We initiate coverage on GKENT with an OUTPERFORM call and TP of RM3.65 with an implied discount of 7% to its SoP-value of RM3.93, which implies FY18E P/E of 16.2x. We like the company for: (i) its unique role as Project Delivery Partner (PDP) for LRT3, which anchors pre-tax profits of at least RM270m for 3-4 years, (ii) upside to PDP share where every RM1.0b upward revision to LRT3’s base cost of RM9.0b adds 4-5 sen to our SOP, (iii) strong RM5.9b orderbook with upside from upcoming rail projects, (iv) strong balance sheet of RM0.66 net cash per share to support ~3% DPS yields, (v) superior ROEs (26%) and net margins (19%). We estimate FY18E/19E earnings +24%/+12% with rising recognitions from LRT3 and modest RM500m orderbook replenishments.

Steady earnings stream supported by PDP fees… Looking ahead, GKENT’s mid to long-term prospects remain promising given a steady earnings stream backed by its massive order-book of RM5.9b of which RM1.4b is from its external order-book while the remaining RM4.5b are from LRT3 which they are entitled for 6% PDP fees. Based on the 6% PDP fees alone, GKENT has theoretically locked in cumulative pre-tax income of RM270.0m (40%-36% of FY18E-19E) for the next 3-4 years as the construction works for LRT3 commences.

Potential upside on PDP fees? We believe that LRT3 would definitely see a higher revision in construction cost due to higher building material and labour. For example, steel prices were hovering at RM1.6k/mt last year while it has shot up by c.60% to RM2.6k/mt currently. If we were to assume similar increase in construction costs as per the increase in steel prices, we reckon that LRT3 cost could potentially go up to the range of c.RM14.0-15.0b. While we are still unable to confirm the total project cost until all the contracts are awarded, every RM1.0b increase in LRT3 project cost would represent RM30.0m additional pre-tax profits to its existing locked-in PDP fees pre-tax profits of RM270.0m (based on RM9.0b contract size). (Refer to Financial Analysis section for sensitivity analysis.)

Strong war chest of RM0.66/share. Unlike peers whose net gearing ranges between 0.5x-0.8x, GKENT’s net cash/equity at 0.93x is the best amongst its peers despite its smaller market capitalization. This is unwarranted given its anchored PDP role in LRT3 – similar to bigger boys like IJM and Gamuda. GKENT has the ability to raise RM550.0-650.0m cash by increasing its net gearing up to 0.5x-0.6x for mega projects or acquisitions in the future with lower odds of cash-calls.

Leader in water metering products. GKENT’s bread-and-butter water metering division is a major manufacturer and supplier of water metering products with existing annual capacities of 2.5m metering products (vs. 1.8m actual production in FY17). Going forward, we expect steady, albeit modest 10% growth on steady 20% margins to keep this division a marginal 13-16% contributor in FY18E-19E.

Estimates FY18-19E earnings to grow 24%/12% to RM126.1m- /RM141.0m, backed by annual construction order-book replenishment of RM500.0m, (ii) 6% PDP fees based on LRT3 cost of RM9.0b, (iii) 10% growth for metering division and (iv) stable net margins from 19%. Our FY18E estimates are 21% above consensus but even then, we see upside from upward revision to LRT3’s cost.

Initiate with OUTPERFORM with key re-rating catalysts being potential cost escalation in LRT3 project. Our TP of RM3.63 is based on i) 14x FY19 P/E for metering, ii) 17x FY19 P/E for construction, iii) NPV of 6% PDP fees based on RM9b cost, iv) 30% disc to net cash. Implied FY18/FY19 PER of 16.2x/14.5x is not excessive given its net cash position. (Kindly refer to Valuation and Recommendation section for further details

Source: Kenanga Research - 7 Nov 2017