We reiterate our OVERWEIGHT stance on the Construction sector based on the following investment thesis; (i) contractors’ orderbook replenishment prospects are still bright driven by the recently-approved RM6.0b WCE highways, infrastructure-related projects in the regional corridors, particularly SCORE and ECER, O&G-related projects and PPP/PFI projects, (ii) significant pipeline flows namely the RM25b MRT2 pending Cabinet’s approval and the RM60b RAPID project’s final investment decision (FID) progress, which are expected to materialize soon in the next 1-3 months, and (iii) the government’s effort (i.e. GST, subsidy rationalisation) to address the fiscal position issues mitigate the concern of the government’s ability to finance the mega projects. We reaffirm our view that big-cap contractors such as IJM (OP; TP: RM6.60) and GAMUDA (OP; TP: RM5.25) are poised to benefit from these anticipated contract flows. We believe IJM will benefit the most from the recently-approved WCE construction while GAMUDA will gain from the mega RM25b MRT2 project’s approval from the government. Hence, our Top Picks remain GAMUDA and IJM. In addition, we like both stocks due to their strong fundamentals backed by business diversification, healthy order-books and growing property sales. Interestingly, in our view, these big-cap contractors’ valuations have yet to be fully-priced in. We also favour MUHIBBAH (OP; TP: RM3.00) and NAIM (OP; TP: RM4.45) for RAPID FID progress and Sarawak’s SCORE positive news flows.

Results review and outlook. Most of the contractors’ 3QCY13 earnings disappointed the market with 7 out of 10 under our coverage missed expectations. Top 3 worst hit were MRCB (unexpected loss due to huge provisions), Eversendai (“SENDAI”) (un-finalised VO claims resulted in very low profit of RM1.4m) and BANALEC (first ever quarterly losses due to slow construction progress and delay in land sale recognition). Nonetheless, big cap contractor IJM’s earnings came in within expectations despite a poor performance in its plantation division. The same goes for GAMUDA’s recent 1Q14 results (FYE: July) which came in within our expectations thanks to the steady MRT1 progress and strong property sales. Furthermore, MUHIBAH’s 9M13 earnings delivered as per our estimates, making up 76% of our earnings forecasts. All in, 3QCY13 was the worst quarter for most contractors under our coverage except for the big caps namely IJM and Gamuda. Going forward, we estimate aggregate contractors’ earnings in 2014 to rise by 43% driven by their healthy unbilled orderbook of more than RM30b.

2014 new contracts prospect. A quick flashback for 2013; we did not see any big or major projects being awarded as was the case in 2012 (driven by MRT1). We estimate that only RM17.8b actual new contracts had been awarded in 2013, which is far lower than that of RM34b in 2012. We believe the muted contract flows in 2013 was due to the 13th General Election. Going forward, as the Klang Valley is saddled with active and heavy construction activities, the focus could shift outside the Klang Valley. Amongst the big projects (more than RM1.0b) that we believe to have higher chances to be awarded in 2014 (likely in 2H) are WCE highway (fully approved already), RAPID’s infrastructure projects as well as regional corridors’ infrastructure works (Kuantan Port, East Coast Highways, SCORE infrastructure in Samalaju, Tg Manis, Mukah). Hence, we anticipate about RM22b worth of new contracts to be awarded in 2014; 24% higher than that of 2013 new contract awards.

2014 Budget’s measures favour construction sector. The government unveiled the Budget 2014 in October 2013 which it is going to spend RM44.5b for the development expenditure. Although it is slightly lower than the RM45b in Budget 2013, the government at the same time was announcing some measures meant to address the fiscal position issues such as the implementation of GST and subsidy rationalization. Although GST will be implemented in 2015, the government has already initiated other fiscal measures such as the subsidy rationalisation (i.e. petrol, sugar) and electricity tariff hike, which may provide some buffer to the government spending in 2014. Therefore, this will mitigate the concern of mega projects being shelved or postponed further, in our view.

Meaningful news flows will materialize soon. Key events for the construction sector in the near-term, i.e. next three months include the government’s approval for the RM25b MRT2 project and RAPID’s FID progress. Government’s approval of the RM25b MRT2 project means continuity of contract flows coming from the project in the foreseeable future for GAMUDA (tunnelling contractor and project manager for MRT1) and other existing MRT1 contractors such as IJM (OP; TP: RM6.60), SUNWAY (OP; TP: RM3.08), AZRB (NR), GADANG (NR), NAIM (NR), TRC (OP; TP: RM0.62) and MUDAJAYA (NR). Meanwhile, we reckon O&G/Petronas-related contractors such as MUHIBBAH (OP; TP: RM3.00), EVERSENDAI (MP; TP: RM1.26) and GADANG will benefit from RAPID project’s progress. Elsewhere, we reaffirm our view that the Sarawak contractors namely NAIM (OP; TP: RM4.45), HSL (NR) and CMSB (NR), are amongst the beneficiaries from the continued Sarawak growth story, particularly SCORE.

Construction stocks outperformed the benchmark index

So far in 2013 (up to 20th December 2013), the KL Construction Index has outperformed the benchmark KLCI Index, advancing 15.8% YTD against KLCI’s gain of 8.6% YTD. Muhibbah Engineering (+181.2% YTD) is still the winner amongst contractors in our universe. Investors continued to appreciate Muhibbah due to its bright prospects as a flexible contractor that could undertake various job scopes in various sectors, including infrastructure, marine-related, and O&G. Second place winner Naim Holdings, went up by +105.1% YTD thanks to encouraging earnings performance by its associate, Dayang Enterprise. Meanwhile, Benalec and MRCB are the top losers so far in our construction space which we understand were dragged down by negative sentiments (i.e. MRCB: PJ Sentral court tussle, huge provisions, Benalec: corporate governance issues, un-delivered earnings).

Maintain OVERWEIGHT, All in, we reiterate our OVERWEIGHT stance on the Construction sector based on the following investment thesis; (i) contractors’ orderbook replenishment prospects are still bright driven by recently-approved RM6.0b WCE highways, infrastructure-related projects in the regional corridors particularly SCORE and ECER, O&G-related projects and PPP/PFI projects, (ii) significant project flows namely the RM25b MRT2 which is pending Cabinet approval and RM60b RAPID project’s final investment decision (FID) progress are expected to materialize soon in the next 1-3 months, and (iii) the government’s effort (i.e. GST, subsidy rationalisation) to address the fiscal position issues mitigate the concern of the government’s ability to continue spending for the mega projects.

BUY big caps. We reaffirm our view that big-cap contractors such as IJM (OP; TP: RM6.60) and GAMUDA (OP; TP: RM5.25) are poised to benefit from anticipated contract flows in 2014 as mentioned above. We believe IJM will benefit most from the recently-approved WCE construction while GAMUDA will gain from the mega RM25b MRT2 project’s approval from the government. Hence, our Top pick remain GAMUDA and IJM. In addition, we like both stocks due to their strong fundamentals backed by business diversification, healthy orderbook, and growing property sales. Interestingly, in our view, these big-cap contractors’ valuations have yet to be fully-priced in.

Favouring other news flows beneficiaries. We also favour MUHIBBAH (OP; TP: RM3.00) and NAIM (OP; TP: RM4.45) for RAPID FID progress and Sarawak’s SCORE positive news flows. GAMUDA (OP; TP: RM5.25). The stock had been weakening after: (i) the failed 4th attempt by the Selangor state government to takeover all the Selangor water assets including the Group’s 40%-owned, SPLASH and (ii) concerns of the US Federal Reserve tapering due to the

stock’s high foreign shareholdings content. Nonetheless, these issues have no impact on Gamuda’s strong fundamentals, hence, the selling is just a knee-jerk reaction, in our view. We like GAMUDA as: (i) it has clearer earnings visibility with KVMRT (i.e. RM3.5b tunnelling project and RM11.0b PDP scope for the remainder packages) jobs in hand and strong unbilled property sales of RM1.7b, (ii) it has brighter replenishment orderbook prospect for the next 10 years with the roll-out of KVMRT Line 2 and 3, and more importantly, (iii) its valuation is still cheap where we think the stock should trade above its 5-year historical average of about 17.3x due to its strong fundamentals. The key announcements that should be closely-watched in the near term are: (i) MRT2 project’s approval from the Cabinet and (ii) the re-negotiation of the Selangor’s water asset restructuring.

IJM (OP; TP: RM6.61). Finally, the WCE highway project has been fully-approved by the government and the concessionaire WCESB can start the construction works. As mentioned previously, we believe IJM will be the biggest beneficiary for the highway implementation where: (i) the highway will top-up its orderbook at least RM4.0b on its existing RM3.0b, (ii) its 62-% owned subsidiary, IJM Land (OP; TP: RM3.15) is currently developing the new township worth RM11b GDV spanning over 1878ac in the Kota Kemuning area next to the WCE highway, (iii) the highway will keep its industry division busy supplying quarry products and concrete piles to the highway, and (iv) the highway will bring another stream of recurring income in the foreseeable future (estimated to be completed and ready in 2016) to IJM as it currently effectively owns 38% of the highway operator, WCESB (i.e. direct stake of 20% of WCESB and 22% of KEuro). Once the WCE highway’s financing is concluded, the stock value should gravitate to our SoP valuation, in our view. Besides Gamuda, IJM, Muhibbah and Naim, we maintain our OUTPERFORM calls on TRC SYNERGY (TP: RM0.62), BENALEC (TP: RM1.25). We are also maintaining our MARKET PERFORM calls on WCT (TP: RM2.50), EVERSENDAI (TP; RM1.26), MRCB (TP: RM1.59). KIMLUN (TP: RM1.93).

Long-term orderbook replenishment prospect for contractors

As for the next 10 years, we see a lot of opportunities for contractors in terms of orderbook replenishment prospect. These contracts will come from the remaining ETP and 10MP projects which include:

Infrastructure - Railway. The government has so far shown great commitments in developing railway infrastructure. It has committed billions in building railways including; double tracking, LRT extensions (RM7.0b) and MRT1 (RM23b). Going forward, we understand the government will continue to expand and upgrade the country’s railway tracks. The projects, among others, are: MRT2 and MRT3 (combined value of about RM60b), Johor Rapid Transit (RM3.0b) KL – Singapore High Speed Railway (RM30b), Southern Double Track (Gemas –JB) (RM8.0b), KVDT upgrades (RM850m), LRT3 extensions (RM5.0b), East Coast Region Railway (RM30b) and KL Monorail extension (RM3.0b). These could all amount to a total contract size of more than RM100b.

Infrastructure - Highway. At the same time, Malaysia is poised to expand its expressway. Recently, West Coast Expressway Sdn Bhd (WCESB) (80:20 of KEuro:IJM) had received a green light from the government to commence the RM6.0b WCE highway spanning from Banting- Taiping. Other highway projects also saw Ahmad Zaki Resources Bhd (AZRB) winning the second circle highway of RM1.55b East Klang Valley Expressway (EKVE) highway. Moving forward, there will be more highways to be built especially in the Klang Valley such as Kinrara-Damansara Expressway (Kidex) (RM2.5b), SUKE (RM3.5b) and DASH (RM2.5b). In addition, we also understand that the government has already approved the RM16.0b upgrading of the 3000km Pan Borneo highway (Sabah to Sarawak).

Infrastructure - Water. It was widely reported that a water treatment plant will be built in Hulu Langat (Langat 2) to complete the Pahang-Selangor Raw Water Transfer that is currently on-going with 65% completion (tunnelling). The project is estimated to cost RM1.2b and it will be awarded once the Selangor’s water restructuring is completed.

Oil and Gas-related projects. The imminent O&G projects which will benefit the contractors is the RM60b Petronas petrochemical plants in Pengerang, Johor. We understand the initial works (land clearance, earthworks), which was awarded to Gadang, is on-going. There will be more packages to be awarded by Petronas such as Phase 2 of earthworks, cogeneration power plant, water treatment plant and other basic infrastructure in the area.

Mixed Development projects. To recap, there are few mixed development projects that are already in the pipeline such as Tun Razak Exchange (RM20b) and KWASA’s Rubber Research Institute land at Sungai Buloh (RM10b). Also, WCT secured one of the 3 packages of earthwork in TRX worth RM169m in April 2013 vs. the total earthwork packages which has an estimated value of RM1.2b – RM1.5b.

Source: Kenanga