We maintain our NEUTRAL view as the sector still lacks of fresh catalyst and continues to be bogged down by uncertainties due to the review of mega infrastructure projects, which is taking longer than expect. However, we believe that it is a good opportunity to buy on weakness/bottom fish selectively given that KLCON is currently trading at a lower level of 9.3x which below their 5-year -2SD levels. We choose GAMUDA (TP: RM4.30) as our Top Pick this time around for its long proven track record in the industry coupled with its attractive valuation, which is at trough level at 5-year -2SD levels, and MUHIBAH (TP: RM4.15) for their overseas exposure from which the bulk of its earnings are coming from its associate, i.e. Cambodian Airport, which has continued to register double-digit passenger growth.

Mild recovery in big-caps. At our report cut-off date of 21-Sep-2018, the average capital gains for stocks under our coverage continued its downtrend, registering a negative return of 4.8% for the quarter compared to the negative return of 22.0% in 2QCY18. While it is still registering QoQ negative returns, we deem that it is still better compared to 2QCY18 as the big-caps, especially names like WCT have seen recovery of 13.0% compared to a plunge of 39.0% in 2QCY18. In 3QCY18, the big-caps registered positive average return of 3.6%, while small-mid caps extended their losses by another 11.8%, QoQ as investors switched their attention to the big-caps for more stability in earnings. (Refer to Appendix for details).

Plagued by uncertainties. Since GE14, negative news flows have clouded the construction sector with uncertainties on job replenishment prospect for the next two years, coupled with the review of project cost on mega infrastructure projects like MRT2, and LRT3 yet that are yet to be concluded. Year-to-date, KLCON performance is down by 36% compared to KLCI’s gain of 0.8%, weighed down by most of the contractors as highlighted in our previous strategy report with minimal signs of recovery due to prolonged uncertainties. We believe that in the medium term, i.e. 9-12 months, conclusion on the project costs for both MRT2 and LRT3 would be positive to the sector, albeit at a lower sum as we believe that the negative news flow on lower project cost has been priced in. Furthermore, contractors can continue with their work progress on the above mention projects reducing potential earnings risk.

Results review. We saw weaker performances in 2QCY18 compared to 1QCY18. Out of 11 construction stocks within our coverage, 6 contractors disappointed and 5 came in within/broadly within in 2QCY18 which was more disappointing vis-à-vis 1QCY18 which only saw 2 disappointments. The 6 contractors that disappointed were SENDAI, HSL, KERJAYA, KIMLUN, MITRA and SUNCON. Reasons for the disappointment in earnings for the stocks mentioned above are largely due to: (i) slower billings affected by festive season, (ii) slowdown in infrastructure projects due to GE14, and (iii) lower-than-expected margins due to higher billings of lower margin projects/products. Ytd-YoY, bulk of the contractors registered CNP growth ranging from 1-62%, except for HSL, KIMLUN and MITRA, which saw declines in CNP by 4-65% due to: (i) slower progress billings, and (ii) lower contribution from other divisions i.e. overseas contribution or other divisions like property development.

In terms of earnings revision, we reduced the sector FY18-19E earnings by an average of 9.1-6.3% during the 2QCY18 reporting season review driven by the reduction in earnings for seven stocks within our coverage as a result of: (i) reduced order-book replenishment, (ii) pushed-back progressive billings, and (iii) lower margin assumptions from construction, manufacturing and property development. The companies that saw reduction in earnings are as follows: SENDAI, HSL, IJM, KERJAYA, KIMLUN, MITRA, and SUNCON. Note that the sector’s average earnings downgrade of 9.1-6.3% in 2QCY18 does not include our recent downgrade in earnings for GAMUDA and GKENT as they just recently released their results post 2QCY18 reporting season.

Contract award slower than expected. For 9M18, the total contracts win by the listed contractors amounted to RM12.7b (excluding management contract signed by MRCB of c.RM18.4b), a drastic drop of 42% YoY, which is still short of our optimistic expectations of RM20-30b as project reviews took longer than expected. As we move into 4QCY18, we reckon that contract flows will remain sluggish and contracts secured by listed companies might only reach RM15.0b at best by year-end driven by projects like the development of Tenaga’s office block in Bangsar. Hence, we would be anticipating for more downside risk in earnings, especially when project cost review for MRT2 and LRT3 are currently underway.

Valuations. Despite the lack of catalyst and uncertainty in the sector, we believe the sell-down in the sector is overdone as KLCON is currently trading at only 9.3x which is below 5-year -2SD levels while most contractors’ outstanding order-book are at all-time high, which would easily provide 2-3 years earnings visibility that will help them weather through these tough times. To recap, KLCON’s valuation touched a 5-year low of 8.6x back in July 2018. That aside, KLCON’s Fwd. PER discount factor to FBMKLCI has also widened to 47.6% to below 5-year -3.0SD level from its peak of +2SD level at premium factor of 1.5%. Hence, we believe that at these levels, the negative news flows for the sector have been fully priced in and present a good opportunity for bottom fishing.

Sector risks. Our major concerns for the sector remain the same, i.e. labour issue, high staff turnover, especially midmanagement, which could hurt profitability as the demand for human capital in the sector grows is leading to higher overheads for contractors, escalating building material costs, and also more project cancellations, reviews or delays. That said, contractors’ earnings are also at the risk of project cost review carried out by the government currently; i.e. MRT2 and LRT3, which is already on-going.

NEUTRAL view maintained. We maintain our NEUTRAL call on the sector due to the persisting uncertainties; especially on the cost review for MRT2 and LRT3 as contractors are unable to continue to work on the project in full-swing and any further delay in concluding the cost would result in higher operating cost for contractors arising from idling cost coupled with the lack of direction in policy. Nonetheless, we maintain our view as highlighted in our previous strategy that we believe that this would be a great opportunity to bottom-fish as most of the contractors have seen minimal recovery from sell-down post GE14, which placed valuations at attractive levels, especially when most contractors' outstanding orderbooks are currently at all-time high. However,

we are highly selective with our picks in the space and only feature names like GAMUDA the leading contractor in Malaysia as our Top Pick given that its valuation is at trough level at 5-year -2SD levels; even if we factor in RM8.0b potential cost reduction for MRT2 (Refer to GAMUDA report dated 2 Oct 2018 for earnings sensitivity), GAMUDA’s FY19E PER would inch up from 9.8x to 10.3x (or still between the -1.0SD to -2.0SD levels which is still compelling. For investors wanting safer bets or less domestic exposure, MUHIBAH would be an ideal choice in the sector as we like them for their overseas exposure from which bulk of its earnings (>80%) are coming from its associate, i.e. Cambodian Airport, which has continued to register double-digit passenger growth.

Source: Kenanga Research - 5 Oct 2018