Investment Highlights

• Following the downgrade of our recommendations on most construction companies under our coverage following the 14th general election (GE14), we formally cut our weighting for the construction sector to NEUTRAL from OVERWEIGHT. We are cautious on the outlook for the sector on the heels of the government’s cutbacks on public infrastructure spending on grounds of fiscal prudence.
• Already, the government has decided to put on hold various projects under planning, ranging from the multi-billion Kuala Lumpur-Singapore high-speed rail (HSR) and MRT 3, to small jobs such as sports clubs and a RM180mil contract to repaint public housing units in Kuala Lumpur.
• While ongoing projects are likely to be spared the axe, they could be scaled down, and the government may renegotiate the contract terms with their respective project delivery partners (PDP) and contractors to boost savings. We believe these include the East Coast Rail Link (ECRL), Tun Razak Exchange (TRX), Gemas-Johor Bahru electrified double tracking, Pan Borneo Sarawak Highway, MRT 2 and LR T3.

• We expect a lull in construction activities in the immediate term. Apart from fiscal prudence, the roll-out of public projects, irrespective of size, could also be held back by administrative issues. This is because the decisions made by the preceding administration may be overturned, and the projects may be sent back to the drawing board. Also, the introduction of a more transparent public procurement system (the abolishment of directly-negotiated contracts) will open up the sector for greater competition, resulting in lower margins for players.

• The expropriation of toll roads, if it happens, will hurt construction companies with toll road concessions such as Gamuda and IJM Corp. While toll road concessionaires are entitled to compensation in the event of expropriation, our analysis shows that, for the successful toll roads especially, the compensation (which is generally calculated based on a predetermined return on equity) only amounts to a fraction of the discounted cash flow (DCF) value of the toll roads.

• We may upgrade our NEUTRAL call on the sector to OVERWEIGHT if the government decides to pump-prime the economy with public projects in the event of external shocks such as an unexpected slump in the global economy.

• We may downgrade our NEUTRAL call on sector to UNDERWEIGHT if: (1) the government is to cancel major ongoing projects that make up substantial order backlogs of players, such as the MRT2, LRT3 and Pan Borneo Sarawak Highway, without providing adequate compensation; and (2) the national debt is to stay elevated over a prolonged period of time, limiting the government’s ability to spend on public infrastructure projects.

• We are upgrading our call on Kimlun back to BUY from HOLD as we believe the selldown on the stock post-GE14 has been overdone. At present, the stock trades at 6x FY19F fully-diluted EPS, which is below our benchmark forward target P/E of 7-9x for small-cap construction stocks.

• Our top picks for the sector are Gamuda (HOLD) (the long delayed Penang Transport Master Plan project may finally get off the ground) and Sunway Construction (HOLD) (ability to compete on an open tender basis and recurring building jobs from parent Sunway Bhd) and Kimlun (BUY) (sustained earnings despite the cutbacks on local public jobs as it depends largely on private sector building jobs, coupled with recurring orders for its precast concrete products from Singapore).

Source: AmInvest Research - 18 Jun 2018