We are downgrading the sector to NEUTRAL from OVERWEIGHT previously, owing to: (i) poor earnings performances demonstrated in the recently concluded results season, (ii) slower contract award news flow for 2017, (iii) heightened earnings delivery risks due to delays in work progress/high building material cost, and (iv) valuation seen to be toppish with KLCON trading above its 5-year +1.5SD. Furthermore, we only have two Outperform recommendations, which is MITRA (TP; RM1.49) and KERJAYA (TP; RM2.64) for the sector. That said, we are still maintaining a Trading Buy call on our previous Top Pick i.e. PRTASCO despite its earnings disappointment as we believe they will still be one of the major beneficiaries of road work maintenance. Nonetheless, we reduced its TP to RM1.36 (previously, RM1.52) based on 11x FY18E PER after slashing FY17-18E earnings by 24% and 13%, respectively. At current levels, PRTASCO still offers considerably decent dividend yield of 4.7% for FY17.

Regained interest… At 10-Mar-2017, all of the stocks under our coverage except for SUNCON registered positive gains averaging 7.1%, with the big caps registering an average gain of 3.7% while small-mid caps average gain was 9.0%. For the big caps, IJM registered a positive gain of 5.6% for the first time after registering negative returns for two consecutive quarters in the past. Despite earnings disappointment by SUNCON and WCT, their share prices did not see any negative impact, but WCT continued to register gain of 5.1%. In the small-cap space, MUHIBAH and KERJAYA registered the highest gain at 20.7% and 17.8%, respectively, backed by a satisfactory set of results, which met market expectations. We believe that recovery in performance for the contractors is largely driven by improved market sentiment backed by Election theme. As for our 1Q17 Top Pick i.e. PRTASCO, it registered negative return of 0.9% since our report dated 4-Jan-2017, owing to its poor results performance. In terms of year-to-date performance, KL Construction Index (KLCON) still fared much better with a positive return of 11.2% versus KLCI’s return of 4.6%.

4QCY17 results review. We concluded the financial year with a mixed bag of results with 6 out of 11 of our construction coverage stocks reported results that came in within our expectations, while the remaining 5 came in below. The number of stocks that came below our expectations is the same as compared to 3QCY16, marking the second consecutive quarter of disappointing results. Names that registered disappointing performance are: SENDAI, HSL, NAIM, WCT and SUNCON. Reasons behind their poorer performances vary such as; (i) compression in margins due to higher-than-expected operating costs, (ii) slower-than-expected progressive billings, and (iii) provisioning and impairments. Core coverage aside, we do note that our 1Q17 Top Pick i.e. PRTASCO that falls under On Our Radar, missed our expectations by only accounting for 85% of our full-year estimates owing to higher costs incurred for data collection works in several states for its road maintenance division. Post FY16 reporting season, we downgraded 3 stocks to UNDERPERFORM with a lower Target Price by 16%-30% due to their inability to deliver as reflected in their weak earnings performance. That said, we also downgraded SUNCON to MARKET PERFORM with a mild reduction in Target Price of 2% post earnings adjustment coupled with the fact that SUNCON’s share prices have performed relatively well with a gain of 11% for a big-cap contractor as compared to IJM and GAMUDA since our initiation back in June-2016.

Slower award flows… CY16 was a great year for contractors as we had seen RM56.2b worth of construction jobs clinched by the public-listed players representing a 155% increase from CY15. However, we expect news flow and construction awards to taper off from CY16 level as the major increase in jobs flows in CY16 were mainly from the MRT2 and Pan Borneo Sarawak which made up 60% of entire CY16 value award of RM56.2b. In terms of expectations for CY17, we are looking out for news flow from LRT3 (RM9.0b), Pan-Borneo Sabah (RM12.8b), Gemas-JB Southern track (c.RM9.0b with the assumption that 30% will be subcontracted out to local contractors) and government housing jobs, while jobs from the private sector would be from projects like Bukit Bintang City Centre and new development launches with IJM, SUNCON, GAMUDA, AZRB, GADANG and KERJAYA as likely beneficiaries. Hence, collectively we anticipate contract awards to be at the range of RM25.0b-RM30.0b for 2017, which is lower by 56%-47%. This excludes the much talked about East Coast Rail Line (expected contract amount of RM55.0b with 30% local participation requirement), while news (The Star) reported recently that the construction awards for ECRL could start as early as July as its tender could come as early as April, we are anticipating the contract award news flow for bigger jobs to materialise earliest by 4QCY17 or 1QCY18 as bigger jobs tend to go through a longer tender progress, with similar timeline is also expected for the High Speed Rail. In the event that the ECRL awards came in earlier before 4QCY17 or 1QCY18, this would be a re-rating catalyst for the sector and we believe key beneficiaries would be bigger names like IJM, GAMUDA, and GKENT. Apart from infrastructure and building works, we also expect more contract news flow relating to road works maintenance given that the government have allocated RM4.6b for state road maintenance coupled with expectation that the general election is around the corner, beneficiaries to look out for are names like PRTASCO, CMS, and EDGENTA.

Time to Deliver? We strongly believe that given the slew of contracts won by contractors back in CY16, the theme for this year is earnings delivery, as our major concern for contractors is their ability to deliver their numbers in CY17, especially after they had enjoyed good run ups backed by strong contract award flows, which have built in high expectations for the sector. High building material cost is a further dampener to contractors' earnings given that local long steel prices are currently trading at strong levels of RM2,140-2,290/t (+32% YoY) driven by: (i) cost push factors i.e. higher raw material prices (coal, iron ore, scrap), and (ii) the lower volume of China imports (-32% YoY). While we have already factored in higher operating costs that are reflected in our earnings revision in the recently concluded results season, we remain cautious of further disappointments that lie ahead as delays and unexpected cost issues seems to be rampant.

Valuations. At our report cut-off on 10-Mar-2017, KLCON index was trading at 15.3x at 5-year +1.5SD levels, while valuations are not cheap with big caps’ valuation averaging at 19.0x (IJM, GAMUDA, WCT, SUNCON) which is close to its 2-year high coupled with the lackluster earnings trajectory despite multiple contract wins in the past. Even the recent contract awards did not have much positive effect on share prices. Meanwhile, small-mid caps’ average valuation has risen to 11.2x from six months ago where they were trading at 8.9x; this is considered a 2-year high. We believe that “re-rating” is largely driven by improved market sentiment, and with valuations at a high, any disappointment in earnings delivery will cause contractors to be de-rated due to high expectations.

Downgrading to NEUTRAL. In view of slower contract flows for the year, higher execution risks, while valuations are at 2-year high, we are downgrading the construction sector to NEUTRAL from OVERWEIGHT previously. Furthermore, we only have 2 OUTPERFORM recommendations for the sector namely MITRA and KERJAYA backed by their steady earnings delivery and undemanding valuation as our TP for both stocks imply 1-years Fwd. PER of 11.0 x-11.8x. That said, we also have 4 UNDERPERFORM calls namely SENDAI, NAIM, HSL, and WCT, while the rests are MARKET PERFORM. As for our previous Top Pick i.e. PRTASCO, it is still a Trading Buy call with a lower Target Price of RM1.36 (previously, RM1.56) based on 11.0x FY18E PER after our reduction in FY17-18E earnings of 24% and 13%, respectively.

Source: Kenanga Research - 30 Mar 2017