Investment Highlights

• NEUTRAL. We are neutral as there is a risk of margin compression resulting from higher building material costs together with delays or revisions in the scale of projects under a new unity government. Our top BUY is Kimlun with an upside of 40%. We like Kimlun for its attractive 5.8x FY23F, below our 9x benchmark for construction stocks and decent dividend yield of 2.1%.
  We may upgrade the sector if the government accelerates the implementation of projects or companies’ operating profit margins improve on lower costs. Alternatively, we may downgrade the sector if the compression in operating margin is worse-than-expected coupled with the shelving of mega projects.

• Our top ESG pick is Gamuda. Gamuda has earmarked RM2bil to invest in domestic and international renewable energy (RE) within 5 years. The investments could entail several types of RE sources, not just on solar, such as developing hydro pump projects in Australia. Gamuda announced the acquisition of a 30% stake in ERS Energy. ERS is a solar photovoltaics (PV) engineering, procurement, construction and commissioning (EPCC) and systems integrations company. ERS Energy is also Gamuda’s JV Partner in NEDA Pekan to develop a 39MW (29.99 MWac) solar power plant under the New Enhanced Dispatch Arrangement (NEDA) framework. This would help Gamuda grow its RE asset portfolio to over 800MW over the next few years. Gamuda Land has also entered into a strategic partnership with Tenaga Nasional (TNB) to build 2 electron stations – powered by rooftop solar – for electric vehicle (EV) charging in property development projects in Selangor.
  Earlier this year, Gamuda Cove’s masterplan design received a 5 diamond recognition from the Environment and Water Ministry in collaboration with Malaysian Green Technology and Climate Change Centre at the Low Carbon City 2030 Challenge. This recognition underscores Gamuda’s approach to ESG principles under the Gamuda Green Plan 2025.

• Slower job flows in the near-term. The awarding of government related projects such as MRT3 may see delays in the nearterm. For example, MRT3 was supposed to be awarded in Oct 2022. With the recent change in government, we believe that the award of main packages and sub-contracts may be delayed until 2H2023. According to the Construction Industry Development Board (CIDB), contracts awarded up to Nov 2022 amounted to RM118bil in total. On an annualised basis, this was 3% lower than the RM133bil awarded in 2021. Going forward, we expect a recovery in job flows, especially smaller projects in East Malaysia and West Peninsular Malaysia.

• Adoption of open tenders. We believe that government jobs will be awarded through open tenders in the future. This will lead to fierce competition as contractors have to submit competitive bids to win jobs. Smaller contractors, especially subcontractors may face margin compression.

• Budget 2023 will be tabled in 1Q2023. PM has signalled that Budget 2023 (to be tabled earliest in Jan 2023) would be largely intact. Also, the risk of cost revision for projects under PFI structure is low.

• Potential revision of government projects. The Prime Minister (PM) has ordered a review of flood mitigation projects worth RM7bil as approvals were given without undergoing tender process. We view this negatively as it raises concerns over the future of projects that have not been awarded or projects that were awarded through direct negotiations. Also, there is risk that projects that were awarded may be downscaled. In 2018, the Pakatan Harapan government slashed the cost for MRT 2 by RM8.8bil, or 22% to RM30.5bil. While we do not expect the downward adjustment to be as significant this time as building material costs have gone up, a reduction of 15% will lower the value of the MRT 3 project from RM34.3bil to RM29.2bil.
  The RM7bil is part of the RM15bil long term flood mitigation plan from 2023F to 2030F. According to Budget 2023, some of the projects under the flood mitigation plan include RM500mil for the construction of Sabo Dam at 46 locations across the country, RM2bil for dual-purpose reservoir – flood mitigation & water supply – along Sungai Klang and Sungai Rasau, Selangor and RM500mil for Integrated River Basin at Sungai Golok, Kelantan. 
  A mitigating factor is that on-going construction projects will not be affected. According to Transport Minister Anthony Loke, the government will continue with projects that are in progress. As ECRL was reviewed twice, the government is not looking to amend it and will allow ongoing construction activities to continue.

• Operating margins may face compression due to volatile building material costs. Steel prices in Central Peninsula slid by 28% to RM3,132/tonne in Oct 2022 from a peak of RM4,344/tonne (Exhibit 4) in April. Although China’s easing of Covid- 19 restrictions is expected to support steel prices, we think that prices will remain volatile due to global economic uncertainties.
  As for cement prices, we believe that prices would be high in line with coal prices. According to market sources, cement prices soared 32% to RM22.50/50kg bag in early Dec 2022 from RM17.00/50kg bag from pre-GE15.

• Labour shortages to ease. Contractors, who face labour shortage, have been holding back from bidding for additional jobs due to risk of penalties or damage claims arising from delays in completion. Also, contractors may have to pay more to secure workers to maintain an optimal level of labour force. Nonetheless, we expect labour shortages to ease, allowing contractors to prepare for the rollout of mega infrastructure projects.
  Additionally, DOSM reported that the labour market recovered at a steady pace in 3Q2022, with the unemployment rate falling to 3.7% from 4.7% a year ago.
  We gather that SunCon has obtained approval for 400 Indonesian workers. Out of these, 100 will arrive by the end of the year. Including the existing 100 foreign workers, SunCon’s foreign workforce will amount to 500. In comparison, SunCon had a peak of 800 foreign workers during the construction of MRT2 and LRT3. Kimlun has also obtained approval for 737 foreign workers (comprising Indonesians, Nepalese and Bangladeshis), Out of these, 70 have arrived. The balance will arrive in batches by Mar/Apr 2023, which will bring SunCon’s migrant workforce to 1K (including subcontractors).

• Macro challenges. The government’s fiscal position has been crimped by the economic impact of the pandemic and massive relief spending. Furthermore, national debt remains elevated. Hence, we believe that the future rollout of public infrastructure projects will adopt a private funding initiative structure, which would alleviate immediate capital outlay from the government. This means that contractors would be required to take on additional funding risk in future.

Source: AmInvest Research - 27 Dec 2022