Construction stocks could have reached an upward inflection point, judging from the sector’s mini rally last week which coincided with announcements relating to mega projects LRT3 and TRX. The sector’s valuation has been overly bearish with the market pricing in significant downward revisions of ongoing mega project contract values, and has probably re-rated merely on the government giving the go-ahead for some projects. Valuations should gradually price in option values for future mega projects. Maintain MARKET WEIGHT on the sector.

WHAT’S NEW

• Re-pricing in option values. Before last week’s recovery, construction stocks were overly sold down by 25-60% post the general election and most of the stocks are currently trading well below our fundamentally assessed trough valuations (see overleaf RHS). As valuations have turned overly bearish, it now appears that investors are drawing positive readings from last week’s announcements relating to the LRT3 and Tun Razak Exchange (TRX). It has been announced that these key mega projects will still proceed and contract beneficiaries with perceived links to the previous government will not be displaced.
• Key mega projects still going ahead. The Ministry of Finance (MoF) has announced that the LRT3 project is to proceed at a lower price tag of RM16.6b (from RM31.6b). Additionally, TRX, through Lendlease, has dished out a new contract award to develop a mixed development project worth RM555m to WCT.

ACTION

• Maintain MARKET WEIGHT. Selected infrastructure-related stocks are compelling. While values have emerged with the sell-off of most construction stocks post GE14, we view the government’s confirmation to proceed with mega projects like LRT3 as a positive sign in the construction sector, followed with momentous discussions on the ECRL project which is expected to proceed subject to better terms. Also, the market had thumped construction counters badly while ignoring sector positives which include: a) sustainability of strong earnings with orderbook cover of 2.1x–7.4x (for stocks under our coverage); b) easing of raw material prices like cement prices which will improve overall margins; and c) likelihood of mega projects continuing. However, we have factored in a lower orderbook replenishment assumption (excluding job wins from mega projects like ECRL, MRT3 and HSR) to factor in uncertainty in the sector’s outlook at the moment. We like contractors with clear catalysts (ie strong orderbooks, key beneficiaries of mega projects which are expected to continue, ie ECRL) such as Gabungan AQRS (GAQRS) and Gamuda.

ESSENTIALS

• Adverse impact from LRT3 scale down announcement. The proposed LRT3 scale down measures include: a) to reduce the number of car trains ordered, from 42 sets of 6-car trains to 22 sets of 3-car trains; b) downsizing of the LRT depot; c) LRT stations specification to scale down to follow Kelana Jaya line specifications; d) reduction in the number of stations (from 26 to 20 stations); e) cancelling the 2km underground line; and f) overall LRT construction/completion has been delayed by another four years to 2024 instead of 2020. We expect companies badly hit by the announcement are GAQRS (station removal), IJM Corp (underground tunnel cancellation) and WCT (station removal). Stations to be removed were expected to see construction costs in the range of RM100m-RM400m/station (depending on size) while the cancelled tunnel package was worth RM1.1b
• PDP model changed to “fixed price” contract… Additionally, the government has proposed to restructure the PDP model to a “fixed price contract” with MRCB-GKENT. A contact price will be fixed and will not be subject to cost overruns. Details of this contract are yet to be disclosed.
• but impact is partly mitigated. While definitive official orders are yet to be made by the government, we understand the affected companies may continue with substructure works for shelved stations instead of an absolute cancellation. Meanwhile, the underground rail stretch in Shah Alam will be substituted with an elevated rail, which may halve IJM’s contract value for the LRT3. As such we are keeping our earnings forecast unchanged for companies such as WCT Holdings, IJM, Sunway Construction and GAQRS, pending better clarity on the real situation.
• Government has signalled that mega projects under review will go ahead. Pending the government’s review of mega infrastructure projects and a definitive official decision, selected mega projects are expected to proceed. The government announced on 22 June that the controversial East Coast Rail Link (ECRL) project is expected to proceed, subject to better terms such as: a) lower construction cost, b) better direct and indirect participation of Malaysian companies; and c) a large first progress payment of RM20b being paid out to contractors. Meanwhile, the proposed Pan Borneo Highway Sabah (PBHS) is expected to proceed as infra developments (ie basic road connectivity) in Sabah are relatively well behind compared to that in Peninsular Malaysia. In addition, the current ongoing construction of the Pan Borneo Highway in Sarawak would complement the future development of PBHS as it provides seamless connectivity between these two East Malaysia states and would lead to an economic multiplier effect in these two states.
• MRT3 development to go ahead, followed by HSR. Amid the financial burdens faced by the current government, we expect the MRT3 project to receive the go-ahead to proceed from the federal government on the basis it provides essential connectivity to both MRT1 and MRT2. We expect construction costs can be halved to RM20b with revised specifications (ie smaller underground line portion). Meanwhile, the MoF has hinted that the HSR project will continue if the development costs can be reduced significantly.
• Key beneficiaries from revival of proposed mega projects. Companies like GAQRS are expected to benefit from the continuation of the ECRL and PBHS projects as the company has strong ties with the respective counterparties in both Pahang and Sabah, while Gamuda will be the clear winner (great expertise in rail-related projects like the MRT1 &2) if Putrajaya decides to approve the MRT3 development. Also, the future HSR development is expected to benefit companies like Gamuda, IJM and Sunway Construction.
• Gradual pick-up in construction contract awards post general election. The recent contract awarded to WCT for the development of the TRX is a positive sign for the sector, demonstrating that the new government is committed to pursuing mega projects which are beneficial for the country and that contract beneficiaries with perceived links to the previous government would not be replaced. We strongly believe the review of mega projects will continue, subject to better terms that benefit Malaysia moving forward.

Source: UOB Kay Hian Research - 17 Jul 2018