This article first appeared in The Edge Financial Daily, on March 22, 2016.

Hock Seng Lee Bhd
March 21 (RM2.09)
Maintain buy with a higher target price (TP) of RM2.64: Hock Seng Lee Bhd (HSL) has secured a larger-than-expected RM1.71 billion roadwork package for the Pan Borneo Highway just a day after it won an RM750 million Kuching centralised sewerage contract. We maintain “buy”, with our TP raised to RM2.64 (from RM2.54), after incorporating higher contributions from this project.

Aside from its fruitful job wins, HSL has been enjoying higher margins vis-à-vis its peers in Peninsular Malaysia, given the less intense competition from a smaller pool of contractors. Therefore, we reiterate “buy” on HSL and raise our sum-of-parts valuation-based TP to RM2.64. We value its construction unit based on 12 times forecast financial year 2017 (FY17) price-earnings ratio (PER), in line with our 10 times to 14 times target one-year forward PER for small- and mid-cap construction stocks. Separately, we value its property unit at a 35% discount to revised net asset value and add its net cash as at Dec 31, 2015.

Its 70%-owned consortium — Dhaya Maju Infrastructure (Asia) Sdn Bhd — was awarded a RM1.71 billion contract by Lebuhraya Borneo Utara Sdn Bhd for the development and upgrading of the proposed Pan Borneo Highway in Sarawak (Phase 1), from the Bintangor junction to the Julau junction and from Sibu Airport to Sungai Kua Bridge.

The scope of work for this project includes earthworks, piling, drainage works, roadworks, interchanges, bridges, and related mechanical and electrical works. The contract period is for 51 months.

HSL’s latest win of the Pan Borneo roadwork package was not a surprise. We had earlier anticipated the company to secure a slice of the action in this RM16.1 billion project, given its dominant position in the state’s construction sector.

That said, the contract value is 41.5% larger than our original estimate of RM1.2 billion.

However, we prefer to be prudent in assuming a net margin of 10% for this project, relatively lower than its historical net margin ranging from 11.6% to 15.5%. Coupled with the Kuching City Central Wastewater Management System (Package 2) project worth RM750 million, we believe both projects will keep the company busy for the next four to five years.

Similar to the sewerage project, we expect the company to set up a new joint-venture (JV) company to carry out works for this project. Pursuant to the FRS 11 accounting standard, we believe that contributions from this new JV would be equity-accounted. Despite a revenue drop as both mega projects are expected to be equity-accounted, we have raised our FY16 to FY18 earnings estimates by 0.6% to 6.9% respectively. A key downside risk is an escalation of input and labour costs that could crimp profitability. — RHB Research Institute, March 21