28 January 2019

Water play Company Update HSS Engineers is currently bidding for railway, renewable energy and water-related projects to expand its order book. The government’s ongoing water asset consolidation exercise and planned water tariff HSS Engineers hikes nationwide will support crucial capital expenditure to expand the HSS MK water supply and improve distribution efficiency. The potential revival Sector: Engineering Construction of highway and railway projects will also improve HSS’ new contract procurement prospects. HSS remains our top small-cap sector BUY RM0.99 @ 25 January 2019 with a new target price of RM1.20, based on a FY19E PER of 22x.

Bidding for water projects BUY (maintain) State-owned water utility Pengurusan Air Selangor Sdn Bhd has a capex Upside: 21% plan of RM30bn over 30 years starting from this year. Other state governments also plan to increase their capex to improve their water supply Price Target: RM1.20 and distribution systems. We gather that HSS has submitted 10-12 bids for Previous Target: RM1.18 (RM) water infrastructure design contracts nationwide. Some tenders are 2.00 1.80 submitted in partnership with contractors for design and build projects. 1.60 1.40 1.20 High order book even with ECRL cancellation 1.00 0.80 HSS’ order book stood at RM588.6m as at 30 Sept 2018, providing earnings 0.60 0.40 visibility for the next 2-3 years. It has good prospects of winning new 0.20 0.00 contracts this year with potential tenders worth more than RM300m. HSS’ Dec-16 May-17 Oct-17 Mar-18 Aug-18 Jan-19 suspended contracts for the East Coast Rail Link (ECRL) project (remaining Price Performance value of RM95m or 16% of its order book) will likely be cancelled with the project termination; we excluded them from our forecasts earlier. 1M 3M 12M Absolute 19.3 % 23.8 % -35.3 % Looking to participate in upcoming project tenders Rel to KLCI 18.1 % 22.7 % -29.8 %

As the leading engineering consulting firm for railway and road projects in Stock Data Malaysia, HSS is looking to participate in upcoming tenders including the following: (1) Iskandar Malaysia Bus (BRT); (2) Klang Valley Issued shares (m) 495.9 Mkt cap (RMm)/(US$m) 490.9/119.0 Double Tracking (re-tender); (3) Penang LRT; (4) DUKE Phase 2A Avg daily vol - 6mth (m) 3.3 expressway; (5) LRT; (6) Three paired roads project in Penang; 52 -wk range (RM) 0.45 -1.91 and (7) a Philippine highway. It also plans to expand into renewable energy Est free float 56.0 % BV per share (RM) 0. 67 (RE) generation projects under the third cycle of the large-scale solar (LSS3) P/BV (x) 1. 5 scheme with some partners. Net cash/(debt) (RMm) (44.3) ROE (%) (2018E) 11.0 Sector top small-cap BUY Derivatives Yes We believe HSS is a potential beneficiary of the upcoming infrastructure (Warr 18/23, WP RM0.185, EP RM1.70) Shariah Compliant Yes projects. We lift our core FY19-20 EPS forecasts by 2-6% to reflect higher new contract assumptions of RM200-250m p.a. Based on an unchanged Key Shareholders FY19E PER of 22x, we lift our TP to RM1.20 from RM1.18. Maintain BUY. Tan Sri Ir Kuna singam Sittampalam 24.3% Vanessa A/P Santhakumar 23.2% Earnings & Valuation Summary Datuk Ir Teo Chok Boo 10. 2% FYE 31 Dec 2016 2017 2018E 2019E 2020E Dato’ Ir Nichiananthan 1. 7% Revenue (RMm) 139.0 145.6 184.1 197.0 221.9 Source: Company, Bloomberg EBITDA (RMm) 22.3 24.1 43.3 51.3 55.2 Pretax profit (RMm) 19.9 21.9 30.2 38.5 44.0 Net profit (RMm) 14.0 15.0 21.2 27.0 30.8 Loong Chee Wei, CFA FD EPS (sen) 5.0 4.7 4.6 5.4 6.2 (603) 2146 7548 PER (x) 19.9 21.1 21.8 18.2 16.0 [email protected] Core net profit 14.3 15.8 23.7 27.0 30.8 Core EPS (sen) 4.2 4.6 5.1 5.4 6.2 Core EPS growth (%) 16.5 10.1 9.9 6.7 14.0 Core PER (x) 23.5 21.3 19.4 18.2 16.0 Net DPS (sen) 0.6 0.8 2.4 2.8 2.8 Dividend Yield (%) 0.6 0.8 2.4 2.8 2.8 EV/EBITDA (x) 14.0 12.9 11.3 9.8 8.8 Chg in core EPS (%) 2.3 1.7 5.9 Affin core/Consensus (x) 0.9 0.9 0.8 Source: Company, Bloomberg, Affin Hwang estimates Affin Hwang Investment Bank Bhd (14389-U) Page 1 of 6

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Termination of ECRL project HSS’ contracts for ECRL with an unbilled value of about RM95m have remained suspended since 9 July 2018. We have assumed no earnings contribution from this project in our forecasts. According to newspaper reports quoting the Economic Affairs Minister Datuk Seri Mohamed Azmin Ali, the government has decided to terminate the project and the main contractor China Communications Construction Co. Ltd (CCCC) due to the high total project cost of RM81bn.

Hence, HSS’ subcontracts will likely be terminated together with CCCC’s contract as the turnkey contractor for ECRL. We have excluded the earnings contribution from the subcontracts previously in our forecasts for HSS when they were suspended. The news could cause short-term weakness in the share price as the potential cancellation of the project will reduce HSS’ order book by 16% to RM493.6m. But we remain positive on HSS’ prospects to replenish its order book by securing new contracts this year and reiterate our BUY call.

Good prospects for water projects in 2019 The Budget 2019 allocated RM690m for the implementation of new water- supply projects and the reduction of non-revenue water (NRW), i.e. water loss due to leakage, theft or meter inaccuracies. The government allocated RM590m in 2019 to build more municipal sewerage treatment plants and network systems to connect households that are still using septic tanks and traditional systems. It is considering raising sewerage tariff rates and implementing combined billing for water and sewerage bills to improve collection, ensuring the sustainability of the sewerage utility company, Indah Water Konsortium. The capex expansion for water and sewerage services is positive for HSS, which is the largest local engineering consulting firm in the water and sewerage sectors following its acquisition of SMHB Engineering last year.

Bidding for water grid project The group has also submitted tenders for water projects in Sabah and Sarawak given the water shortage and as certain rural areas are not connected to the water grid in these states, which remain key concerns for the state governments. We gather that the Sarawak state government plans to spend RM7-8bn on the state’s water grid project to draw clean water from the hydroelectric dam reservoirs to supply to rural areas and irrigate agriculture projects. Under the project’s first phase, reservoir water will be brought from the Batang Ai hydroelectric dam in southern Sarawak to Tanjung Manis, one of the growth nodes of the Sarawak Corridor of Renewable Energy in central Sarawak. This phase, which has been allocated RM1bn, will be completed within two years.

Potential beneficiary of higher water sector capex As a leading engineering consultant firm in the water sector, we believe SMHB Engineering, a wholly-owned subsidiary of HSS, is a potential beneficiary of rising capital expenditure (capex) to develop and upgrade water supply and distribution services in Malaysia. Most states in Malaysia had low capex in the past due to the low consumer water tariff rates that were insufficient to fund the capex, and in some cases were even insufficient to fund the operating expenditure of the state-owned water utility company. Hence, it is positive that the Penang and Negeri Sembilan states plan to Affin Hwang Investment Bank Bhd (14389-U)

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` 28 January 2019

increase water tariff rates by up to 20% based on the recommendation of the National Water Services Commission (SPAN).

Large capex planned for Selangor The acquisition of SPLASH’s assets by Pengurusan Air Selangor will also consolidate all the water assets in the state under the control of the Selangor state government effective from 1 April 2019. This will support the increase in water tariff to pass on the higher cost of water supply and capex to build new water treatment plants and improve the water distribution network. State-owned water utility Pengurusan Air Selangor Sdn Bhd has a capital expenditure plan of RM30bn over 30 years starting from this year. It is crucial that the Selangor water supply be expanded as the water reserve margin in the state is 0%. Other states with critical water reserve margins include Kedah (0%), Perlis (1%) and Kelantan (5.8%).

Fig 1: Water reserve margin by state in 2016

Source: Malaysia Water Industry Guide 2016

Earnings forecast revisions In anticipation of higher government spending on infrastructure and HSS’ strong position to win some of the upcoming project tenders, we lift our core FY19-20 EPS forecasts by 2-6% to reflect higher assumptions of new contracts to be secured, ie, RM200m in FY19E and RM250m in FY20E (previously assumed RM150m and RM200m, respectively).

Lower risk profile compared to global peers At the current FY19E PER of 18x, HSS shares are currently trading above their historical mean level (16x), but below the 1 standard-deviation above mean level (21x). The stock is trading at a premium to the global peer weighted average CY19E PER of 16x. We believe the premium valuation is justified as HSS is mostly exposed to local projects, compared to multinational peers that face high geopolitical risks currently (rising protectionism and trade wars) due to their global operations.

Affin Hwang Investment Bank Bhd (14389-U)

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Fig 2: HSS Engineers 12-month forward PER

(x) 34.0

29.0

24.0 +1SD: 20.8x

19.0 Avg: 16.0x

14.0 -1SD: 11.2x

9.0

4.0 Oct-17 Jan-19 Mar-18 Aug-18 Dec-16 May-17

Source: Affin Hwang, Company data

Fig 3: Global engineering peers Company Bloomberg Rating Sh Pr TP Mkt Cap Mkt Cap Year Core PE (x) EPS gr (%) EV/EBITDA P/B ROE (%) Yield (%) Code LC LC (USDm) Wght end CY18E CY19E CY18E CY19E CY18E CY18E CY18E CY19E CY18E CY19E HSS Engineers* HSS MK BUY 0.99 1.20 119 0.003 Dec 19.4 18.2 50.3 13.8 13.2 1.1 12.3 8.9 2.4 2.8 Monadelphous MND AU N/R 15.13 N/R 1,025 0.029 Jun 20.8 17.3 12.7 20.1 10.7 3.5 16.6 19.4 4.1 4.8 Worleyparsons WOR AU N/R 13.89 N/R 4,602 0.132 Jun 17.4 13.9 102.6 24.8 11.7 1.2 8.0 9.1 3.1 4.1 WSP Global WSP CN N/R 62.88 N/R 4,947 0.142 Dec 20.1 16.5 47.2 21.6 11.9 2.0 10.2 11.7 2.4 2.4 Stantec Inc STN CN N/R 31.61 N/R 2,687 0.077 Dec 21.6 14.3 68.3 50.6 11.5 0.0 9.7 12.7 1.8 1.8 Shandong Sunw ay 002469 CH N/R 3.96 N/R 294 0.008 Dec - - n.m n.m 39.2 0.0 na na - - Arts Group 603017 CH N/R 16.45 N/R 674 0.019 Dec 22.9 17.7 30.1 29.2 19.6 2.5 11.1 13.2 1.5 2.1 Sinoma 600970 CH N/R 5.74 N/R 1,487 0.043 Dec 7.3 6.0 39.8 22.4 3.3 1.2 16.3 17.3 3.5 4.5 China Zhonghua 002542 CH N/R 4.30 N/R 1,155 0.033 Dec 31.7 28.8 3.8 10.0 30.5 0.0 na na - - Nbcc India NBCC IN N/R 56.64 N/R 1,433 0.041 Mar 19.0 11.9 30.9 58.9 10.5 4.3 22.9 32.8 2.2 4.4 Engineers India ENGR IN N/R 112.73 N/R 1,001 0.029 Mar 15.4 16.6 22.2 (7.5) 4.5 2.8 19.1 20.8 3.5 4.2 Sw eco Ab-B Shs SWECB SS N/R 186.92 N/R 2,345 0.067 Dec 18.7 17.1 (5.6) 9.0 12.8 3.4 18.6 18.8 2.9 3.2 Af Ab-B Shs AFB SS N/R 161.80 N/R 1,362 0.039 Dec 14.2 12.0 14.8 18.1 11.1 2.3 17.0 17.0 3.4 3.8 Ricardo Plc RCDO LN N/R 6.29 N/R 436 0.012 Jun 10.9 10.1 13.8 7.9 6.3 0.0 15.9 15.2 3.4 3.6 Spirax-Sarco SPX LN N/R 63.59 N/R 6,076 0.174 Dec 25.3 23.8 18.6 6.4 16.4 6.5 27.9 24.6 1.6 1.7 AECOM ACM US N/R 30.01 N/R 4,692 0.134 Sep 10.4 9.5 25.6 9.9 8.0 1.1 9.9 10.6 - - AWC AWCF MK N/R 0.68 N/R 47 0.001 Jun 6.6 6.0 15.3 10.0 2.6 1.0 15.2 15.2 1.2 1.2 UEM Edgenta UEME MK N/R 2.75 N/R 556 0.016 Dec 18.1 16.3 (68.4) 10.8 9.4 1.4 8.3 8.9 4.0 4.3

Average 18.5 15.8 36.3 18.9 12.4 2.5 14.6 15.3 2.1 2.5 Source: Bloomberg, Affin Hwang estimates Note: Pricing as of 25 January 2019

Maintain BUY with higher RM1.20 target price We believe HSS will see an upward re-rating on potential news flow of new contract awards this year. Based on an unchanged target FY19E PER of 22x, we raise our target price to RM1.20 from RM1.18 previously. We believe HSS’ premium valuation to the global CY19E PER average of 16x is due to its position as the only public-listed engineering consulting firm in Malaysia (scarcity premium). HSS remains our top small-cap construction sector BUY.

Key downside risks to our call Key risks to our BUY call: (1) higher financing costs; (2) earnings lag due to the timing of contract wins; (3) execution risks involved in its expansion plans; and (4) a slowdown in the award of construction contracts.

Affin Hwang Investment Bank Bhd (14389-U)

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HSS Engineers - FINANCIAL SUMMARY

Profit & Loss Statement Key Financial Ratios and Margins FYE 31 Dec (RMm) 2016A 2017A 2018E 2019E 2020E FYE 31 Dec (RMm) 2016A 2017A 2018E 2019E 2020E Revenue 139.0 145.6 184.1 197.0 221.9 Grow th Operating expenses (116.7) (121.5) (140.7) (145.7) (166.7) Revenue (%) 14.4 4.8 26.4 7.0 12.7 EBITDA 22.3 24.1 43.3 51.3 55.2 EBITDA (%) 42.7 8.0 80.0 18.4 7.6 Depreciation (1.4) (1.4) (6.6) (6.7) (6.9) Core net profit (%) 45.6 10.1 50.3 13.8 14.0 EBIT 20.9 22.7 36.8 44.6 48.3 Net int income/(expense) (0.9) (0.1) (4.1) (6.2) (4.5) Profitability Associates' contribution 0.2 0.1 0.1 0.1 0.1 EBITDA margin (%) 16.1 16.5 23.5 26.1 24.9 Forex gain/(loss) (0.2) (0.1) (0.1) 0.0 0.0 PBT margin (%) 14.3 15.0 16.4 19.6 19.8 Exceptional gain/(loss) (0.2) (0.6) (2.5) 0.0 0.0 Net profit margin (%) 10.1 10.3 11.5 13.7 13.9 Pretax profit 19.9 21.9 30.2 38.5 44.0 Effective tax rate (%) 29.5 31.5 30.0 30.0 30.0 Tax (5.9) (6.9) (9.1) (11.6) (13.2) ROA (%) 13.8 10.9 7.5 6.5 7.4 Minority interest 0.0 0.0 0.0 0.0 0.0 Core ROE (%) 25.0 18.8 12.3 8.9 9.7 Net profit 14.0 15.0 21.2 27.0 30.8 ROCE (%) 29.0 22.6 16.3 12.3 12.7 Dividend payout ratio (%) 11.9 13.8 44.5 48.9 43.5 Balance Sheet Statement FYE 31 Dec (RMm) 2016A 2017A 2018E 2019E 2020E Liquidity Fixed assets 5.7 5.4 8.7 8.4 8.2 Current ratio (x) 2.6 2.4 1.2 1.4 1.7 Other long term assets 2.0 2.0 263.5 258.5 253.5 Op. cash flow (RMm) 2.9 7.1 38.0 38.8 35.7 Total non-current assets 7.6 7.4 272.2 266.9 261.7 Free cashflow (RMm) 2.0 2.5 36.6 37.3 34.0 FCF/share (sen) 0.6 0.8 7.9 7.5 6.9 Cash and equivalents 41.1 45.3 50.6 50.7 49.1 Debtors 72.7 88.0 80.7 86.3 97.3 Asset management Other current assets 3.7 8.6 8.6 8.9 9.6 Debtors turnover (days) 165.5 201.4 160.0 160.0 160.0 Total current assets 117.5 141.9 139.9 146.0 155.9 Stock turnover (days) 26.5 40.5 40.5 40.5 40.5 Creditors turnover (days) 77.0 81.5 81.5 81.5 81.5 Creditors 18.2 24.7 23.6 26.3 29.2 Short term borrow ings 17.1 20.5 79.2 62.2 45.2 Capital structure Other current liabilities 10.4 13.4 12.6 14.0 15.4 Net gearing (%) net cash net cash 9.4 3.4 net cash Total current liabilities 45.6 58.6 115.4 102.5 89.8

Long term borrow ings 0.6 0.9 0.9 0.9 0.9 Other long term liabilities 0.2 0.6 0.6 0.6 0.6 Quarterly Profit & Loss Total long term liabilities 0.9 1.5 1.5 1.5 1.5 FYE 31 Dec (RMm) 3Q17 4Q17 1Q18 2Q18 3Q18 Shareholders' Funds 78.7 89.2 295.2 309.0 326.3 Revenue 37.4 41.1 34.0 55.1 53.8 Operating expenses (33.1) (31.0) (29.0) (43.1) (39.2) Cash Flow Statement EBITDA 4.2 10.1 5.0 11.9 14.6 FYE 31 Dec (RMm) 2016A 2017A 2018E 2019E 2020E Depreciation (0.4) (0.4) (0.4) (0.4) (0.5) PAT 14.0 15.0 21.2 27.0 30.8 EBIT 3.9 9.8 4.6 11.5 14.1 Depreciation & amortisation 1.4 1.4 6.6 6.7 6.9 Net int income/(expense) (0.0) (0.0) 0.0 (1.6) (1.5) Working capital changes (12.7) (7.2) 5.4 (1.9) (7.3) Associates' contribution 0.1 (0.0) 0.1 0.1 0.1 Others 0.1 (2.1) 4.9 7.0 5.3 Forex gain/(loss) (0.0) (0.0) (0.1) 0.0 0.0 Cashflow from operation 2.9 7.1 38.0 38.8 35.7 Exceptional items (0.0) (0.6) (2.5) 0.0 (0.6) Capex (0.9) (4.6) (1.4) (1.5) (1.7) Pretax profit 3.8 9.0 2.1 10.0 12.2 Disposal/(purchases) 0.1 0.1 0.0 0.0 0.0 Tax (1.0) (3.0) (1.3) (3.1) (3.0) Others (0.4) 5.1 (270.0) 0.0 0.0 Minority interest 0.0 0.0 0.0 0.0 0.0 Cash flow from investing (1.2) 0.6 (271.4) (1.5) (1.7) Net profit 2.8 6.0 0.9 6.9 9.1 Debt raised/(repaid) (2.6) (3.2) (58.7) 17.0 17.0 Core net profit 2.9 6.7 3.4 6.9 9.7 Net interest income/(exp) (0.9) (0.1) (4.1) (6.2) (4.5) Dividends paid (1.7) (2.1) (9.4) (13.2) (13.4) Margins (%) Others 26.8 (1.5) 311.0 (34.8) (34.8) EBITDA 11.4 24.6 14.6 21.7 27.1 Cash flow from financing 21.7 (6.9) 238.7 (37.2) (35.7) PBT 10.3 22.0 6.3 18.1 22.6 Net profit 7.6 14.7 2.6 12.5 17.0 Free Cash Flow 2.0 2.5 36.6 37.3 34.0 Source: Bloomberg, Affin Hwang

Affin Hwang Investment Bank Bhd (14389-U)

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Equity Rating Structure and Definitions

BUY Total return is expected to exceed +10% over a 12-month period

HOLD Total return is expected to be between -5% and +10% over a 12-month period

SELL Total return is expected to be below -5% over a 12-month period

NOT RATED Affin Hwang Investment Bank Berhad does not provide research coverage or rating for this company. Report is intended as information only and not as a recommendation

The total expected return is defined as the percentage upside/downside to our target price plus the net dividend yield over the next 12 months.

OVERWEIGHT Industry, as defined by the analyst’s coverage universe, is expected to outperform the KLCI benchmark over the next 12 months

NEUTRAL Industry, as defined by the analyst’s coverage universe, is expected to perform inline with the KLCI benchmark over the next 12 months

UNDERWEIGHT Industry, as defined by the analyst’s coverage universe is expected to under-perform the KLCI benchmark over the next 12 months

This report is intended for information purposes only and has been prepared by Affin Hwang Investment Bank Berhad (14389-U) (“the Company”) based on sources believed to be reliable and is not to be taken in substitution for the exercise of your judgment. You should obtain independent financial, legal, tax or such other professional advice, when making your independent appraisal, assessment, review and evaluation of the company/entity covered in this report, and the extent of the risk involved in doing so, before investing or participating in any of the securities or investment strategies or transactions discussed in this report. However, such sources have not been independently verified by the Company, and as such the Company does not give any guarantee, representation or warranty (expressed or implied) as to the adequacy, accuracy, reliability or completeness of the information and/or opinion provided or rendered in this report. Facts, information, estimates, views and/or opinion presented in this report have not been reviewed by, may not reflect information known to, and may present a differing view expressed by other business units within the Company, including investment banking personnel and the same are subject to change without notice. Reports issued by the Company, are prepared in accordance with the Company’s policies for managing conflicts of interest. Under no circumstances shall the Company, be liable in any manner whatsoever for any consequences (including but are not limited to any direct, indirect or consequential losses, loss of profit and damages) arising from the use of or reliance on the information and/or opinion provided or rendered in this report. Under no circumstances shall this report be construed as an offer to sell or a solicitation of an offer to buy any securities. The Company its directors, its employees and their respective associates may have positions or financial interest in the securities mentioned therein. The Company, its directors, its employees and their respective associates may further act as market maker, may have assumed an underwriting commitment, deal with such securities, may also perform or seek to perform investment banking services, advisory and other services relating to the subject company/entity, and may also make investment decisions or take proprietary positions that are inconsistent with the recommendations or views in this report. The Company, its directors, its employees and their respective associates, may provide, or have provided in the past 12 months investment banking, corporate finance or other services and may receive, or may have received compensation for the services provided from the subject company/entity covered in this report. No part of the research analyst’s compensation or benefit was, is or will be, directly or indirectly, related to the specific recommendations or views expressed in this report. Employees of the Company may serve as a board member of the subject company/entity covered in this report.

Third-party data providers make no warranties or representations of any kind relating to the accuracy, completeness, or timeliness of the data they provide and shall not have liability for any damages of any kind relating to such data.

This report, or any portion thereof may not be reprinted, sold or redistributed without the written consent of the Company.

This report is printed and published by: Affin Hwang Investment Bank Berhad (14389-U) A Participating Organisation of Bursa Malaysia Securities Berhad

22nd Floor, Menara Boustead, 69, Jalan Raja Chulan, 50200 Kuala Lumpur, Malaysia.

T : + 603 2142 3700 F : + 603 2146 7630 [email protected]

www.affinhwang.com

Affin Hwang Investment Bank Bhd (14389-U)

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