Wednesday, 15 March 2017

Beaten, Not Broken: Construction Companies | Analysis & Opinion



The local market has experienced an incredible blast off this year, with the Straits Times Index up by around 9% YTD. Valuations have generally risen across the board, with stocks in formerly depressed industries like banking (eg. UOB) and property development (eg. Capitaland) turning around remarkably. However, in a quiet corner of the market reside a group of depressed counters that have been neglected – construction companies. A few things are ubiquitous in the world of local construction – Hokkien company names, low P/E ratios and lacklustre business outlooks. Sounds like a place where one might start a value hunt.

Their plight is unsurprising, as the government’s property cooling measures in full force since 2013 (until recently) has crimped demand for newly built homes, combined with a weaker local economy.  This has left many construction companies trading at low valuations, although the prices of a few have started picking up in recent months. While not trying to pick a bottom, I believe there could be better days ahead for the sector in the coming years. 

The Building and Construction Authority (BCA) expects the value of construction contracts to be awarded this year to be between $28 and $35 billion, with the bulk ($20-24 billion) stemming from public sector works. This is higher than $15.8 billion in public sector demand in 2016, and $13.3 billion in 2015. However, private sector construction is expected to remain depressed. [BCA Release] Annual demand is further projected to be $26-35 billion in 2018-2019, and $26-37 billion in 2020-2021.

Looking ahead, with many public sector projects in the pipeline (eg. new MRT lines), it seems reasonable to expect that any industry turnaround would be led by the public sector. Private sector demand may also pick up, and already early signs are showing with news of aggressive bidders for new residential sites [article], signalling confidence and a potential turnaround for the industry. While they are mostly property developers, construction companies would get a reprieve from the property market picking up. 

Sieving Out Firms

I ran a search on SGX’s Stock Screener for the construction industry, in attempt to search for potentially undervalued counters. Based on my selected criteria, and the following 7 companies were filtered out.




I then did some fact-finding and complied the relevant data.





All data sourced from SGX’s website.

Most of the metrics I’ve chosen are rather self-explanatory, and so I shall not waste time elaborating on those, but proceed to further eliminate counters and narrow down further.

Elimination Round

For ease of comparison, I’ve colour-coded some figures in red and green, representing either the largest or smallest figures in that category, both which can be good or bad depending on context. 

First up, the price-to-something ratios. We see that all have P/Bs of less than 1, and P/Es of less than 10 (with the exception of PEC). Price-to-sales ratios also fall below 1 (with Low Keng Huat standing out). EV/EBITDA values are rather thin, except for LKH (again). 

All the counters pay decent dividends, with yields exceeding 3%, going as high as 8% (Keong Hong). Dividend payout ratios give us a rough idea about the sustainability of future dividend payments, and LKH stands out once again (3rd time) with the highest ratio. Lian Beng’s is kept low at 9.8%, which could signal the potential for dividend increases down the line.

Moving over to financial health and creditworthiness, LKH (4th time!) has the highest debt/equity ratio at 62%, while the rest are moderately geared (40-50%). However, when measured by the ability to quickly pay down their debts (debt/EBITDA), Lian Beng fares the worst at 13.5x Debt/EBITDA, hinting that its moderate gearing ratio could be more lethal than expected. LKH’s debt/EBITDA of 8.6x is slightly concerning as well. KH, KSH and PEC are standouts for having much better ability to repay their debts. In fact, all 3 of them are in a net cash position

Stripping out the (very likely) anomaly of LKH’s 141% net profit margin, Lian Beng handily managed a net profit margin of a respectable 22%. Worth mentioning are also KH and KSH, for managing double digit margins. On the other end of the spectrum is Tiong Seng, which only managed a meagre 2% NPM and 5% ROE

Looking at return on equity (ROE), Keong Hong fared best in its last fiscal year, at nearly 25%, nearly double of the next highest (KSH) at 13%. The firm also managed to grow its revenue (albeit only slightly) in these difficult recent years, which most of its peers did not. Lian Beng seemed to have suffered the most from this downturn revenue wise.

Lastly, I tried to find data on each firm’s total order book as of the end of its most recent quarter and listed are those which I managed to look up. Tiong Seng boasts the most impressive order book at about a billion dollars, and not far behind is Lian Beng at $644M, following its latest contract win. Note the size of each firm’s order book relative to its total revenue and market cap. Also note that the order book size may not accurately reflect immediate revenue as revenue is usually booked progressively in stages.

Verdict

Unsurprisingly, I’ve decided to eliminate Low Keng Huat first, owing to it having the highest leverage, and being the most expensive based on EV/EBITDA and P/S ratio.
Now the selection process becomes a lot harder. None of the firms stand out particularly – what area it excels in, it compensates for in another

PEC looks very promising, given its low gearing, big pile of cash and extremely low EV/EBITDA. However, the company is mainly involved in construction and engineering for the oil & gas and petrochemical industries, which links it to volatile O&G. Its order book is not very large, and my guess is that the firm is loading up on cash to cushion it from downturns in the O&G industry.

Tiong Seng’s last-12-months revenue surpasses all at $774 million, and its order book looks impressive at a billion dollars, but with profit margins so low, and assuming they do not improve, not much is going to be made from it. This explains the very low price/sales ratio. Nonetheless, the firm maintained respectable growth in the years prior and its conservative dividend payout ratio gives headroom for dividend increases in future.

Lian Beng looks very promising, except for its debt/EBITDA ratio of 13.5. Simply put, the firm has to continue making money at its current rate for at least 13.5 years, to completely pay off its current debt! Being in a net debt position of $421m (more than 150% its market cap!) means that business has to markedly pick up in coming years and profit margins cannot deteriorate, for the business to remain financially sound. Should the industry be hit by another downturn again, Lian Beng could face financial pressure. Its share price may have advanced lately on news of its contract wins, but investors should stay cautious.

It is hard to criticise the final 3, Keong Hong, KSH and Lum Chang, but they are of course, far from perfect. In a low-growth and saturated environment that is construction, share price upside is rather limited and daily stock trading volumes are lacklustre. Therefore I believe one should choose higher dividend paying stocks to compensate for the opportunity cost of holding such counters. Not only do high dividends cushion a stock’s fall, it also gives the investor income while waiting for an industry recovery to materialise. 

Keong Hong’s 8% dividend yield very mouth-watering. The dividend payout ratio is fairly conservative and the firm is in a net cash position, ensuring the stability of dividends in the near future. It also has decent profit margins and return on equity, and even managed to achieve revenue growth in the past 3 years.

Through a little research, I discovered that KSH is labelled as the government’s “preferred” contractor for civil construction works. This does somewhat give it an economic “moat”, or an advantage over competitors. Their portfolio is a litany of public contracts (eg. NUS) and so is their order book. Besides benefitting from the uplift in public construction spending, public contracts tend to be more stable than private ones as the risk of a counterparty default is minimal (speaking of which, just look at the mess in Singapore’s O&M sector). KSH’s 5% dividend yield is far from shabby, providing the investor with decent income while sitting out the downturn. 

The Final Word

Based solely on the above, I personally have 2 picks for exposure to the construction industry – Keong Hong and KSH, the rationale being collecting dividends while waiting out the industry downturn

Of course, this does not mean that one immediately goes out and buys them. More due diligence has to be conducted on these two stocks and I hope to review them in greater depth soon.


Just my two cents.

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