Surprise Election Outcome

The surprise election outcome with Pakatan Harapan (PH) winning the election led to a knee-jerk sell down in construction stocks. This is due to PH’s manifesto to review infrastructure projects in the implementation stage, which raises the risk of cancellation, variation in scope or postponement. We downgrade the Construction Sector to NEUTRAL from Overweight on these concerns. We also downgrade our call on Gamuda to HOLD from Buy given the heightened risks on order book replenishment and cut target prices for other construction stocks.

Infrastructure Project Review

The new PH government has indicated that it will review infrastructure projects to be implemented, especially those involving loans and investments from China, to ensure the cost is reasonable and will not overly burden the federal government’s financial position. We believe the projects that will likely be affected include the RM55bn East Coast Rail Link (ECRL), RM60bn Kuala Lumpur-Singapore High Speed Rail (HSR), RM45bn Klang Valley Mass Rapid Transit Line 3 (MRT3) and RM9bn Gemas-Johor Bahru Electrified Double Tracking Rail (EDT) projects.

Likely Postponement or Cost Reduction of Certain Projects

Given that ECRL project has been awarded to China Communication Construction Co. Ltd (CCCC), we believe the project is unlikely to be cancelled to ensure the sanctity of government contracts is preserved. However, the implementation of the project could be staggered to reduce the government’s loan obligations, ie, the more viable Port Klang-Kuantan Port stretch could be implemented first. The implementation of MRT3 and HSR could be postponed to reduce the government’s financial burden.

Downgrade Gamuda to HOLD

Given the risk that HSR and MRT3 that Gamuda is pursuing could be affected, we cut our EPS forecasts by 7-16% in FY19-20E assuming no new contracts. We downgrade our call on Gamuda to HOLD from Buy with a reduced RNAVbased TP of RM4.42. We cut our target prices and EPS forecasts for selected construction companies in our universe to reflect the de-rating of the sector and future order book replenishment risks.

Downgrade to NEUTRAL

We downgrade the Construction Sector to NEUTRAL from Overweight due to concerns on delays in implementation of infrastructure projects slowing the companies order book replenishment prospects. We switch our top BUYs to IJM Corp for large-cap (previously Gamuda), Suncon for mid-cap (previously MRCB) and HSS for small-cap picks, favouring apolitical companies.

Re-prioritise Implementation of Projects

We believe the new government will likely re-prioritise the implementation of projects to reduce the foreign borrowings and contingent liabilities from government-guaranteed bonds to be issued to finance infrastructure projects. Government revenue will be reduced from its plan to abolish GST while operating expenditure will increase to compensate concessionaires for its plan to abolish toll collection on highways gradually and introduce petrol subsidies to targeted groups. Deferring the implementation of infrastructure projects to cap the federal government deficit during this period of adjustments in government policies.

Rail Projects to be Reviewed

PH has indicated that it plans to review public-sector projects to ensure transparency in contract awards that will likely lead to delays in the implementation of planned projects such as the MRT3, EDT, ECRL and HSR. In particular, projects awarded to Chinese contractors will be reviewed under PH’s manifesto. The RM55bn ECRL and RM9bn EDT were awarded to Chinese contractors under government-to-government agreements previously. The Exim Bank of China also offered a 20-year soft loan to finance 85% of the cost for ECRL.

LRT3 and MRT2 to Continue

We believe ongoing projects such as the LRT3 (George Kent-MRCB JV), MRT2 (MMC Gamuda JV) and ECRL (China Communications Construction Co. Ltd) will continue as PH will likely have to preserve the sanctity of contracts awarded by the government to ensure Malaysia’s international sovereign ratings are not adversely affected. However, the implementation of the project could be staggered with reduced scope of works to reduce cost. In summary, there will be delays in new infrastructure project implementation that will affect the medium-term prospects of the construction sector.

Likely to Scale Down ECRL and Delay MRT3

We believe the development of the railway network nationwide will remain a priority to improve inter-city and intra-city connectivity, and expand freight cargo transportation using train services. The Port Klang-Kuantan Port stretch of ECRL and EDT will complete the East-West and North-South railway connectivity in Peninsular Malaysia, which we believe will proceed. The MRT3 Circle Line project will connect the lateral rail lines in Klang Valley, which is important to improve public transport ridership. However, we believe the project implementation could delayed to ease the financing burden of the government given the ongoing MRT2 and LRT3 projects.

ECRL and EDT Delay Risks

The possible delays/cancellation of these projects will be negative for HSS and Lafarge, which have been awarded subcontracts for ECRL and YTL Corp, which was reported to have been awarded subcontracts for EDT. The risk of cancelling of these projects is it will adversely affect Malaysia’s good relationship with China that led to Malaysia being a major beneficiary of China’s Belt and Road Initiative. Hence, it is more likely that these projects could be delayed in implementation or scaled down rather than cancelled in our view. We understand that WCT, AQRS and IJM Corp were bidding for subcontracts for the ECRL and hence there will order book replenishment and earnings forecasts risks for these stocks if the implementation ECRL is delayed or scaled down.

Order Book Replenishment Concern for Gamuda

We gather that Gamuda has ceased discussions with CCCC for an ECRL subcontract. It secured a Letter of Appointment as PDP for the HSR north section. Since a PDP agreement is still pending to be signed, there is a risk that the implementation of the project could be postponed. Although Gamuda is a frontrunner for the MRT3 project together with CCCC, the implementation of the project could be postponed. We assumed some of these projects will be secured to meet our new contract assumption of RM10bn in FY18E in our EPS forecasts. However, its high estimated current order book of RM13.5bn (RM6.9bn as main contractor, RM6.6bn as PDP) will sustain modest earnings growth ahead.

HSR Delay Risks

MRCB Gamuda Consortium and YTL THP JV Sdn Bhd received Letters of Appointment (LOA) to be the Project Delivery Partners (PDP) for HSR infrastructure works in Malaysia. Since the PDP contracts have not been signed, it is uncertain whether the PH will review the terms stipulated in the LOA or the project implementation could be delayed. Since HSR is a Malaysia-Singapore government-to-government project, the Singapore government will need to be consulted for any variation from the initial scheduled completion by 2026.

Gamuda Faces Uncertainties on Its Concessionaire Stakes

We believe the stalemate on the potential sale of SPLASH could be resolved in the medium term as the federal government and Selangor state government are both controlled by PH following the recent election. There is still uncertainty on the new price to be offered for SPLASH (previously at Price/book of 0.1x). PH has also stated that it intends to abolish highway tolling gradually with fair compensation to concessionaires. Gamuda’s stakes in toll road concessions face restructuring uncertainties.

Downgrade Gamuda to HOLD From Buy

Gamuda was appointed the Project Delivery Partner (PDP) for the north section of the HSR. We gather that it is also the frontrunner for the MRT3 project. Given the risk that the implementation of the projects could be delayed, we remove our assumption of RM10bn new contracts to be secured in FY18E and cut our EPS forecasts by 7-16% in FY19-20E. Assuming lower sustainable earnings of RM260m instead of RM400m and lower valuation for its 40% stake in SPLASH at estimated Price/book of 0.9x (also removed 3-year accumulated earnings in book value), we cut our RNAV-based target price to RM4.42 (applying a 10% discount to RNAV) from RM5.85 previously. We downgrade our call on Gamuda to HOLD from Buy.

Significant Cut in TP for WCT and AQRS

We downgrade cut WCT’s TP to RM1.31 based on 50% discount to RNAV from RM2.36, based on 20% discount to RNAV, given the risk of slower order book replenishment and delay in restructuring its property segment. We downgrade lower AQRS’ TP to RM1.48 based on 30% discount to RNAV from RM2.25 based on 10% discount to RNAV, given the order book replenishment risk as it is vying for ECRL subcontracts (EPS cut by 9-12% in FY18-20E). Maintain BUY as valuations are attractive following the correction in share prices. We upgrade our call on WZ Satu to HOLD from Sell following the share price correction to below our TP of RM0.45, based on 10% discount to RNAV.

Long-term Positive for Efficient Contractors

Long-term prospects will likely remain positive for efficient contractors with strong track records as they will be competitive in bidding for contracts through open tender, eg, Suncon, WCT and IJM Corp, which is professed by PH. After a review of projects, we believe most of the railway projects planned will likely go ahead as these projects will improve intra-city and inter-city public transport connectivity. PH will likely push ahead with the Penang Transport Master Plan (PTMP) that will benefit the Gamuda-led consortium that has been appointed as PDP.

Uncertainties on Abolishment of Toll Roads Gradually

Under its manifesto, PH will review toll concessions with the view of taking them over and abolishing tolls gradually if it takes over the government. Affected companies will be compensated fairly according to its manifesto. There will be uncertainties for listed companies with toll road concessions, which include Gamuda, MRCB, IJM Corp, Ekovest, Taliworks, Litrak and AZRB. They will lose the toll collection income if the concessions are taken over and there are uncertainties on the price to be paid by the government. There was an instance in the past that the PH-led state government of Selangor offered to take over the concessions for Sungai Selangor Water Supply Scheme Phase 1 and 3 from SPLASH at Price/book of 0.1x instead of offering a price based on DCF valuation, which is generally viewed as a fair method of valuation for long-term concessions.

Attractive Valuations Following Knee-jerk Sell Down

Pakatan Harapan’s (PH) win in GE14 led to a knee-jerk negative reaction for the construction stock prices (down 10-30% yesterday) due to uncertainties in government policies. Stocks with high foreign shareholdings such as Gamuda and IJM Corp (>30%) saw selling pressure. We believe some small-cap stocks, such as WCT, AQRS and HSS, seem oversold and PER valuations are attractive. Most of the construction stocks are trading close to the 1sd below mean 12-month forward PER.

Source: Affin Hwang Research - 15 May 2018