After going through rough times post 2008 crisis, KNM, an EPCC specialist in process equipment fabrication, is now staging a comeback as it ride on the Malaysian downstream upcycle in the coming years due to RM20b RAPID project and emerging renewable energy trend both domestically and globally. Financial crisis in 2008 have taken the company out of the market’s radar for a while and it is made worse with several unlucky business ventures abroad. Since then, the group has taken several measures to rejig its business namely disposing unprofitable foreign business ventures and reduction in borrowings through 2 private placements and 1 rights issuance. This has brought down its gearing from the peak of 0.5x in 2008 to 0.2x currently, reducing liquidity risk for the group which is essential for sustainability of the business, especially during these difficult times. Contract replenishment for the group has also picked up steam this year with RM1.2b worth of contracts announced by the group YTD, comprising of mainly renewable energy and O&G downstream EPCC projects and process equipment supply. Moving forward, more is expected to come from RAPID whereby more contracts are expected to be awarded in different phases of the project over the next few years. Earnings are expected to be strong to be growing at CAGR of 56% over the next 2 years if project execution is intact on the back of stronger contract flows. Stock is valued at RM0.62 pegging to CY16 PER of 11x with a Not Rated call.

Not just an O&G player. KNM is a turnkey solutions provider for spanning across several industries like oil, gas, petrochemicals and renewable energy industries encompassing its core business of providing process equipment manufacturing. Today, it offers capability of process equipment fabrication and EPC which could be applied across several industries: oil storage terminals, biofuel plants, biomass plants, gas treatment plants, fertiliser plants and ethanol plants. That aside, it is also one the world’s largest supplier of complete Air Cooled Heat Exchangers used in Refineries, Gas, Petrochemicals and Chemical plants supplemented by services ranging from thermal and mechanical engineering to manufacturing, modularization, delivery at site and after sales service.

On contract winning streak. Contract awards from the RM20b RAPID mega project has been picking up steam of late. Since 2H15, more contracts from RAPID have been dished out with some construction players bagging several infra-related projects. KNM is slated to be one of the major beneficiaries and the RAPID project involves a lot of EPC capabilities in process equipment of which is KNM’s bread and butter since long time ago. Aside from RAPID, the group has also secured EPCC projects for renewable energy purposes both locally and overseas. YTD the group has secured RM1.2b worth of EPC & process equipment supply projects, showcasing its improving ability and visibility in the process equipment EPCC market. We believe more is to come as RAPID development picks up coupled with the rise in renewable energy business due to increased awareness.

Rehabilitation phase. While it used to be the darling stock in the market during pre-2008 crises times, it took a hit due to overly high market expectations on its earnings performances, leading to its plunge in share price and lost in market confidence. It has taught the company a lesson and since then it has undergone business restructuring to hive off its unprofitable business while reducing its gearing through several corporate exercises (i.e., rights issue and private placements) in the past few years. Net gearing has come off from 0.5x in 2008 to 0.3x in 2014, which is expected to be even lower due to the private placement done recently. This has opened more room for its balance for capacity expansion in the long run.

Execution is key, NOT RATED with fair value of RM0.62. With the increase in expected orderbook replenishment for its EPCC business, earnings of the group is expected to improve in the next 2 years with projected CAGR of 56% on the back of higher work orders in line with yearly orderbook replenishment assumptions of RM1.5b in both 2015 and 2016. With an orderbook of RM3.6b which is higher than last year, pointing towards higher growth in the coming years. We believe it is now down to the company’s project execution ability while avoiding major cost overruns and delays. We arrived at a Fair Value of RM0.62 on the group pegged to 11x CY16 PER, which is higher than our average PER of 8-9x ascribed to O & G small-mid caps due to (i) its exposure in the downstream segment which is now shielded from the oil price risk and (ii) intention to increase its recurring income with more O&M jobs to be secured in the future. We have a NOT RATED call on the stock.

Financing for Peterborough project to be finalised. The long awaited Peterborough power project is finally gaining traction with the SGD300m multi-currency programme set up in June and we believe the drawdown will begin next year. Phase 1 of the project will provide 17.6MW which is scheduled to be commissioned in 3Q17. Full year PAT contribution of the project is expected to be at RM50m estimated. Full capacity of the waste-to-energy project is 80MW while it could potentially bring the yearly earnings contribution to RM200m, which could potentially more than triple the group’s earnings base. The power generated from the renewable energy plant would be sold partially on long term concession (8-10 years) and the remaining to the wholesale market to capture potential upside in power price.

Multiple revenue streams from Peterborough project. There will be 3 revenue streams from this project namely revenue/MW, gate fee from receiving waste(feedstock)/tonne and green credit (c. GBP80/MW). While power revenue and gate fee are generally more predictable, the green credit is needed to market through a different channel and it is subject to demand from the other industrial players. We opt to not include the project into our valuation for the group as operational risks remain high as the group has no experience in renewable energy power plant operations and it hinges on the group’s proper execution to extract value from the project. Pegging 11x PER to its annual earnings contribution for the first phase, the project could add value of c. 28sen to our fair value assuming everything goes as planned, which is a quantum leap for the group.

Higher focus on recurring income stream. Its intention to increase its recurring income stream as a share of its total income to achieve higher business sustainability in the long run is clear with the venture into Peterborough renewable energy project. On top of that, the Thailand plant O&M (operations & maintenance) programme is expected to commence in 2H16, bringing in more stable income for the group with PAT contribution expected to be RM7.5m in 2H next year. In the long run, the group targets to increase its recurring income contribution to 30% of its income base in the long run from current <5% to widen buffer for the company to withstand earnings volatility of its process equipment & EPCC business, which could be lumpy at times due to its business nature. We concur with this strategy as the process equipment & EPCC business possesses higher inherent risk, including cost overrun, project delay and uncertain timing of project award. Higher recurring income base will provide more stability to its earnings profile while reducing its business risk overall to be in a stronger position to ride through tough times.

What could go wrong? Despite the positive outlook overall for the company, we believe there are still several risks with the company that are important to be noted. First to look out for is the impairment risk of the company in extreme events. As of FY14, intangible asset of the company amounted to RM876.6m, which comes up to 21.7% of the group’s total assets. Sentiment towards the company could deteriorate in the event of major impairment on the intangibles. That aside, renewable energy business still possess some risks although we concur that the positive long term prospects still hold. From the business perspective, the economics of renewable energy power generation is less compelling now compared to the times whereby oil price is above USD100/bbl, resulting in lesser cost advantage of using renewable energy sources for power generation. In KNM’s context, this could result in slower process equipment & EPCC project awards for renewable energy projects whereby the project operators might take a longer time frame to reconsider the feasibility of upcoming projects. 

Source: Kenanga Research - 8 Dec 2015