Maintain OVERWEIGHT on the Construction sector but with a cautious tone. The sector’s prospect remains bright, buoyed by multi-billion ringgit public infrastructure and governmentbacked mixed development projects under the ETP. We reaffirm our view that in the near-term (next 3-6 months), the sector will continue to be supported by news and contract flows from the remnants ETP projects namely the MRT2 (RM25b), sub-contract works from Petronas’ Pengerang and RAPID projects, urban highways (RM20b), LRT3 (RM9.0b), KL-Singapore HSR (RM40b), KL118 Menara Warisan (RM3.0b), TRX (RM26), redevelopment of Pudu Jail (RM7b), and Kwasa Damansara mixed development projects (RM10b). We also expect that there will be more newsflows with regards to the 11MP that will be announced middle of next year. Nevertheless, we are cautious on the sector’s earnings risk going forward. This is after seeing the contractors’ recent earnings disappointment in 3Q14. Hence, all in, we advocate investors to be selective, i.e. pick contractors that: (i) has strong orderbook, (ii) face minimal earnings risk i.e. high probability of meeting new orderbook replenishment expectations and sustainable margins, (iii) will benefit from the news/contract flows in 2015, and (v) have compelling valuations. Hence, we maintain our top pick GAMUDA (OP; TP: RM5.29) for 2015. We have also introduced MMCCORP as another top pick for 2015 on the back of the group’s corporate exercise. For mid-small cap pick, we found that HSL (OP; TP: RM2.21) and MUHIBAH (OP; TP: RM3.63) fit the above-mentioned criteria.

The KL Construction Index (-4.6% YTD) has continued outperforming the FBMKLCI (-10.3% YTD). IJM was the top gainer (+14.2% YTD) amongst all contractors in our universe, thanks to the group’s restructuring exercise (IJMLAND privatisation, divestment of non-core assets) coupled with contract flows from WCE and other property jobs. Second winner was GAMUDA, up +4.2% thanks to positive newsflows from MRT2. Meanwhile, KIMLUN (-24.8%) and SENDAI (-44.7%) continued being the top losers in our construction space as both stocks were dragged down by disappointing earnings.

Major news/events in 4Q14 vs expectations. Amongst the major events that happened in 4Q14, which were within expectations are: (i) MMC-GAMUDA JV again appointed as PDP for the MRT2 project, and (ii) sizeable building jobs from private GLCs i.e. IKANO building in Jalan Cochrane which was awarded to WCT. Meanwhile, those that missed our expectations include the absence of job flows related to TRX works, RAPID sub-contract works and Phase 2 of Kuching Wastewater Treatment Plant. Nonetheless, we expect these projects’ contract flows to happen in 1Q15.

Quarterly earnings review and outlook. To recap, 3Q14 results season saw most contractors (5 out of 9 companies we cover) registering numbers below expectations namely: SENDAI, KIMLUN, IJM, WCT and HSL. They were hit by low margins aggravated by: (i) poor property division’s performance, and (ii) higher input costs namely material and labor costs. Going forward, despite robust prospects in construction industry next year, we believe that contractors that were hit by margins compression and slower property market have earnings risks. Earnings-growth-wise, we estimate aggregate earnings for construction stocks under our coverage to grow by 11.3% and 9.9% in FY14 and FY15, respectively.

What to expect in 2015? (i) Continuity of MRT2 news flows and LRT3 news flows (appointment of PDP), (ii) Contract flows from Sarawak namely road and water infrastructure works in Kuching (Phase 2 of Kuching Wastewater treatment plant (RM700m)), Pan Borneo highways (RM27b), SCORE (Samalaju, Tanjung Manis, Mukah) infra-related works, (iii) contract flows from GLCs i.e. PNB namely KL118 Menara Warisan (RM2.0b), tendering process of SUKE highway (RM2.0b) and DASH Highway (RM2.5b), (iv) TRX basic infrastructure works, (v) sub-contract works in RAPID and Pengerang, and (vi) announcement of 11MP in May 2015.

Sector’s valuation still compelling. Valuation-wise, KL Construction Index is still hovering at its mean level (13.3x Fwd PER), since May 2014. Recall, in 2009-2010, the sector’s fwd-PER was trading at +1SD - +2SD level i.e. 15.5x – 17.4x thanks to the introduction of the 10-year ETP plan. With booming construction sector on the back of more than RM100b worth of projects to be announced in the near-medium-term, we believe it is justified for the sector’s valuation to mirror 2009-2010 level i.e. 15x-17x fwd-PER.

Be selective in 2015. Due to our “cautiously optimistic” view on the sector in 2015, we advocate investors to be selective i.e. pick contractors that: (i) has strong orderbook, (ii) face minimal earnings risk i.e. high probability of meeting new orderbook replenishment expectations and sustainable margins, (iii) will benefit from the news/contract flows in 2015, and (v) have compelling valuations. We found that GAMUDA, HSL and MUHIBAH, fit the above-mentioned criteria. Refer Page 3 for summary for each stock.

Source: Kenanga