.1m and 81% of our estimate of RM20.8m. Operating conditions remain challenging due to the ongoing review of government projects. Higher interest expense of RM4.4m (+333% yoy) and one-off corporate exercise expense of RM2.6m held back earnings in 9M18. The amortisation of goodwill on the acquisition of SMHB amounting to RM4-5m will kick in in 4Q18, reducing earnings. Core net profit doubled yoy to RM20.1m in 9M18, stronger than revenue growth of 37% yoy, due to a higher EBIT margin of 21.2% in 9M18 compared to 13.2% in 9M17.

High Order Book Supports Earnings

Core net profit jumped 41% qoq and 231% yoy to RM9.7m in 3Q18 due to higher profitability on completion of several projects. HSS’ order book stood at RM588.6m as at 30 September 2018, providing earnings visibility for the next 2-3 years. The suspension of the East Coast Rail Link (ECRL) contract effective from 9 July 2018 will result in no earnings contribution from this contract in 4Q18. Ongoing projects such as Tun Razak Exchange External Roads and West Coast Expressway will continue to contribute to earnings.

Maintain BUY With TP of RM1.18

We reiterate our BUY call with a 12-month TP of RM1.18, based on regional peer’s average FY19E PER of 22x. 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 small-cap BUY.

Good prospects for water projects in 2019

The Budget 2019 allocated RM690m for implementation of new water-supply projects and reducing non-revenue water (NRW). The government allocated RM590m in 2019 to build more municipal sewerage treatment plants and network systems to connect households that are still using septic tanks and traditional systems. This is positive for HSS following its acquisition of SMHB Engineering, which is the largest local engineering consulting firm in the water and sewerage sectors. The group has also submitted tenders for water projects in Sabah and Sarawak as water shortages in these states remain a concern for the government.

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 Nov 2018