We are keeping our NEUTRAL recommendation on the sector in view of a tepid industry’s outlook over the next 12-18 months as orderbook replenishment will be unexciting with lack of catalysts. We believe most of the negatives have been priced in for the big names like GAMUDA and investors can start to bottom-fish the stock given steady dividends (12.0 sen, yield: 4.95%) backed by recurring cash flows from its concession assets. However, we opine that investors should remain selective with the small-mid-cap players due to earnings risk arising from the exposure to MRT2, LRT3 and other government related jobs that might be reviewed. Amongst the small-mid-cap players, we selectively like contractors like KERJAYA and MUHIBAH due to their minimal to zero exposure in MRT2 and LRT3 projects.

Uneventful Budget 2019. We opine that Budget 2019 was uneventful for the construction industry, which came in within our expectations as we did not expect any major allocation for mega public infrastructure development. This is mainly due to the government’s current focus of reviewing public infrastructure projects costing, which we have seen in recent months whereby the government have successfully reduced the overall construction cost for MRT2 and LRT3 by 22% and 47%, respectively. We laud the government for their transparency, speediness and relentless effort in maximizing the value of taxpayers’ money without sacrificing the much-needed development of public infrastructure projects, especially in Klang Valley.

Casualties of change. In terms of share price performance, the construction industry recorded one of the worst performances in recent years as KLCON Index recorded a yearto-date loss of 45% vis-à-vis FBMKLCI’s loss of 5%. Based on our observation, the KLCON Index only fell 38% after 9th May 2018, but its year-to-date performance further worsened to a loss of 45% which we believe to be due to: (i) weak market sentiment amidst the trade war and negative local headlines with regards to the nation’s debt levels, and (ii) the abrupt cancellation and reinstatement of mega infrastructure projects, which further dampened investors’ confidence in the sector due to the uncertainties arising from these cost reviews.

MRT2 and LRT3 to continue, but fewer prospects for contractors. Prior to Budget 2019, the government has given the green light to proceed with the construction of MRT2 and LRT3. The total construction cost of RM30.5b for MRT2 was announced prior to Budget 2019, but the total construction cost for LRT3 of RM11.9b was announced post Budget 2019. Surprisingly, the total construction cost for LRT3 of RM11.9b was higher compared to our assumptions of RM9.0b previously. The construction timeline for MRT2 remains the same, which is scheduled to complete by July 2022, while LRT3 has been rescheduled to Feb 2024 from its initial schedule of Aug 2020. Overall, we expect a negative spill-over effect from the cost review of the turnkey contractors, like GAMUDA-MMC and MRCB-GKENT, as it will have a negative domino effect on the other contractors, especially those that have already started work on these two particular projects (especially LRT3) which completion timeline extended by another 42 months albeit a higher contract value of RM11.9b.

Earnings risk imminent. As highlighted above, we believe that there could be more earnings risk for the Work-PackageContractors (WPC) that are involved in MRT2 and LRT2, underpinned by lower overall construction cost due to reduced scope, coupled with the extension of timeline of 42 months for LRT3 from the original completion date of Aug 2020, which would result in a slower recognition for these contractors. Contractors involved in MRT2 and LRT3 are AZRB, GADANG, ECONBHD, MRCB, SUNCON, TRC, WCT, GBGAQRS, MUDAJYA and others. However, we are unable to ascertain the earnings risks quantum for these WPC at this juncture due to the lack of details on the reduced scope of works, which are likely still pending decisions of the turnkey contractors, i.e. GAMUDA-MMC and MRCB-GKENT. Based on our back of envelope calculation, the earnings risks for these contractors could range between 5-20% depending on the contract size to their outstanding order-books.

Neutral maintained. Currently, KLCON Index is trading at 1-year Fwd. PER of 7.4x which is at 7-year record low which we think provides investors opportunities to bottom fish selectively. We are keeping our NEUTRAL recommendation on the sector in view of a tepid outlook over the next 12-18 months as order-book replenishment will be unexciting and lacking catalysts. We believe most of the negatives have been priced in for big names like GAMUDA and investors can start to bottom fish for the stock given steady dividends (12.0 sen, yield: 4.95%) backed by recurring cash flows from its concession assets. However, we opine that investors should remain selective with the small-mid-cap players due to their looming earnings risk arising from the exposure to MRT2, LRT3 and other government related jobs that might be reviewed. Amongst the small-mid cap players, we selectively like contractors like KERJAYA and MUHIBAH due to their minimal to zero exposure in MRT2 and LRT3 projects.

Source: Kenanga Research - 7 Nov 2018