We are reiterating our OVERWEIGHT recommendation on the construction sector premised on strong construction award newsflow in upcoming months and towards the end of 1H16, as we believe that the awards for MRT2 and LRT3 are just around the corner on the heels of subsequent package awards from Pan Borneo Highway. However, we still prefer the small-mid-caps space for their earnings growth potential and undemanding valuations as compared to the big caps players, which are becoming less appealing due to their potential earnings risk, underpinned by huge exposure to the property sector. As such, we advocate investors to keep an eye on quality and value construction stocks such as KIMLUN, MITRA, and MUHIBAH which are set to benefit from more newsflow in the future. As we maintain KIMLUN as our Top Pick for 2QCY16 with an unchanged Target Price of RM2.10 based on 9x FY16E PER, we also introduce MITRA as another Top Pick with a Target Price of RM1.77 based on SoP, as we believe that it would be one of the few mid-cap contractors that is set to benefit from Pan Borneo Highway.

Outperforming selectively… At our report cut-off date of 25-Mar-16, the share price performance of stocks under our coverage were softer, registering an average gain of only 4.2% over 1QCY16 vis-à-vis 9.8% gain in 4QCY15. This was mainly due to the lack of mega contract replenishments registered in 1QCY16, except for KIMLUN and HSL, which bagged WPC3 (RM1.5b) and WPC7 (RM1.7b) of the Pan Borneo Highway project, respectively. With the award from Pan Borneo Highway, KIMLUN and HSL’s share prices have appreciated by 24.8% and 9.1%, in 1QCY16, outperforming the performance of 15.6% and 5.6% in 4QCY15, respectively. In terms of year-to-date performance, KL Construction Index still outperformed FBMKLCI’s performance by 2.9ppt with a gain of 3.5%. Note that KIMLUN has been our top pick since our 4QCY15 strategy (5/10/15).

Better performances recorded in 4QCY15. In 4QCY15, we see better earnings performances from the contractors with most of them reporting results, which were above expectations and withless disappointments as compared to 3QCY15. However, note that in 3QCY15, we did some drastic cuts in earnings for several stocks, i.e. (WCT, HSL, NAIM, SENDAI). Out of 10 stocks within our coverage, 4 (HSL, MITRA, WCT, SENDAI) were above, 4 (KIMLUN, MUHIBAH, IJM, GAMUDA) came in within, while the remaining 2 (MMCCORP, NAIM) were below expectations. Note that the stocks that came in above expectations had seen earnings downgrade in 3QCY15, except for MITRA. NAIM disappointed on construction cost overruns and sluggish property contributions while MMCCORP suffered from lack of land sale recognitions and margin compressions.

Pan Borneo Highway, the Sarawakians’ dream is coming true… To recap, in our previous report dated 29th January 2016, we highlighted that we would be expecting two package awards from Pan Borneo Highway in February/March, which materialised in mid-March as the two work packages, i.e. WPC3 (RM1.5b) and WPC7 (RM1.7b) was awarded to the ZECON-KIMLUN and HSL-DhayaMaju consortiums, respectively. The award of the first two packages of the Pan Borneo Highway has reaffirmed the Federal Government’s commitment in realising Sarawakians dream of a having a better infrastructure and connectivity in the state and we are expecting the remaining eight packages to be dished out from June onwards up till the end of the year. With eight packages remaining with an estimated value of RM1.4b per package, we expect consortiums with strong track records in the infrastructure scene to stand a higher chance of bagging the upcoming awards. (Kindly refer overleaf for more details.)

What’s in West Malaysia? Moving into 2QCY16, we would be expecting more newsflow from MRT2 and LRT3 as players like GAMUDA-MMC has already bagged the award for the tunnelling works for MRT2 amounting to RM15.4b yesterday. We are neutral on their win, as we have already factored in the winning of the tunnelling jobs in our forecasts. As we understand from GAMUDA, there will be four viaduct packages from the Northern side to be rolled out initially given that these packages are deemed more challenging compared to the remaining six viaduct packages on the Southern side as it is located in highly matured townships, two packages have been awarded to AZRB (V202, RM1.4b) and SUNCON (V201, RM1.2b). Hence, we expect that publicly-listed MRT1 players like IJM, GADANG, and MUDAJYA stand a higher chance in securing the remaining two viaduct packages from the northern side. That aside, we are also expecting newsflow for highways (SUKE/DASH), building (Warisan 118) and RAPID projects to pick up pace closer to 2H16.

Top Twin Picks for 2QCY16. For 2QCY16, we are still maintaining KIMLUN as our TOP PICK as we continue to believe that they will be the forefront runner for MRT2’s 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, coupled with the fact that they are the only contractor under our coverage that had been consistently outperforming our and market estimates in terms of earnings performance and being the first West Malaysia contractor to bag Pan Borneo Highway project, which further reaffirmed our conviction on the stock. To recap, they also managed to bag RM200.0m worth of Segmental Box Girders (SBG) from MRT Co recently. Nonetheless, they are still bidding for more infrastructure jobs, i.e. SUKE, and DASH, as compared to building jobs in diversifying their income stream from building projects solely due to the recent slowdown in the property market. Valuationwise, KIMLUN’s TP of RM2.10 is valued at PER of 9.0x, in line with its historical average and small-mid cap peers range of 7x-13x. That said, we also like contractors with strong execution track record like MITRA and MUHIBAH which can deliver consistent earnings performance. Beside KIMLUN, we are also positioning MITRA as one of our TOP PICK for 2QCY16, given their strong financial performance in the past few quarters; being one of the few stocks that delivered earnings above our and market expectations. Furthermore, we strongly believe that they could be one of the frontrunner for Pan Borneo Highway project in coming months, and that would be a re-rating catalyst for the stock as we have yet to factor Pan Borneo Highway in our estimates. In terms of valuation, MITRA currently trades at a undemanding FY16E PER of 7.6x while our SoP-based TP of RM1.77implies FY16E PER of 11.1x which is inline with small-mid cap peers range of 7x-13x. 

Source: Kenanga Research - 1 Apr 2016