Kenanga Research & Investment

CONSTRUCTION - Still Cheap in a Cyclical Boom

kiasutrader
Publish date: Wed, 02 Jul 2014, 10:18 AM

We continue to remain OVERWEIGHT on the sector due to the following investment merits:- (i) the sector is currently still experiencing a cyclical boom, registering a double-digit growth, (ii) there are several major events in 2Q14 indicating more positive job and news flows in 3Q14, (iii) there are still lots of other potential positive news and contract flows that will drive the overall investors’ sentiment on the sector, (v)potential M&A activities, (iv) the sector’s undemanding valuation (fwd-PER currently trading at 5-year mean of 14x versus 15x – 17x during previous boom cycle in 2009-2010. We switch our top pick to Gamuda (OP; TP: RM5.52) from IJM Corp (OP; TP: RM7.57) in 3Q14 as we believe Gamuda will be the biggest beneficiary from M&A activities and KVMRT2 news flows in 3Q14. Meanwhile, we favour Mitrajaya (TRADING BUY; TP: RM1.13) for small cap pick as it is one of the cheapest quality small-cap stock in the construction space with its growth prospects overlooked by market.

KL Construction still outperformed the FBMKLCI. KL Construction Index performed well since 6 months ago. YTD, (up to 20th June 2014), the KL Construction Index has outperformed the benchmark KLCI Index, advancing 7.9% YTD against KLCI’s gain of only 0.5% YTD. This time around, Benalec was the winner amongst contractors in our universe. The stock started gaining investors’ recognition after a series of positive news flows with regards to its Malacca’s reclaimed land sale. Second place winner Muhibbah, went up by +30.7% YTD, thanks to positive news flows from RAPID Petronas. Muhibbah is expected to win at least one or few packages in the project given that most of the group’s tender book is largely from the project. Meanwhile, Gamuda and Kimlun are the top losers so far in our construction space as the former was dragged by overhang in its 40%-owned water asset, SPLASH takeover deal while the latter was dragged down by disappointment in earnings.

1Q14 construction GDP growth registered double-digit growth again. Construction GDP growth registered double-digit growth of 18.9% in 1Q14, accelerating from 9.8% in 4Q13. This is thanks to the implementation of big-ticket infrastructure projects namely KVMRT1, highways and property projects. Going forward, our in-house economics team estimated the sector to grow by 11.5% in 2014. The growth momentum is expected to continue driven by remnant mega projects under 10MP and ETP namely new highways, high-rise towers, KVMRT2, LRT3, O&G’s RAPID Pengerang, regional corridors, and new property launches.

FY14-FY15 net profit growth forecasts of 27%-18% remain intact. Out of 9 stocks under our coverage, 7 were within our expectations while the remaining 2 missed our estimates for the latest reporting season. The last two stocks were IJM and KIMLUN as they registered lower-than-expected margins. Going forward, we still expect earnings of construction stocks in our coverage to rise by double-digit growth of 27% in FY14 and 18% in FY15, driven by aggregate outstanding order book of about RM17.2b and decent unbilled property sales.

Major events in 2Q14 could be leading indicators to positive news flows in 2H14. We have seen several major events in 2Q14:- (i) appointment of IJM Corp-KEURO as the main contractor of RM5.0b WCE highway, (ii) RAPID infrastructure jobs started to be awarded to contractors, i.e. Siemens-MMC (RM3.5b Co-generation plant) and Gadang (RM350m Phase 2 earthworks), (iii) RM1.0b Langat 2 WTP being awarded to a consortium comprising Salcon-MMC-AZRB JV, and (iv) Puncak (OP; TP: RM4.30) reached an agreement with Selangor state government to take over the former’s water concession assets. We believe these major events are leading indicators for more positive news flow that will excite the sector as a whole in 2H14. Firstly, there are 5 more packages in the WCE highway project amounting to RM2.2b to be awarded on open tender basis. Secondly, a few more RAPID infrastructure projects estimated at about RM2.0b such as water treatment plants, access roads, and other infrastructure works will likely be awarded in 2H14. Thirdly, the recent acceptance from Puncak to sell its concession assets signals that the Selangor water sector will be consolidated soon. This has also resulted in Gamuda’s 40%-owned SPLASH relegated to the main focus by federal government (FG) and state government (SSG) to reach amicable solutions for the former’s takeover pricing (SSG only offered 10% of SPLASH equity value). We take the view that either FG and/or SSG will likely to top up the shortfall of its equity value worth about RM2.0b. Hence, we are reverting back to our initial expectation that Gamuda’s shareholders may soon be enjoying special dividends (40 sen/share or 8% yield assuming almost all of the proceeds to distribute to shareholders) pursuant to sale of its SPLASH.

Other positive news flows that we think will excite investors in 2H14 are:- (i) KVMRT2 final alignment to be publicized as we gather that the preliminary works have already started (i.e. land acquisition, fine-tuning the alignment and recruitment), (ii) other private jobs such as high-rise commercial towers/residentials also to be implemented soon, (iii) some job and news flows in respect to civil works in power plant projects, i.e. Track 3B and 4A, (iv) other infrastructure jobs in corridors development, i.e. SCORE and ECER, and (v) water-related jobs in Borneo region.

Challenges and Issues. We gather from contractors that there are still some challenges and issues that need to be addressed in the sector such as: (i) labor shortages (non-skilled and skilled) and (ii) escalation in input costs. Nonetheless, we understand that these issues are “part and parcel” of their nature of businesses and they have been proactively addressing the issues. KL Construction Index’s rally has just begun. Despite 7.9% YTD gains, we found the sector’s valuation still relatively cheap, judging from the cyclical boom stage of the sector. Save for national general election and economic crises (which is unlikely to materialize now), whenever the sector experiences a double-digit GDP growth, the sector’s fwd-PER will be trading at an average of 16x (range of +1.0 and +1.5 above standard deviation of its average 5-year fwd-PER). Interestingly, the index is currently trading at fwd-PER of 14x (also equivalent to its 5-year mean). With the fact that: (i) the sector is still experiencing double-digit growth, (ii) contractors’ healthy order book with visible earnings for at least next 2 years, (iii) strong earnings growth (higher than benchmark’s KLCI Index’s earnings growth of 9.6%), and (iv) contractors’ bright job replenishment prospects, it is justified that the sector’s fwd-PER should go as high as 15x-17x, levels similar to the previous up-cycle valuation. Hence, with that, we conclude that the sector’s rally is not finished yet.

So, what to pick in 3Q14? Selectively, we advocate investors to focus on stocks that we believe will be the beneficiaries of upcoming news and contract flows coupled with quality small cap counter which has deep value. They are: (i) Gamuda (OP; TP: RM5.52) – to benefit from the possible positive outcome from the negotiation with Selangor and Federal governments and KVMRT2 news flows, (ii) Muhibbah (OP; TP: RM3.30) –to benefit from RAPID-related news and contract flows as bulk of its tenderbook is from the project; (iii) HSL (OP; TP: RM2.31) – to benefit from water-related infrastructure projects in Sarawak, (iv)Mitrajaya (TRADING BUY; TP: RM1.13) – one of the cheapest quality small-cap stock in construction space despite its bright growth prospects.

Maintain OVERWEIGHT, valuation still undemanding. All in, we reaffirm our OVERWEIGHT call on the sector in 3Q14 due to the following investment merits: (i) the sector is currently still experiencing a boom cycle, registering double-digit growth, (ii) several major events in 2Q14 indicating to more positive job and news flow in 3Q14, (iii) there are still lots of other potential positive news and contract flows that will drive the overall investors’ sentiment on the sector, (v) potential M&A activities, (iv) the sector’s undemanding valuation (fwd-PER is currently trading at the 5-year mean of 14x versus 15x-17x during the previous boom cycle in 2009-2010. We are maintaining our OUTPERFORM calls on BENALEC (TP: RM1.25), GAMUDA (TP: RM5.52), IJM (TP: RM7.57), MUHIBBAH (TP: RM3.30), NAIM (TP: RM4.27), SENDAI (TP: RM1.18), MARKET PERFORM call on WCT (TP: RM2.32) and UNDERPERFORM call on KIMLUN (TP: RM1.60).

As for stock picks, while we like IJM Corp’s long-term prospects, we are now switching our Top Pick for big-cap in 3Q14 to GAMUDA (OP; TP: RM5.52) from IJM Corp as Gamuda will be the biggest beneficiary for the potential M&A activities in Selangor’s water industry in 3Q14 as well as KVMRT2 news flows. We understand that the group is currently in the midst of negotiation with federal government (FG) and state government (SSG) to resolve the takeover pricing issues of its 40%-owned SPLASH. We believe that there are only 2 scenarios, which will likely happen after the negotiation: (1) either FG or/and SSG to top up its shortfall of equity value required by SPLASH amounting RM2.0b, or (2) SPLASH will continue its operation. Either one of these scenarios will definitely benefit Gamuda. We think the likeliest scenario will be the first option (i.e. topping up the equity value of about RM2.0b) given the fact that it is line with the proposed National Water Restructuring. Hence, this led us to return to our initial expectation that Gamuda will distribute part of the cash proceeds from sale of its 40%-owned SPLASH to its shareholders as special dividends. We also believe that Gamuda will be the biggest beneficiary of the expected more KVMRT2 news flows in 3Q14 as they are doing good job in KVMRT1 as PDP and the tunelling contractor. Valuation wise, Gamuda is currently trading at a fwd-PER of 14.6x FY15E which is substantially cheaper than that of its 5-year average of 16-17x.

As for small-cap pick, we favour Mitrajaya (TRADING BUY; TP: RM1.13) as this under-researched stock is one of the quality small-cap contractors that is worth considering given its visible earnings growth prospects. Mitrajaya’s earnings reached an inflection point in FY14 as its order book reached an all-time high of RM1.2b (3.3x to FY13 revenue), 140% higher than the previous high of RM500m. Based on our conservative analysis, we forecast Mitrajaya’s core earnings could at least record high double digit net profit growth of 52% and 31% in FY14E and FY15E, respectively. More importantly, valuation-wise, we perceive the stock’s current price has yet to fully reflect its growth prospects, trading at only 7.2x against peers’ average of 9-10x.

Risks to our calls including: (i) negative news with regards to delay in executions, scrapping of government projects which will dent investors’ sentiment, hence resulting in discounted valuations, (ii), lower-than-expected new contract wins, and (iii) earnings disappointment which will affect our earnings growth estimates.

Source: Kenanga

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