While we maintain our OVERWEIGHT recommendation on the construction sector, we do not expect much news-flow going forward except for the remaining packages from MRT2 and LRT3, as it will be a year of delivery. Contractors need to be highly focused in delivering these high-profile projects to minimise any risk of delays. That said, we remained fairly selective in our stock picks as we still prefer pure play contractors over conglomerates like GAMUDA and IJM. Hence, we continue to reiterate SUNCON (OP, TP: RM1.81) and KIMLUN (OP, TP: RM2.51) as our Top Pick in the big-cap and small-cap space, while introducing GKENT (TB, TP: RM2.80) as the Top Pick in the mid-cap space. We believe that investors should accumulate these three names as they are still fairly undervalued compared to peers. Furthermore, they have been consistently registering earnings performance that has yet to fail market expectations, coupled with a decent DPR that ranges between 25-40%. As for Budget-2017, we do not expect any new mega projects to be announced but a reiteration of the previously announced projects. However, we do hope for the announcement of the timeline for the execution of high-speed rail and MRT3.

A better quarter… As of 15-Sep-2016, the share price performance of stocks under our coverage registered better returns with positive gain averaging 4.2% vis-à-vis negative return of 8.6% in 2QCY16. Amongst the big boys, IJM registered the worst performance with the widest loss of 3.7%, while in the small-mid cap space, only NAIM registered negative return of 5.0%, while the others had since registered positive returns of 2.5-11.9% over 3QCY16, recovering from weak performance in 2QCY16. In 3QCY16, SENDAI registered the best recovery in share price from a negative return of 36.3% in 2QCY16 to a positive gain of 1.1% in 3QCY16, partly due to the recovery in its profitability, while the top performer in the small-mid-cap space are our Top Pick KIMLUN which registered the highest return of 10.5%, mainly driven by its solid 2Q16 results performance and it has never failed market expectations since our recommendation as Top Pick four quarters ago. In terms of year-to-date performance, KL Construction Index still fared much better with a positive return of 3.2% versus KLCI’s negative return of 5.7%.

2QCY16 results review. For 2QCY16, out of 11 stocks under our coverage, 3 was above (KIMLUN, MMCCORP, SENDAI), 3 within (GAMUDA, MITRA, SUNCON), 3 below (HSL, NAIM, IJM) while the remaining 2 were “broadly within” (WCT, MUHIBAH). Compared to 1QCY16, which saw only 1 exceeding expectations, 3 missing, 2 within and 4 broadly within, 2QCY16 performance was better. Post 2QCY16 results, we downgraded our FY16-17E core earnings for HSL, IJM and NAIM by a range of 10-144% on the back of slower progress billings and higher costs assumptions. Conversely, we upgraded KIMLUN, SENDAI and MMCCORP’s FY16-17E core earnings by 12-55% after factoring in higher margin assumptions.

What’s next? In 3QCY16, jobs flows have picked up with c.RM12.0b worth of jobs awarded to the listed players as compared to only RM5.9b in 2QCY16, with the bulk from Pan Borneo Sarawak. However, it was to our surprise that most of the big-boys have failed to secure any single package of the much talked about highway, i.e. SUKE and DASH as bulk of the jobs were awarded to private contractors. Going forward, we would expect job flow momentum to taper off as we are only expecting news-flow from the remaining viaduct packages from MRT2 and also LRT3 awards to commence soon. Hence, we believe that once all these contracts are dished out, it would be a year of delivery. Contractors’ main focus in the next 2-3 quarters will be on project execution as any delays would affect their earnings performances.

Valuations. Currently, the big caps are trading at 2-year Fwd. PER of 15.6x down from 16.7x due to positive revision in earnings in the recent reporting season, while the small-to-mid caps are trading at an average of 8.9x down marginally from 9.1x as compared to 2QCY16. In terms of our Top Picks, SUNCON and KIMLUN; their 2-year Fwd. PER has expanded to 14.2x and 7.2x from 13.4x and 6.6x PER, respectively, which we believe is gaining more interest and traction from investors, and we believe that investors should continue to accumulate these two stocks as valuations are still lagging peers.

Budget 2017. As for the upcoming Budget 2017, we are not expecting any more new mega infrastructure plans to be announced but only expect a reiteration of the projects that had been previously committed in the recent budget i.e. MRT2 & 3, high-speed rail, LRT3 Pan Borneo and etc. However, we do hope that the government announces the implementation timeline for these projects especially for high-speed rail, MRT3, BRT, and development of Bandar Malaysia as it is crucial in terms of jobs flow continuity for contractors in the coming years.

Reiteration of Top Picks. Heading into 4QCY16, we continue to reiterate two of our Top Picks i.e. SUNCON and KIMLUN, premised on their strong earnings performances in the past coupled with their strong credentials and track record in securing mega infrastructure jobs. For SUNCON, we like them for their ability to propose, design and build mega infrastructure projects, i.e. BRT and being the only pure play contractor with a strong net cash position amongst the big boys with minimal risks or threats from other sectors. Our TP of RM1.81 for SUNCON implies 15.3x FY17E PER that is still below its big-cap peers’ average (excluding SUNCON) of 16.0x. As for KIMLUN, we continue to favour them for their consistent performance, which even outperformed our and market estimates 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 the MRT2’s Tunnel Lining Segment (TLS) contracts given their strong track record and expertise in the Industrial Building System and they had won numerous contract awards both locally and internationally in Singapore supplying both SBG and TLS.

Introducing GKENT as another Top Pick. Apart from SUNCON and KIMLUN, we are also introducing one of the construction stocks under On Our Radar series namely GKENT as one of the Top Pick in 4QCY16. We like GKENT for its ability to secure highprofile projects like LRT2 extension and MRT2 track works while delivering decent pre-tax margins of 15-18% coupled with the fact that they are the only mid-sized contractor that has secured a PDP role for LRT3. On the valuation front, at our TP of RM2.80, it only implies 2-year Fwd. PER of 11.4x, which is still within our mid-cap space valuation of 9.0-13.0x.

Being selective. While we are keeping our OVERWEIGHT call on the sector, we remained very selective on our picks as we prefer pure-play contractors as these players 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, GKENT (TB, TP: RM2.80) in the mid-cap-space, while KIMLUN (OP, TP: RM2.51) continues to prevail in the small-cap space.

Source: Kenanga Research - 5 Oct 2016