Reversal in progress… At our report cut-off date of 21-Sep-2017, we saw the average capital gains for the stocks under our coverage down by 5.7% compared to 2QCY17, which registered average capital gains of 20.4%, with the small-mid caps, registering average negative returns of 8.6% over big-caps’ average negative returns of 1.3% on a QoQ basis. In our 3QCY17 performance review over 2QCY17, only three contractors under our coverage registered positive gains with KERJAYA garnering the strongest performance with positive gains of 13.3% followed by SUNCON and MUHIBAH, which registered positive gains of 11.4% and 5.2%, respectively, while the rest registered negative returns ranging between 0.9%-35.8%. We believe that reversal in share price trend for bulk of the contractors were largely due to steep valuations as KLCON index was trading at the peak of 16.4x back in 2QCY17, and we believe that stocks that have performed fairly well in 3QCY17 should see some corrections ahead. In terms of year-todate performance, KL Construction Index (KLCON)’s gain of 15.6% still outperformed KLCI’s gain of 6.8%.

2QCY17 results review. Out of 10 construction stocks under our coverage, only two contractors disappointed in earnings, while the remaining eight construction players’ earnings performance came in within/broadly within our expectations. The two contractors that disappointed were HSL and MITRA, which saw unexpected costs overrun due to delays in construction progress. The number of stocks that disappointed in 2QCY17 is the same as 1QCY17.

YoY, bulk of the contractors registered CNP growth ranging from 5%-33% except for four contractors that saw declines in their CNP by the range of 20%-32%. The decline in the performance for these four contractors, i.e. HSL, KIMLUN, MITRA, SENDAI are mainly due to slow progress billings and cost overruns due to delays in certain projects. QoQ-wise, four contractors registered decline of 1%-30% in their CNP due to similar reasons mentioned above. In terms of earnings revision, we lowered our earnings estimates for three stocks, i.e. IJM, MITRA, HSL as we factored in a slower progressive billing cycle and higher operating cost for MITRA and HSL, while the minor tweak in IJM’s earnings are mainly due to the reduction in IJMPLNT’s earnings.

Construction award flows down year-on-year as expected… As highlighted in our previous strategy report, we are anticipating slower contract flows at the range of RM25.0-30.0b for listed construction players in CY17 which came in within our expectations thus far given that we only saw RM20.5b worth of jobs clinched by listed players in 9MCY17, down by 41%, YoY. In terms of job flow expectations for 4QCY17, we are looking out for news flow from LRT3 (RM9.0b), Pan-Borneo Sabah (RM12.8b), and government housing jobs, while jobs from the private sector would be from projects like Bukit Bintang City Centre and new development launches with beneficiaries such as IJM, SUNCON, GAMUDA, AZRB, GADANG and KERJAYA.

Earnings delivery is critical. We maintain our view that earnings delivery performance is crucial for contractors as they need to execute the slew of contracts clinched in CY16 and 1HCY17. Our major concern for contractors is their ability to deliver earnings in CY17, especially after they had enjoyed a good run backed by strong contract award flows, which have built in high expectations for the sector. Furthermore, we believe that contractors’ earnings risk is heightening due to the rising cost of building material and labour costs.

Budget 2018. Last year, the government announced c.RM81.0b worth of construction projects under Budget 2017 of which the bulk of it is not executed nor awarded yet. Hence, we believe that the upcoming Budget 2018 will still be focused on the Rakyat with less emphasise on construction industry. Nonetheless, we believe that the government will most likely reiterate previously announced projects with more details, i.e. award and execution timeline. Likewise, we continue to maintain our view that contract award flows for ECRL is only expected to materialise earliest by 4QCY17 or 1QCY18, and should the contract award be dished out earlier than expected it would be a re-rating catalyst for the sector and we believe that most contractors would benefit given the sheer size of the project. Names to look out for are GAMUDA, IJM, AZRB, GBGAQRS, and potentially GKENT. That said, contractors with strong piling track record like SUNCON, ECONBHD, PTARAS, and IKHMAS should also be in the limelight as news flow picks up in 4QCY17.

Valuations tapering but... At our report cut-off on 21-Sep-2017, KLCON index is trading at 1-year forward PER of 15.7x which is at 5-year +1.5SD level even though it has come off from its peak at 16.4x, and we deem valuations to be fairly rich with big caps trading at 1-year forward average of 20.5x even though it has tapered from 21.3x (IJM, GAMUDA, WCT, SUNCON) in last our last quarter review, coupled with the lackluster earnings trajectory despite multiple contract wins in the past. Meanwhile, small-mid caps 1-year forward valuations fell slightly to an average of 13.3x from 13.5x as compared to the 2QCY17 review period when valuation remains rich in the mid-cap space. We believe that the “re-rating” is largely driven by improved market sentiment, and with valuations at seemingly toppish levels, risk of share price corrections is high if there are disappointments in earnings delivery or swing in market sentiment, especially in the mid-cap space.

Maintain NEUTRAL. In view of the lack of strong catalyst throughout the year, higher execution risks, and coupled with valuations at 2-year high; we continue to reiterate our NEUTRAL recommendation on the sector. Furthermore, we no longer have any OUTPERFORM calls for our core coverage under the sector. Looking ahead, we advocate a sell-on-strength strategy on the sector in which we urge investors to take the opportunity to take profit on any positive news flow that is expected in 4QCY17.

Source: Kenanga Research - 6 Oct 2017