Reiterate OVERWEIGHT rating on the Construction sector. The sector’s fundamental is still on solid ground backed by: (i) healthy contractors’ outstanding orderbooks that provides visibility for the next 2-3 years, and (ii) still bright orderbook replenishment prospects over the medium-term driven by a slew of infrastructure jobs whereby more construction award newsflow is expected in mid-2016, However, the big caps are becoming less appealing due to their potential earnings risk underpinned by huge exposure to the property sector. As such, we advocate investors to accumulate quality and value construction stocks with i.e. (i) strong orderbook visibility of at least 2-3 years, (ii) minimal earnings risk i.e. high probability of meeting new orderbook replenishment expectations and sustainable margins, and (iii) compelling valuations. No change in our target PER for big caps of 16x, but lowered our target PER for small-mid cap to 7x – 13x from 10x – 14x previously. Our Preferred Pick for 4Q15 is KIMLUN (OP; TP: RM1.63).

KL Construction Index still outperforms FBMKLCI albeit negative returns. As of our report cut-off date of 25th Sept 2015, the KL Construction Index has slipped into negative territory registering negative returns of 6.2%, dragged down by the larger caps due to the recent foreign sell-offs. However, it still outperforms the FBMKLCI which registered negative returns of 8.3%. Overall, MITRA is still the top performer among all contractors in our universe with a gain of 57.7%, thanks to the group’s growing orderbook and higher earnings base. It is followed by MUHIBAH, which advanced 7.5%, backed by its strong orderbook replenishments and earnings contribution from associates. Meanwhile, NAIM (-26.8%) continued to be the top loser in our construction space, dragged down by disappointing earnings and significant exposure in property development, and we may consider ceasing coverage on NAIM should they perform poorly again in the upcoming quarter.

Mixed bag of performance for 2QCY15. Out of 10 contractors under our coverage, 5 registered results that were within expectations, 1 above, while the remaining 4 came in below expectations. We deem the 2QCY15 set of results as weak as there were more disappointments compared to 1QCY15 despite lesser coverage. To recap, we ceased coverage on BENALEC in 1QCY15 due to constant disappointments in earnings coupled with bleak earnings outlook. Following our earnings review in 2QCY15, we are still expecting a healthy earnings growth of 20.6% and 11.5% for FY15-16E on average for contractors under our coverage underpinned by healthy outstanding orderbook that will last for another 2 – 3 years except for HSL.

Budget 2016 expectations. In the upcoming Budget 2016, we will be expecting mega rail projects i.e. MRT2 and LRT3 to be emphasized even though the PDP role has been awarded to GAMUDA-MMC and MRCB-GKENT joint-ventures. That aside, there are also talks that there is potential for Gemas-JB Electrified Double Tracking Railway to be revived which we will be expecting in the upcoming Budget. Aside from rail projects, we believe that Budget 2016 will continue to emphasise on highway projects like Pan Borneo Highway, Sungai Besi Ulu Kelang Expressway (SUKE), and Damansara-Shah Alam Highway (DASH). As such, we do not believe there would be much surprise from the upcoming Budget 2016, and we believe that the contractors are fairly priced in for now.

Contractors to be busy over the next 4-5 years. We expect the sector to continue to be driven by infrastructure projects over building projects underpinned by MRT2, LRT3, RAPID, Pan Borneo Highway, SUKE, and DASH. Given the sheer size of these jobs, we will be expecting most of the contractors in town to benefit from these contracts whereby most awards are expected to be dished out in mid-2016. For the big boys, i.e. GAMUDA, IJM, and SUNCON will most likely be eyeing the viaduct packages for MRT2 and LRT3, while players like WCT will continue to eye for more earthworks-related jobs, i.e. TRX. As for more specialized works such as segmental box girders (for MRT and LRT), foundation and sub-structure piling works and structural steel works (super structure building), SENDAI, KIMLUN, PTARAS and ECONBHD should be key beneficiaries.

Expecting better performance in 3QCY15. Despite the disappointments in earnings from several contractors (4 out of 10) in 2QCY15, we are hopeful for the earnings delivery in 3QCY15 to be better and expect most of the contractors to register satisfactory results underpinned by strong outstanding orderbook that provides 2–3 years earnings visibility.

Mild de-rating in the mid-cap space. In terms of valuation, the big cap players have remained stable, trading at an average 16.0x since our 1QCY15 review. However, the valuation for mid-cap contractors saw a mild de-rating from an average of 10.0x to 9.0x due to the recent foreign sell-down. This has led us to lower our valuation range for the mid-cap developers to 7x–13x from 10x–14x, previously. Nevertheless, we still see value in mid-cap contractors, especially those that have strong earnings visibility with an orderbook size that could last them for the next 2-3 years, i.e. SENDAI, MITRA, KIMLUN and MUHIBAH.

KIMLUN, our 4Q15 Top Pick. We attended KIMLUN’s 1H15 results briefing recently, and we came back still feeling positive despite management’s cautious tone on the construction sector in 2016 due to uncertainties driven by macro factors. Reasons being we continue to believe that they will be the forefront runner for MRT2’s Segmental Box Girder (SBG), and Tunnel Lining Segment (TLS) contracts given their strong track record and expertise in the Industrial Building System of which KIMLUN had won numerous contract awards both locally and internationally in Singapore supplying both SBG and TLS. That said, the group is looking to bid for more infrastructure jobs, i.e. Pan Borneo Highway, SUKE, and DASH, as compared to building jobs in diversifying their income stream from building projects alone due to the recent slowdown in the property market. Valuation-wise, KIMLUN’s TP of RM1.63 is valued at PER of 9.0x, in line with its historical average and small-mid cap peers range of 7x-13x.

How Low Can It Be; How High Can It Go?

In view of the recent market selldown in 3QCY15, stocks under our coverage were bashed down within the range of 4.8%- 16.9% since our 2QCY15 review. Hence, we have worked out the floor and ceiling valuation for respective stocks under coverage in order to have a view of the potential low and high stock prices. 

Source: Kenanga Research - 6 Oct 2015