Maintain OVERWEIGHT recommendation on the construction sector premised on strong construction award newsflow in upcoming months in 2HCY16, as contract awards for MRT2, LRT3, and Pan Borneo Highway are expected to resume after a quiet 2QCY16. This time around we are positioning SUNCON (OP, TP: RM1.81) as our Top Pick for the big boys, riding on a stronger news flow as we are expecting SUNCON to bag at least one package from LRT3 coupled with its strong balance sheet, which positions it as one of the few big-cap contractors with minimal risk of cash call. As for the small-mid cap space, KIMLUN still prevails as our Top Pick as we continue to like them for their consistent outperformance and attractive valuation which is currently trading at 6.6x (as per cut-off) vis-à-vis its small-mid cap peer average of 9.1x.We urge investors to accumulate these two names being grossly undervalued compared to peers coupled their consistent earnings performance that have yet to fail market expectations.

A weak quarter… As of 24-June-2016, the share price performance of stocks under coverage has weakened further registering negative return averaging 8.6% vis-à-vis 5.6% positive gain as of 1QCY16 after including SUNCON into our coverage. Amongst the big boys, SUNCON registered the worst performance with the widest loss of 7.2%, while in the small-mid cap space, Sarawak counters i.e. HSL, and NAIM registered negative returns of 18.6%T and 25.1%, respectively. However, the biggest loser in 2QCY16 was SENDAI, which saw its share price tumbled by 32.2% over 1QCY16. We believe that the weaknesses are largely due to: (i) slower mega contracts news flow unlike 1QCY16 when we still see contract flows from MRT projects, (ii) weak financial performance, and (iii) lethargic market sentiment. The largest contract award announced in 2QCY16 amounts to only RM1.5b which was bagged by IJM. In terms of year-to-date performance, KL Construction Index still managed to register a marginal positive return of 0.3%, which still fared better compared to FBMKLCI’s negative performance that was down by 6.8%. 1QCY16 results round up. For 1QCY16, earnings performances from the contractors were slightly weaker with 3 companies registering disappointing results as compared to only 2 companies back in 4QCY15. The companies that disappointed in 1QCY16 are HSL, NAIM, and IJM. Following the disappointing performance from these companies, we adjusted our FY16E earnings by a range of 7%-31% after assuming slower progressive billing and higher associate losses.

Long-awaited 2HCY16. As mentioned above, the job flows in 2QCY16 had been fairly slow with only RM5.9b dished out vis-à-vis RM30.8b worth of jobs awarded back in 1QCY16 mostly driven by MRT2 contracts that was awarded to players like MMC, GAMUDA, SUNCON, and AZRB amounting to RM18.1b, whereas job flows from MRT2 in 2QCY16 only amounted to RM2.1b to IJM (RM1.5b) and MRCB (RM0.6b). However, we remain excited with the prospect and the job flows for the construction sector in coming months closer to Aug 2016 as we are expecting more contract awards to be announced coming from MRT2 in 1QCY17 (c.RM6.0b), LRT3 (RM9.0b), SUKE (RM8.0b), DASH (RM8.0b), and Pan Borneo highway Sarawak (c.RM11.7b). While some of the small-mid caps could response actively to such news flow, the big-boys’ share prices are less sensitive due to built-in expectations.

Valuations still holding up. Compared to 2QCY16, we have not seen any major expansion or contraction in valuation range for the stocks under our coverage except for a few i.e. WCT and SENDAI, which saw contraction in valuation as their FY17E PER of 12.0x and 10.2x previously contracted to 9.0x and 7.0x, respectively. This is due to negative news flow on earnings risks and also potential cash calls. Meanwhile, other stocks have been holding up quite well with minimal changes vis-à-vis last quarter. Currently, the big caps are trading at 2-year Fwd PER of 16.7x, while the small-to-mid caps are trading at an average of 9.1x. Investors should accumulate both SUNCON and KIMLUN, which are being traded at only 13.4x and 6.6x PER, respectively, which we deem as lagging to their respective peers.

Earnings risk. In terms of earnings visibility and risk, we are quite comfortable with our orderbook replenishment assumptions for the stocks under our coverage while we see minimal earnings risk, as our margin assumptions are fairly conservative, as most of the contractors are on-track to meet our order book replenishments except for players like MUHIBAH, MITRA, and WCT. In fact, we do hope to see some minor margin expansion amongst contractors due to mild improvements in bidding prices. However, we believe that it is still too early to assess as most of the mega projects awarded recently are still in preliminary stages. On average, most contractors have 2.3 years of visibility with their existing orderbook size and we expect the visibility to be maintained with more contract awards in the pipeline.

Budget 2017. As for the upcoming Budget 2017, we are expecting the government to reiterate the already announced projects in Budget 2016 i.e. SUKE, DASH, MRT2 and etc. on its implementation timeline and potentially revise budgets on some of these infrastructure project such as LRT3.We do hope to see some news on MRT3, KL-Singapore High-Speed Rail, and the development of Bandar Malaysia.

All about pure play, hence SUNCON as big cap Top Pick. While we like the big-cap contractors for their ability to secure and execute mega infrastructure projects riding on the construction up-cycle in Malaysia due to the recent infrastructure play, most of the big-boys like WCT, IJM, GAMUDA, and MMC’s profitability are threatened by risks from other divisions, i.e. property, plantation and etc. For 3QCY16, we are introducing SUNCON as our Top Pick for the big-cap space due to its excellent track records in the construction industry with the ability to propose, design and build mega infrastructure projects, i.e. BRT. That said, SUNCON is the only pure play contractor with a strong net cash position of RM297.9m (as of 1Q16) amongst the big boys with minimal risks or threats from other sectors. In the coming months, we are anticipating SUNCON to at least bag a contract from LRT3 while standing with a good chance in securing a package or two from SUKE and DASH. Our TP of RM1.81 for SUNCON implies 15.3x FY17E PER that is still below its big-cap peers’ average (excluding SUNCON) of 17.8x.

KIMLUN, our Top Pick for small-mid cap space. Likewise, in the small-to-mid cap space, KIMLUN still remains as our Top Pick for its consistent performance which even outperformed our and market estimates previously and being the first West Malaysia contractor to bag the Pan Borneo Highway project. 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. To recap, they also managed to bag RM200.0m worth of Segmental Box Girders (SBG) from MRT Co. last quarter. Valuation-wise, 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.

Keeping an eye on piling contractors. Apart from our two stock picks for the sector, we also recommend investors to keep track on the piling contractors, i.e. ECONBHD (NR, TP: RM1.41), PTARAS (TB, TP: RM4.20) and IKHMAS (Not Rated) as we strongly believe there will be a surge in demand for piling contractors as all the infrastructure projects mentioned above proceed to full steam. To recap, the piling contractors have collectively won RM1.0b worth of jobs in 1HCY16 with PTARAS securing the least projects at only RM167.6m as compared to ECONBHD and IKHMAS, which won c.RM420.0m worth of jobs, respectively. Hence, amongst the piling contractors, we position PTARAS as one of the Dark Horses on expectations that they may secure a few more jobs by year end.

Selectively OVERWEIGHT. While we are reiterating our OVERWEIGHT call on the sector on the anticipation of strong contract award news flow in coming months, we remained very selective on our picks as we prefer pure-play contractors as these players would have minimal earnings risks as compared to those that have both property and plantation exposure. Hence, our Top Pick for 3QCY16 is SUNCON (OP, TP: RM1.81) in the big-cap space while KIMLUN (OP, TP: RM2.10) continues to prevail in the small-mid cap space.

Source: Kenanga Research - 12 Jul 2016