Reiterate OVERWEIGHT on the Construction sector as prospect remains bright driven mainly by multi-billion ringgit public infrastructure and government-backed mixed development projects under the Economic Transformation Programme (ETP). So far, ETP is seen to be progressing well. For instance, KVMRT1 construction has already hit the half-way point to completion and quite a number of RAPID Pengerang jobs have already been awarded to contractors. In the near term (next 3-6 months), the sector will continue to be supported by news and contract flows from the remnants ETP projects namely the RM25b KVMRT2, remaining RM89b RAPID-related infrastructure projects, RM20b urban highways, RM40b KL-Singapore HSR, RM26b TRX Financial District, and RM7b redevelopment of Pudu Jail. We reiterate our big-cap top pick Gamuda (OP; TP: RM5.52) as we reaffirm our view that Gamuda will be the biggest beneficiary from M&A activities and KVMRT2 news flow in 4Q14. Meanwhile, we switch our small-mid cap top pick to Muhibbah (OP; TP: RM3.55) from Mitrajaya (TRADING BUY; TP: RM1.13) as we expect the former to benefit from the RAPID infrastructure project’s progress.

KL Construction keeps outperforming KLCI. The KL Construction Index performed relatively well since 9 months ago. YTD, (up to 19th September 2014), the KL Construction Index has outperformed the benchmark KLCI Index, advancing 8.8% YTD against KLCI’s loss of 0.9% YTD. Muhibbah was the top gainer (+34.6% YTD) amongst all contractors in our universe thanks to their O&G-related job flows coupled with positive news flow from RAPID Petronas. Second winner was IJM Corp, up +11.3% YTD thanks to its growth strategy via M&A activities i.e. IJML privatisation, SILK Holdings. Meanwhile, Kimlun and Eversendai were the top losers so far in our construction space as both stocks were dragged down by disappointing earnings.

Quarterly earnings review and outlook. Out of 9 stocks under our coverage, 6 of them were within expectations while the remaining 3 missed estimates namely WCT, KIMLUN and SENDAI. Overall, most of them performed within expectations YoY and QoQ except for the 3 stocks mentioned above following weaker-than-expected billings and margins. Of these 3, SENDAI had the biggest downward revision (-61%) for FY14 estimates due to timing issues of its construction billings and weak margins. Going forward, while we do not expect any earnings suprises, we expect construction stocks’ 2H14 earnings to perform better than 1H14 because of the absence of festive season coupled with orderbook progress. All in, we estimate aggregate earnings for construction stocks under our coverage to grow by 16% and 19% in FY14 and FY15, respectively.

Major news/events in 3Q14. To recap, almost all the major news/events which happened in 3Q14 were within our expectations such as RAPID infrastructure projects’ series of contract flows, more East Coast’s basic infra projects being dished out to contractors, development of KL-Singapore’s HSR, pre-qualification of TRX project’s infrastructure works, and the launching of RM27b Penang Integrated Master Plans’ Request For Proposal (RFP).

Budget 2015 to focus on transportation infrastructure and affordable housing. We take a view that the government will continue to announce some projects under Economic Transformation Programme (ETP) given its duration slated for 10-year plan (from 2010 to 2020). Hence, amongst the projects that we expect the government to highlight in the upcoming Budget 2015 (this month) are as follows: (i) the RM25b KVMRT2, (ii) 7 new urban highways, (iii) TRX projects, and (iv) PR1MA housing project.

What to expect in the next 3-6 months? In the near term (next 3-6 months), we expect the sector to continue to see more news flows from the remnants ETP projects namely RM25b KVMRT2, RM20b urban highways, RM27b Penang Integrated Transport Master Plan, RM30b KL-Singapore HSR, RM26b TRX Financial District, and RM7b redevelopment of Pudu Jail as well as job flows from the remaining Petronas’ RM89b RAPID packages, WCE’s open tender packages, infrastructure jobs (water and roads) in Sarawak, and some property projects from private sector/GLCs.

Sector’s valuation still at mean level since May 2014. Valuation wise, KL Construction Index is still hovering at its mean level (13.6x Fwd PER), since May 2014. Recall, in 2009-2010, the sector’s fwd-PER was trading at +1SD - +2SD level i.e. 15.5x – 17.4x thanks to the introduction of the 10-year plan of ETP. As for now, with (i) key ETP projects (e.g. KVMRT1, LRT extension, RAPID,) progressing well with more mega projects soon to be executed (e.g. KVMRT2, KL-Singapore HSR, new highways, Greater KL mixed development’s TRX and Bandar Malaysia) which will continue to benefit contractors, (ii) contractors’ healthy current order book with visible earnings for at least next 2 years, and (iii) strong earnings growth (higher than benchmark’s KLCI Index’s earnings growth), it is justified that the sector’s valuation should mirror 2009-2010 level i.e. 15x-17x fwd-PER in the near-medium term (3-12 months).

Source: Kenanga