We make no changes to our NEUTRAL sector weight for 2023. Post GE15, there are uncertainties over the timing of mega infra rerating catalysts. Meanwhile, our cumulative CY23 earnings forecast sees growth at a muted 2.8%. Despite this, sector valuations are undemanding at 12.1x forward P/E (5 year mean) and 0.6x P/B (-1SD 5 year range). Key catalysts include MRT3 news flow and contract wins. Risks: MRT3 cancellation, prolonged elevated materials prices, labour shortage and political instability. Top picks are Gamuda (BUY; TP: RM4.15) and SunCon (BUY; TP: RM1.83).

Review of 2022. At the time of writing, KLCON’s YTD performance in 2022 is -2.2% in absolute terms. Things look better on a relative basis faring better than KLCI performance at +4.2%. Bear in mind KLCI’s performance has been partly dragged by poor performing glove stocks. For the KLCON, one key factor that led to this performance is strong YTD share price performance from index heavyweight Gamuda, driven by successful diversification into Australia, MRT3 news flow in 1H22, toll monetisation resulting in special divvy and strong earnings (MRT2 buffers and Vietnam property recognition). To the contrary, other stocks were largely lacklustre due to weak contract flows, meagre earnings performance – hit by inflation and labour shortage and domestic orientation augmented political risks leading to heavier de risking seen.

11M22 job flows. As at 11M22, domestic contract awards were flattish at -1.9% (vs 11M21) coming in at RM15.9bn. However, we expect the negative gap to widen for full year comparison basis in view of GE15 disruptions. Public sector jobs were impacted by a dissolved parliament while private sector project awards were kept on hold until GE uncertainty passes. After a dry 1H22, 3Q22 saw big projects like Rasau (RM2.0bn), MRT3 - PMC (RM998m) and RTS (RM2.7bn) awarded. Looking at the year as a whole, we reckon the significantly volatile and inflationary costs environment has made tenders trickier as most contracts are typically executed on a fixed price basis. While the trend of raw materials costs has stabilised in recent months, materials like cement saw a major leg up in prices in Oct-22 (costs driven) and this tends to further delay project rollouts.

Growth moderates with low base gone. Going into 2023, we expect mild earnings growth as most companies under coverage returned to pre-pandemic run rates in 2QFY22, therefore the higher base of comparison next year is a tougher grind. This is considering a sluggish pace of general contract flows in 2022. For the companies under our coverage, forecasted CY22 cumulative earnings are on course for a 95% increase (vs 2021) given the low base while CY23 cumulative earnings growth is projected to downshift to a 2.8% increase. The slower projected growth comes mainly from a forecasted dip for Gamuda in CY23 due to tolls disposal. Generally, upside risks to CY23 forecasts are quicker-than-expected ramp up of new projects and margin accretion from falling costs.

Budget 2023. Looking at election precedents, the last time Malaysia held an early election in Nov was in 1999 and Budget 2000 was only tabled in Feb-00. Our economics team reckons there could be a possible curtailment in DE from the earlier high of RM95bn which was tabled prior to GE15 (unapproved). The possible revised DE number could come in at ~RM85bn inclusive of USD3bn 1MDB bond repayment. This would translate to flattish “clean” 2023 DE vs projected 2022 DE of RM71.8bn. Going into 2023, given consistent misses in actual DE disbursement over past few years we are not too perturbed by lower headline numbers but rather concern on implementation due to: (i) late approval of Budget-23 and (ii) changes to procurement process may slow job flows. We expect the bulk of DE focus in the upcoming budget to centre on flood mitigation, hospitals, water and various infra projects in Sabah & Sarawak. The fate of the MRT3 will also be revealed in the Budget announcement.

Key catalysts hang in the balance. Newly minted MOT Anthony Loke (while not going into specifics) mentioned that ongoing mega projects in particular the ECRL will continue. The sector’s only near term catalyst, MRT3 however was not specifically green lighted. We believe for a complex mega project under procurement involving an estimated total price tag of RM50.2bn, there could be a review by the new government (our base case). This is considering the much smaller RM11bn DNB project and RM15bn flood mitigation budget are also undergoing their respective review process. We expect a potential 3-6 months review period to push awards to mid-2023 onwards. Our base case of no shelving of the project is also predicated on: i) final loop to KV railway transport and ii) external economic uncertainties next year could result in more domestic pump priming. Longer term catalyst like the HSR project looks to be a back burner issue and unlikely to make a comeback under the current administration.

Operational challenges could slowly dissipate. Ongoing execution problems faced by contractors are labour shortage and wide array of inflationary material costs (see Fig 6 & 7). Some of these factors could stay persistent in CY23. EC recently announced the implementation of higher electricity tariff surcharge of +20 sen/kWh (from +3.7 sen/kWh) to be affected in 1HCY23 - translates to ~+40% hike on electricity costs. We see this as inflationary on critical materials like cement and could lead to sticky ASPs even as other fuel costs taper down (coal etc). On the labour front, we think the new government will prioritise solving labour shortage given its impact on the economy. Based on feedback, most contractors are seeing labour supply coming of late but the numbers are still suboptimal with some guiding for situation to resolve in 1H23. Without pump priming, we think the above timeline is probable. Given such, we think that elevated day wage rates could also start gradually abating thereafter (inflated by 30-80% in 2022). We do not consider the amended Employment Act (effective on 1 Jan-23) as materially inflationary as overriding factor in CY23 will be scale of labour shortage.

Different state, different fate. Post GE15 hung parliament, kingmakers like Sarawak and Sabah have emerged with stronger political leverage. Case in point is the first appointed DPM from Borneo and an expedited restoration of the MA63 agreement. Several beneficial measures are: i) higher share of oil royalties ii) streamlining approval regulations and iii) proposed trust fund for DE allocation. Overall, we see this as translating to stronger development focus in both Borneo states. Sabah and Sarawak was allocated DE of RM6.3bn and RM5.4bn in the previous federal budget; we expect the upcoming Budget to at least match this. We do not anticipate major hiccups to ongoing/new projects like PBH, Kuching ART, SSLR, trunk road and port expansions. Another state which could fare better is Penang but near term developments could be limited to critical raw water and airport expansion projects.

Maintain NEUTRAL. We make no changes to our NEUTRAL sector weight for 2023. Post GE15, there are uncertainties over the timing of mega infra rerating catalysts. Meanwhile, our cumulative CY23 earnings forecasts see growth at a muted 2.8%. Despite this, sector valuations are undemanding with 12.1x forward P/E (5 year mean) and 0.6x P/B (-1SD 5 year range). Key catalysts include MRT3 news flow and contract wins. Risks: MRT3 cancellation, prolonged elevated materials prices, labour shortage and political instability. Our top picks are Gamuda (BUY; TP: RM4.15) and SunCon (BUY; TP: RM1.83) due to their lower reliance on domestic public infra spending.

Source: Hong Leong Investment Bank Research - 21 Dec 2022