Investment Highlights

• We are still positive on construction, but risk premium has risen. While maintaining our OVERWEIGHT stance on the construction sector, we are mindful that the market is pricing in a higher risk premium, which is weighing down share prices of construction stocks. We believe the slight de-rating of the sector has been triggered largely by the surprised move by MRT Corp to introduce a "build and finance" model for MRT3 that gives an upper hand to foreign contractors with strong financial backing from their governments, i.e. the Chinese and Japanese. Not helping either is investors' increased cautiousness towards construction stocks ahead of the 14th general election, as construction stocks are generally perceived to be vulnerable to policy changes. After the MRT3 news, share prices of sector bellwether Gamuda and IJM Corp fell as much as 5.9% and 7.5% to RM4.77 (1-year low) and RM2.97 (2-year low) respectively.

• The "build and finance" model. The model is not new to Malaysia. Among large-scale projects which were carried out via a similar model in recent years include the RM4.5bil Second Penang Bridge and the RM1.3bil Pahang-Selangor Raw Water Transfer Tunnel project. According to media reports, the Second Penang Bridge was built by China Harbour Engineering Company (partnering UEM) with US$800mil (RM2.7bil based on the prevailing exchange rate then) 3% 20- year soft loan from the EXIM Bank of China. On the other hand, the Pahang-Selangor Raw Water Transfer Tunnel project was constructed by Shimizu and Nishimatsu (partnering IJM Corp and UEM) and it was reported that the project was 50% funded with 1% soft loan from the Japan Bank for International Cooperation. Fast forward to the present day, the media reported that the EXIM Bank of China will provide a 20-year soft loan for 85% of the project cost of the RM55bil East Coast Rail Link (ECRL), currently being undertaken by China Communications Construction Co (CCCC).

• Local boys to move down the food chain? Realistically, under the "build and finance" model, a foreign contractor is very likely to emerge as the main contractor for MRT3. MMC-Gamuda, who has effectively been the main contractor for the MRT1 and MRT2 projects (by virtue of its capacity as the project delivery partner for the elevated section and tunnelling contractor for the underground section), would now have to settle for a lesser role. Similarly, first-line subcontractors to MMC-Gamuda in the MRT1 and MRT2 projects such as IJM, Sunway Construction and WCT, will see themselves dropping by at least one rank in the food chain too.

• We understand that in the case of the ECRL, the Chinese main contractor CCCC has subdivided the project into a number of large packages and awarded all but one to its subsidiaries. The subsidiaries, which are effectively the first-line subcontractors to CCCC, will then subdivide their respective work packages further and parcel out part of them to Malaysian contractors. In other words, Malaysian contractors can only, at best, become second-line subcontractors to CCCC for the ECRL project. There is only one exception to this scenario, that is if CCCC decides to award the remaining large package directly to a Malaysian contractor.

• Typically, when a contractor moves down the level of subcontracting, the value and hence the margins for the contract tend to go south correspondingly. This could be negative for the local construction industry as a whole.

• Mitigating factors. The saving grace is during a media briefing on 13 Nov 2017, MRT Corp CEO Datuk Seri Shahril Mokhtar was quoted as saying that local firms have not been denied "the leading role" for the MRT3 project, as they are allowed to "partner with eight (foreign) firms". Also, he was reported as saying that "one of the requirements (for foreign firms to bid for the MRT project) is to have local and bumiputera participation."

• Earnings prospects still strong. While seemingly negative, we do not believe the latest development warrants a downgrade to the construction sector. The sector's earnings prospects remain strong with most players sitting on record order books, thanks to the rollout of the Pan Borneo Sarawak highway (RM16bil), MRT2 (RM32bil) and LRT3 (RM12bil) in recent years. The players' order backlogs could only go up further over the medium term with another wave of mega projects including the Pan Borneo Sabah highway (RM12.8bil), ECRL (RM55bil) and Kuala Lumpur – Singapore highspeed rail (RM50-60bil). In the basic infrastructure space, the government remains committed to spending on roads, bridges, schools, hospitals, public housing, water and electricity supply. Under Budget 2018, despite financial constraints, the gross development expenditure has been kept at 2017's level of RM46bil.

• Key risks. These include: (1) the Government is to embark on an austerity drive, resulting in mega and basic infrastructure projects being scaled down, postponed or cancelled; (2) escalation in key input costs, particularly, steel and labour; (3) liquidated and ascertained damages (LADs) due to late delivery (arising from labour shortage, delays in construction site handover, construction site mishaps, unforeseen ground conditions, challenges in relocation of utilities and traffic diversion); and (4) legal disputes with clients, subcontractors or suppliers.

• Our top BUYs for the sector. They are Gamuda (expertise in tunnelling and resilient property profits), Sunway Construction (involvement in all key mega projects such as the MRT2 and LRT3, and recurring internal jobs), Kimlun (supply of concrete segments to rail projects including potentially the ECRL and attractive valuations) and Protasco (recurring incomes from road maintenance concessions and attractive dividend yield).

Source: AmInvest Research - 16 Nov 2017