On the whole, we maintain our NEUTRAL weight on the sector despite rosy headline DE numbers under Budget-21 due to ongoing execution risks. We remain cautious on weak earnings fundamentals, unpredictable political landscape and stiffer competition for jobs. Sector catalysts are likely to be delayed vs expectations, MRT3 included. The KLCON index trades at a forward P/E of 11.9x. Key catalysts: 12MP/Budget-22, MRT3 and quick revival in job flows. Downside risks: political fragility as state of emergency lapses and slow project rollout. Our top pick is SunCon (BUY, TP: RM1.87).

Review of 1H21. KLCON performed roughly in-line with the KLCI in 1H21 (absolute: - 10.2%; relative: -4.4%). Challenging dynamics like: (i) fluid politics, (ii) MCO2.0 & 3.0, (iii) surging material prices (50% surge in steel prices) and (iv) missing earnings expectations (1Q21 earnings generally met 10-16% of full year estimates); were counterbalanced by MRT3 news flow and recovery optimism tilt. Dissecting KLCON’s 1H by constituents, sector heavyweight, IJM has outperformed the KLCON/KLCI by 14.9%/10.5% respectively riding on its earnings beat and IJMP monetisation. Overall, from an earnings standpoint we continue to see downside risks to FY21-22 street estimates from: (i) movement restrictions, (ii) margin markdown, (iii) slow jobs replenishment and (iv) labour shortages. Our aggregate FY21-22 numbers are - 14.1%/-9.5% lower than consensus after slashing aggregate coverage earnings by 12.7%/-9.7% previously in addition to a 15-30% cut during results review in May.

1H21 job flows decent but uninspiring... In 1H21, admittedly our recovery expectations at the start of 2021 have not panned out with a vicious revival in Covid19 cases. This resulted in companies under our coverage merely replenishing in the range of nil-44% of annual expectations. Our tracking of contract awards to listed contractors also reveal that sequential recovery momentum from Covid-19 lows appears to have stalled this quarter (-18% QoQ). Larger contract sums awarded in 1H21 were for WTP jobs (more beneficial to niche water players), affordable housing jobs and last section of WCE. While lumpy contract awards in 2H21 could still materialise with tender outcomes potentially back loaded, earnings recognition would be delayed relative to forecasts. Additionally, we now anticipate fierce competition if and when projects do rollout considering the jobs vacuum since Covid-19. As such, new projects even assuming full normality à la pre-Covid-19, should see margins clock in much lower.

...should pick up with vaccination progress. Despite difficulties spelled out above, we draw comfort from an accelerating pace of inoculation (>250k/day). Given such, we believe in due time, the federal government would revitalise their economic revival playbook addressing the infrastructure projects outlined in Budget-21. One such priority project is the MRT3 (RM33bn; assuming similar cost/km with MRT2) to be implemented over five phases spanning 10 years; tenders by end 2021 at the earliest, in our view. Despite a larger than anticipated project value (c.30% larger), sectorial earnings impact p.a. is roughly 34% lower with double the execution period. We foresee cut throat competition for above ground portions (RM13bn) but lesser scale for underground sections (RM20bn) given scarcity of tunnelling expertise coupled with likely emphasis on local content. Apart from the MRT3, we hope to see contracts like hospital, bridges, roads and water projects as highlighted in Budget-21 finally move but are less likely to benefit bigger players given smaller contract sums. Other mega projects like PTMP and PBH Sabah seems to have hit a snag further delaying initial rollout targets. By our estimates, order book for stocks under coverage has declined by between -17% to -54% since GE14 necessitating a speedier rollout of new mega projects, which at this point seems to be solely MRT3.

Impact of National Recovery Plan. Broadly speaking, we are positive on the recovery plan as it could lead to a more sustainable recovery path but also indicates more pain for the remainder of 2021 against our initial expectations. While restrictions will be relaxed to 80% cap in Phase 2 (from 60%), the ongoing labour and materials shortages could continue to drag operations. Rather than focusing on the degree of relaxation we are more concern on labour intake developments. To recap, under Phase 1, we gather contractors under coverage are able to selectively restart projects with varying degrees. Nonetheless, this has also been completely derailed by the EMCO imposition in selected areas. Some contractors have noted the irrelevance of the 60% cap resulting from ongoing labour crunch. Additionally, current suspension of quarry operations and steel/cement industries at “warm idle”, we foresee lingering supply chain issues persisting into Phase 2 as more sites reopen and materials suppliers having destocked in Phase 1.

Maintain NEUTRAL. On the whole, we maintain our NEUTRAL weight on the sector despite rosy headline DE numbers under Budget-21 due to execution risks and possible redirection of allocation. We remain cautious on weak earnings fundamentals, unpredictable political landscape and stiffer competition for jobs. Contractors with bigger balance sheet are better positioned for PFI driven projects given constraint fiscal space. The KLCON index trades at a forward P/E of 11.9x. Key catalysts: 12MP/Budget-22, MRT3 and quick revival in job flows. Downside risks: political fragility as state of emergency lapses and slow project rollout.

Top Pick. SunCon (BUY, TP: RM1.87) due to (i) strong balance sheet; (ii) extensive track record of infrastructure projects and (iii) strong support from parent-co. The stock is a safer bet considering on-going difficult conditions. The company’s ability to secure overseas contracts provides some comfort should domestic rollout continue to suffer.

Source: Hong Leong Investment Bank Research - 13 Jul 2021