Indo Construction: Mispricing, Misbelief, Misconception

We re-initiate the Construction sector with an OVERWEIGHT rating and a 12-month share prices return of 18-47%. The recent outperformance has legs and shall continue as concerns over slowing new contracts growth, rising leverage and weakening cash flow are overdone. Our backward calculations suggest that the market is overly pessimistic in discounting the contractors’ 2019 EPS growth potential and their ongoing balance sheet improvement.

Mispricing. Indonesian contractors have undergone a massive valuation de-rating as investors were pricing in concerns over slowing new contracts growth, rising leverage and weakening cash flow amidst the turnkey payment scheme. We believe the risk-reward is still attractive, even after the recent rally. Sector forward P/E now hovers at just 7.1x, a 38% discount to the 5-year mean even excluding the 2014-16 infrastructure bull cycle. We think the market is overly pessimistic as the current valuation implies that the market is only pricing in 2019 earnings growth of 6% (ex-WSKT), versus our 16% forecast.
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Misbelief: infra budget, SOEs’ balance sheets, and election. The market perceived the flat growth in infra state budget 2019 has created a glass ceiling in the new order-booking. However, most of the recent projects have been driven by SOEs since 2015. Given the healthy leverage position of major unlisted-SOE project owners, we believe the shortening projects in 2019F/20F is just a misbelief. Contrary to popular belief, SOE contractors recorded positive new contracts growth in the both election years of 2009 and 2014. As new contracts achievement has surprisingly contracted earlier than expected in 2018, we believe new contracts will advance by 14.2% yoy in 2019F.

Misconception on SOE holding creation. The establishment of Infrastructure and Housing holdings creates a separation between SOE contractors. WIKA and PTPP are set to be under Housing holding with Perumnas at the helm, while ADHI and WSKT are members of Infrastructure holding under Hutama Karya (HK). Given the degree of difference between Infrastructure and Housing holdings, concerns are raised on whether all the upcoming infrastructure projects will exclusively be given to SOE Infra holding. This shall not be the case as we think that the tender process is still required to determine an infra project’s tender-winner.

OVERWEIGHT the sector. We are positive on the construction as the sector discount to JCI has widened to 53%, the largest since 2012. Our top pick on the sector are PTPP and WIKA as the major overhangs have been diminished, along with strong balance sheet and operating cash flow. We also like WTON for precast name due to its earnings stability and growing order book. Key risks on our recommendation are construction delay in turnkey projects, slower-than-expected land acquisition, and higher-than-expected land clearing costs.

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