We maintain our NEUTRAL weight on the sector remaining cautious due to ongoing execution risks, margin pressure, labour situation and possible event risk in 2H. Jobs flows in 1H22 are poor but MRT3 coming in by year end could remedy the situation although there are delay risks. The KLCON index trades at a forward P/E of 12.1x (~5 year mean). Key catalysts: MRT3 and quick revival in other job flows. Downside risks: political uncertainty, project delays and execution. Our top pick is SunCon (BUY, TP: RM1.84).

Review of 1H22. KLCON’s performance in 1H22 is lacklustre with absolute performance coming in at a mere +0.9%. Nonetheless, with an even poorer KLCI performance, the sector clocked in a decent relative performance of +6.7%. While sector index performance was largely in-line with KLCI for most of 1H, the sector started surging in mid-March (largely big cap driven) catalysed by: i) MRT3 news flow and ii) BN’s strong showing in Johor state elections capturing 71% of seats (12 Mar). We believe the latter was a key factor in significantly reducing perceived political uncertainty risk which helped the sector rally. The sector topped out in late April-22 and has since substantially tapered back gains for 1H22. We attribute this to profit taking, broad market weakness and weak 1Q earnings. Overall, 1H22 index performance is tracking somewhat similarly to the run-up periods for GE13 & 14, peaking early in the year (see Fig 3). While the past may not be an accurate barometer for the future, it does indicate a potential for a lacklustre performance in 2H22 as political risks comes to the fore.

1H22 job flows: really poor. Jobs flows were weak in 1H22 amounting to only RM4.5bn (-49% YoY). The average sizes of contracts were also notably smaller compared to the year before. We reckon the significantly volatile and inflationary costs environment has made tenders trickier as most contracts are typically executed on a fixed price basis. On a sequential basis, contracts awards in 2Q22 was disappointing falling a further -22% QoQ. The quarter saw major price hikes in cement while fuel and premix materials crept up higher. Dissecting 2Q22 further, the contract sizes were smallish mainly featuring lamp post and replacement type jobs.

Could finish strong. Despite a beleaguered jobs flow situation in 1H22 – we believe caused by relentless inflationary pressure and labour shortage – we continue to expect recovery in flows this year mainly driven by the MRT3 rollout in Dec-22. Given that its PFI based, risks of delays to foot high subsidies (this year) may not be substantial. Based on industry checks, the three civil turnkey contracts could carry a total value of RM27bn. Civil tender briefings were held recently and factoring in the evaluation period, we think that Dec-22 is a reasonable timeline (assuming no GE in between). Thereafter, we would expect a string of subcontract awards in 1Q23. Given that the minimum payment moratorium period is two years, contractors with better balance sheets are significantly advantaged in tenders. Prior to the aforementioned mega job, we would anticipate ECRL, Kuching ART and snippets from various highway projects including in East Malaysia. The EIA for the PSR project was also recently resubmitted in May but progress to be award ready could be further down the road.

No let-up in operational challenges. Based on 1Q22 earnings, margins for some contractors have fallen significantly with some carrying margin markdowns. Given how persistent costs pressures have been, we expect such weakness to remain. Some private sector contracts do have risk sharing clauses while public sector contracts with design flexibility have built in escalation clauses. However, we believe a majority of contracts are on a fixed lump sum basis. Additionally, the costs benchmark used in claiming VOs lags the actual costs escalation, in our view. We also flagged the lapsing of Covid-19 relief VOP period (31 Dec-21) which covers government projects. Another source of uncertainty is dwindling labour supply as replenishment has been slow to come by. We believe this would lead to further upward pressure on labour rates as the situation looks to remain unresolved for the remainder of this year (wages are above min. RM1.5k/month since last year). This poses further challenges in the MRT3 rollout considering the scale of the project. There is a potential for crowding out labour for non-MRT contractors.

Maintain NEUTRAL. We retain our sector NEUTRAL weight on two key reasons: (i) soaring materials costs (impacts job flows and margins) and (ii) possible event risk in 2H22. We continue to expect sector coverage earnings to recover this year but we flag rising concerns over deteriorating labour shortage situation. Sector valuations are fair trading at 12.1x forward P/E and 0.7x P/B (see Fig 6 & 7).

Preferred picks. Within the mid cap space we prefer SunCon (BUY, TP: RM1.84) due to (i) strong balance sheet; (ii) extensive track record of infrastructure projects and (iii) strong support from parent-co. Around 20% of its construction orderbook has built in cost escalation clause.

Source: Hong Leong Investment Bank Research - 13 Jul 2022