While we maintain our OVERWEIGHT recommendation on the construction sector,we expect contract newsflow to be slower as compared to CY16, as we are expecting the remaining packages from MRT2, LRT3 and Pan Borneo Sabah to be announced in CY17, while the High Speed Rail and East Coast Rail Link to be awarded as early as 4QCY17 and we expect the industry big boys to be the main beneficiaries. We note that contractors need to be highly focused in delivering such high-profile projects in CY16 to minimise risk of delays. Hence, we remain fairly selective in our stock picks and this time around, we prefer contractors with steady revenue stream such as PRTASCO which is trading at only 8.3x and offers an attractive dividend yield of 6.0%, which is far superior compared to its mid-cap peer average of 2.1%. At our Target Price of RM1.52 based on 11x FY17E PER, it still offers a decent yield of 5.2%, which is still very attractive compared to peers. Hence, we urge investors to accumulate the stock as we believe it is grossly undervalued for its value proposition.

A weaker closing, but… As of 22Dec2016, the performance of stocks under our coverage registered a weak performance with negative returns averaging 0.5% vis-à-vis positive return of 4.2% in 3QCY16. Amongst the big boys, WCT registered the highest return of 7.3% followed by SUNCON with a return of 3.7%, while IJM continued to be the worst performer with a negative return of 4.2% in 4QCY16. In the small-mid cap space, SENDAI took the lead with a positive return of 21.3% on a rebound from its low of RM0.47 driven by its profitability, while KIMLUN trailed behind with positive return of 7% in 4Q16 while others registered negative returns of 5.9-17.5%. Our Top Picks i.e. SUNCON and KIMLUN performed well against the KL Construction Index despite the weaker market sentiment. Apart from these two, GKENT which is also one of our Top Picks but not a component stock of KL Construction Index had also performed fairly well with an impressive return of 34.8% over 3QCY16. In terms of year-to-date performance, KL Construction Index (KLCON) still fared much better with a positive return of 2.2% versus FBMKLCI’s negative return of 7.4%.

3QCY16 results review. For 3QCY16, out of 12 stocks under our coverage, 5came in below expectations (MITRA, WCT, MUHIBAH, HSL, SENDAI), while the rest was within expectations. Compared to 2QCY16 which saw 3 stocks exceeding expectations, 3 missed and 5 within/broadly within, 3QCY16 performance was weaker than expected. Post 3QCY16 results, we downgraded our FY16-17E core earnings for MITRA, HSL, WCT, MUHIBAH, and SENDAI by a range of 5-24% on the back of slower progress billings and higher costs assumptions, while there were no earnings upgrade for the rest.

Expect contract flows to slow down in 2017. For CY16, we have seen RM56.2b worth of construction jobs clinched by the public-listed players which is a 155% increase from CY15. The major increase in jobs flows were mainly from the MRT2 and Pan Borneo Sarawak of c.RM34.0b. However, it is still a let-down that most of the big-boys failed to secure any single package of the much talked about highway, i.e. SUKE and DASH as the bulk of the jobs were awarded to private contractors. Going forward, we expect jobs flow momentum to taper off as compared to CY16 by 40%-50% as we are only expecting newsflow from the remaining viaduct packages from MRT2, LRT3 to commence in 1H17 while Pan Borneo Sabah is expected in 2H17. As for the much talked about High Speed Rail (HSR) project and East Coast Rail Line (ECRL) project that are collectively worth >RM100.0b, we believe the timeline for the execution works for these two mega projects will take place earliest by 2018, meaning contract awards would be announced earliest by 4QCY17 for the bigger players, while we expect small-mid caps to continue bidding for more building-related jobs, i.e. government building and hospital jobs.

Valuations. Currently, the big caps are trading at 2-year Fwd. PER averaging at 15.8x, inching up from 15.6x in 3Q16 previously despite earnings downgrade in certain stocks as the share price performance for some of the big boys have come off since 3QCY16. In terms of the small-to-mid caps, they are no major changes from the previous quarter as they are still trading at an average of 8.9x. In terms of our Top Picks, SUNCON, KIMLUN and GKENT; their 2-year Fwd. PER has expanded to 14.8x, 7.7x, and 12.3x from 14.2x,7.2x, and 9.1x, respectively, indicating more interest and traction from investors.

A change in flavour in terms of Top Picks. Despite slower news flow expected for CY17 and our Market Perform recommendation for the big-caps, we are still keeping an OVERWEIGHT recommendation on the sector, as we believe that the action lies in the small-mid cap contractors as they backed by healthy orderbook size with earnings visibility of 2-3years, coupled with decent earnings growth (average of 15%) for FY17 and an undemanding valuation at an average of 9.1x FY17E PER vis-à-vis the big boys i.e. IJM and GAMUDA’s milder growth (average of 8%) with rich valuations at an average of17.1x FY17E PER. That said, we do note that contractors may face difficulties in execution due to labour or mobilisation issues resulting in higher risk for earnings downgrade, and we view that contractors with exposure in Pan Borneo Sarawak might face higher execution risks due to the geographical location and terrain. That aside, we would not be surprised if contractors face further margin compressions due to higher building material costs. Hence, we had been highly selective with our picks in the construction space and picked contractors with strong execution track records in the past with minimal disappointment in earnings delivery such as SUNCON, KIMLUN and GKENT. While we still like these names, we opt to recommend contractors with steadier earnings like PRTASCO (TB, TP: RM1.52) as our Top Pick for 1QCY17. We like PRTASCO for its niche in the construction space specialising in roadwork maintenance, which provides a steady income stream as most of its maintenance works are based on concessions awarded by state and federal governments, which commands decent pre-tax margins at c.13%, especially when we are expecting lesser contract news flow for CY17. At current levels, PRTASCO that is trading at 8.3x FY17E PER offers a highly attractive dividend yield of 6.0% which is far superior to its mid-cap peers average of 2.1%. That said, it also has more potential upside to its yield should they declare a DPR of 60% vis-à-vis our assumptions of 50%, which would translate to a higher yield of 7.2%.

Source: Kenanga Research - 5 Jan 2017