We maintain OVERWEIGHT as the sector’s fundamental remains strong 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 where more construction awards are 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 and rich valuations. As such, we advocate investors to accumulate quality and value construction stocks with qualities such as:(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 i.e. MITRA, MUHIBAH, and KIMLUN. No change in our target PER for big caps of 18.0x and small-mid cap PER target of 7x – 13x. Our Top Pick for 1QCY16 is KIMLUN (OP; TP: RM2.05).

The awakening of contract flows and shares performance. As of our report cut-off date of 23rd Dec 2015, we have seen recovery in share prices for the stocks under our coverage with an average gain of 9.8% in 4QCY15 vs. last quarter’s average loss of 10.3%. We believe that the pick-up in share prices over 4QCY15 were mainly driven by strong construction award flows where we saw RM4.9b worth of local contracts being dished out in 4QCY15, which was 42% higher than the amount in 3QCY15. RAPID jobs made up 41% of the RM4.9b worth of jobs being dished out in 4QCY15, and WCT is a major winner with most contracts bagged bringing with a total of RM1.2b. In terms of year-to-date performance, KL Construction Index registered a smallish decline of 0.2%, still outperforming FBMKLCI’s performance, which registered greater losses of 5.1%.

Mild improvements in 3QCY15 results. Out of of 10 contractors under our coverage, 5 registered results that were within expectations, 1 above, while the remaining 4 came in below expectations. As highlighted in our previous 2QCY15 strategy report, 3QCY15has indeed seen mild improvements with lesser disappointments compared to 2QCY15. That said, companies that disappointed in the recent reporting season seen drastic downward revisions in FY15-16E earnings were HSL, WCT, NAIM and SENDAI, ranging from 10% to 74%. The main drag in their performance was mainly due to higher-than-expected operating costs arising from variation orders, especially those who have exposure in Middle East i.e. WCT and SENDAI. Post-our earnings revision; we are still expecting an average growth of 6%-29% for FY15-16E, and the growth expectation in FY16 is significantly higher due to timing differences in the recognition of existing construction orderbook coupled with a low base effect in FY15.

A year of awards! Moving into 2016, we are maintaining our view that the construction sector will remain busy for the next few years driven by mega infrastructure 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 out in mid-2016, while the initial packages for MRT2 are likely to be awarded in 1QCY16. For MRT2, we would expect the listed contractors for MRT1, i.e. GADANG, SUNCON, IJM, GAMUDA, AZRB, and MUDAJAYA to stand a higher chance in winning the second package given their track record for MRT1. Other players like WCT would be busy executing their massive outstanding orderbook of RM4.6b while eyeing more infrastructure/earthworks-related jobs and MUHIBAH is expected to remain focus on RAPID projects. 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.

High-Speed Rail back in the limelight? Recently, 14 companies have been invited to share their ideas on the high-speed rail. However, we still think that high-speed rail project is still at preliminary stages and it could take at least another 1-2 years before it could take off as it involves G2G collaboration with Singapore. That said, we do opine that the Chinese contractors do stand a higher chance in bagging the contract given their strong financial capabilities to fund and ability to execute such mega projects.

Big-caps remain unattractive? In terms of valuation, big-cap players remain unattractive trading at an average of 17.2x since our 1QCY15 review, except for WCT that traded up to 23.5x albeit earnings disappointments due to high contract award news flow. As for small mid-cap players, valuations have seen minor improvements of 1x from the range of 6.0x – 11.0x to 6.0x – 12.0x attributable to better contract news flow in December. Nonetheless, we still believe that value lies deep 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 and strong execution track record, i.e. MITRA, KIMLUN and MUHIBAH.

KIMLUN remains one of our Top Picks in 1QCY16. We are maintaining KIMLUN as our TOP PICK in 1QCY16 as we continue to believe that they will be the forerunner for MRT2’s Segmental Box Girder (SBG), and Tunnel Lining Segment (TLS) contracts given their strong track record and expertise of which KIMLUN won numerous contract awards both locally and internationally in Singapore, supplying both SBG and TLS. They are the only contractor under our coverage that have been consistently outperforming market estimate and that of ours in terms of earnings performance. 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 to diversify their income streams from relying on building projects alone due to the recent slowdown in the property market. Valuation-wise, KIMLUN’s TP of RM2.05 is valued at PER of 9.0x, in line with its historical average and small-mid cap peers’s range of 7x-13x. That said, we also like contractors with strong execution track records like MITRA and MUHIBAH that can deliver consistent earnings performance.

How Low Can It Be; How High Can It Go? Looking at 4QCY15, stocks under our coverage had seen recovery, registering positive gains ranging from of 3.1%-28.4% since our 3QCY15 review. Hence, we have worked out the floor and ceiling valuations for respective stocks under our coverage in order to have a view of the potential low and high stock prices. 

Source: Kenanga Research - 6 Jan 2016