Investment Highlights

• We cut FY19-21F net profit forecasts by 16%, 15% and 14% respectively, reduce our FV by 19% to RM2.71 (from RM3.34), and downgrade our call to UNDERWEIGHT from HOLD. Our new FV is based on 12x revised CY19F FD EPS of 22.6 sen (from 13x 26.2 sen previously), in line with our benchmark forward target P/E of 11-13x for large-cap construction stocks. The earnings downgrade is to reflect the government’s termination of MMC-Gamuda as the tunnelling contractor for the MRT2 project.

• The government over the weekend made some major decisions with regards to the MRT2 project:

1. It has accepted an offer from MMC-Gamuda, the former project delivery partner (PDP) for the project, to complete the above-ground (elevated) portion of the project as a turnkey contractor for RM17.42bil, which is equivalent to a reduction of RM5.22bil or 23% from the original cost of RM22.64bil; but
2. It has terminated MMC-Gamuda as the contractor for the underground (tunnelling) portion of the project, and the unfinished work will be retendered via an international open tender exercise.

• As at end-FY18 (31 Jul 2018), the above-ground and underground portions of the project were 28% and 37% completed respectively.
• The latest development is highly negative to Gamuda. While the government’s decision on the above-ground portion is consistent with Gamuda’s expectations (i.e. an actual reduction of 23% in terms of cost vs. Gamuda’s previous guidance of 25%, coupled with the expected conversion of the PDP model to a turnkey contract basis), the termination of MMC-Gamuda as the underground contractor came as a complete shock to us. Based on our estimates, the termination will mean a loss of contract to MMC-Gamuda of up to RM10.53bil or 63% of the original contract of RM16.71bil, while for Gamuda’s half share, it will be up to RM5.26bil or 63% of the original value of RM8.36bil.
• We believe Gamuda was guided by the adherence to fiduciary duties it owes to its shareholders in its negotiation with the government with regards to the MRT2 project (and as such, it was under the obligation to walk away from a deal which was not in the best interest of its shareholders). However, as far the market is concerned, apart from the loss of the underground contract, it may also have to decide if the latest episode is an isolated case, or will it put a dent on Gamuda’s prospects of winning major government contracts in future.We remain cautious on the outlook for the local construction sector as the government cuts back on public infrastructure projects on grounds of fiscal prudence. While the rollout of public infrastructure projects will resume over the medium term as infrastructure development remains key to nation-building, we believe the focus will shift to smaller scale/value-for-money basic infrastructure projects such as road upgrading, bridges, schools, drainage, rural water and electricity supply and smallish sewerage schemes, from multi-billion mega projects. The smaller projects are less economical to large-contractors such as Gamuda, given their high fixed overheads. Not helping either, is the uncertainty arising from the potential expropriation of Gamuda’s toll roads.

Source: AmInvest Research - 8 Oct 2018