Investment Highlights

• We maintain our NEUTRAL weighting on the local construction sector as the government cuts back on public infrastructure spending on grounds of fiscal prudence.

• Having tracked the government’s measures on public infrastructure projects and spoken to various players in the industry since the 14th general election (GE14), we have identified several key trends (or potential key trends) in the local construction sector:

1. The government has not dialled back from its austerity drive on public infrastructure projects. This is despite its decision to carry on with several mega infrastructure projects, namely the MRT2, LRT3 and Pan Borneo Highway in Sarawak (while deferring the KL-Singapore High-Speed Rail). We believe the key rationale is, given that these projects have already hit the ground with substantial progress, it could be costly to cancel them (in some instances, it may cost more to cancel the projects than to complete them, given the huge amount of compensation the government has to fork out to the contractors in the event of contract termination). At present, the completion of the MRT2, LRT3 and Pan Borneo Sarawak Highway already stands at 10–20%, 10% and 25% respectively. There was talk of the government having some flexibility in deferring the RM12.8bil Pan Borneo Highway in Sabah. Works Minister Baru Bian was quoted as saying in the parliament that thus far, only 12 out of the 35 packages of the Pan Borneo Highway project in Sabah have been awarded. We gathered from sources that the progress on these 12 ongoing packages is still fairly preliminary with an average completion of only about 5%.

2. The return to the “fixed price” model from project delivery partner (PDP). The government is replacing the existing PDP contract for the LRT3 project with a “fixed price” one (and in the absence of any indication to the contrary, it appears that the PDP MRCB-George Kent JV is prepared to go along with it). We believe the rationale is twofold. Firstly, it helps to cut cost by doing away with the fixed PDP fee amounting to 6% of the contract value (which means instead of a fixed fee, the contractors now make a spread equivalent to the difference between the project value and cost). Secondly, it will shield the government from cost overrun (including additional costs arising from delays) as the cost overrun risk is then carried directly and entirely by the contractors (as compared with only a formula-based “penalty” imposed on the contractors, while the government bears the full brunt of the cost overrun under the PDP arrangement). For the contractors, it means the contract is less lucrative, but with higher risks. There is a risk that the government may apply this model in other ongoing mega public infrastructure projects such as the MRT2 (which will impact its PDP, namely, MMC-Gamuda JV) and Pan Borneo Highway in Sarawak (which will affect its PDP, i.e. Lebuhraya Borneo Utara Sdn Bhd [LBU]).

3. Lopsided China contracts to be resolved via the G-to-G route. The government has suspended the RM67bil East Coast Rail Link (ECRL) led by China Communications Construction Company Ltd, as well as two oil & gas pipeline projects, one each in Peninsular Malaysia and Sabah, with a combined value of RM9.4bil led by China Petroleum Pipeline Bureau. The oil & gas pipeline projects comprise: (1) a 600km multi-product pipeline linking Melaka/Port Dickson to Jitra, Kedah; and (2) the 66-km Trans-Sabah Gas Pipeline linking Kimanis to Sandakan/Tawau. All three projects are 85% funded with China Exim Bank borrowings. These projects have been marred by irregularities, particularly, excessive upfront payments to contractors. For the ECRL project, the main contractor has been paid a “mobilisation fee” of RM10bil, equivalent to 15% of the project value of RM67bil, which is very high as compared with the industry norm of 5%. For the pipeline projects, a total sum of RM8.25bil, equivalent to 88% of the project value, has been disbursed despite the projects being only 13% completed. Given that these deals may involve elements beyond commercial terms, the government will seek an amicable solution through government-to-government (G-to-G) negotiations.

4. Priority for small-scale/value-for-money projects, not mega projects. Over the medium term, while we have no doubt that the rollout of public infrastructure projects will resume as infrastructure development remains key to nation building, we believe the focus will shift from multi-billion mega projects 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. The smaller projects are less economical to large contractors such as Gamuda, given their high fixed overheads.

5. Open bidding to promote healthy competition. The introduction of a more transparent public procurement system under the new administration should weed out rent-seekers, paving the way toward healthier competition within the local construction sector. Against a backdrop of a more level playing field, we believe highly efficient and costeffective contractors such as IJM Corp, Sunway Construction and WCT should do well over the longer term.

• 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). We are cutting our call on Kimlun to HOLD from BUY as its upside potential is exhausted following the recent recovery in share price.

Source: AmInvest Research - 9 Aug 2018