Currently, the construction sector lacks catalyst, and we do not see much infrastructure spending from the government after the major cost reduction in two mega projects, i.e. LRT3 and MRT2. However, the recent heavy sell-down on the sector presents a good opportunity to buy on weakness/bottom-fish selectively given that KLCON is currently trading at a new low of 7.0x PER, at 10-year -3SD levels, a level that is even lower compared to the low during the 2008 financial crisis. Hence, we advocate investors to adopt selective stock picking strategy on stocks that have minimal earnings risk in the near-to-medium term like GAMUDA and KERJAYA. As for our Top Pick, we choose WCT for its ability to constantly win jobs under the current challenging environment, and its weak share price performance as it now trading at a new low at 0.3x FY19E PBV. However, WCT’s high net gearing of 1.00x remains a concern, and we believe that the re-rating catalyst for WCT would strongly lie on their ability to de-gear in the next 12 months to 0.5-0.7x, through the clearing of inventories and the potential monetisation of its investment properties.

Bloodbath continues. At our report cut-off date of 14-Dec-2018, the average capital changes for stocks under our coverage continued trending down, registering a negative return of 20.8% for the quarter compared to the negative return of 4.8% in 3QCY18. In terms of share price performance, it is similar to 2QCY18, which lost 22.0% right after the general election. We believe that the sell-down continued due to: (i) weak market sentiment with no foreseeable strong catalysts for the sector, (ii) unexpected project termination by the government of MRT2, which heightened investors’ fears on other awarded infrastructure contracts, and (iii) uninspiring 3QCY18 results performance albeit a slight improvement from 2QCY18. (Refer to Appendix for details).

Lacking catalyst. Year-to-date, KLCON Index is down by 50% compared to KLCI’s gain of 7.5%, weighed down by uncertainties and lack of catalyst. Interestingly, we are now seeing leading contractors, like GAMUDA, vying for smaller building jobs around RM300.0-500.0m which means they are competing against smaller local contractors, while targeting overseas market that have massive underground infrastructure works i.e. Taiwan and Singapore. We believe that GAMUDA’s sudden shift into smaller jobs is an indicator of a major slow-down in local infrastructure projects, leading them to compete in the smaller-size contracts space. We opine that should more big-cap contractors compete in the smaller-size space in the future, we might see consolidation in the sector, as the smaller-sized contractors that are less competitive due to limited resources may struggle for survival.

Results review. We saw an improvement in 3QCY18 compared to 2QCY18 with less disappointment. Out of 11 construction stocks within our coverage, 4 contractors disappointed, and the remaining came in within/broadly within. To recap, 2QCY18 registered 6 earnings disappointments. The 4 contractors that disappointed were SENDAI, GKENT, KIMLUN, and MITRA. Reasons for the disappointment in earnings for the stocks mentioned above are largely due to: (i) slowdown in infrastructure projects after project reviews, and (ii) lowerthan-expected margins due to higher billings of lower margin projects/products. Ytd-YoY, bulk of the contractors registered CNP growth ranging from 2-39%, except for GKENT, IJM, KIMLUN, MITRA, and WCT which saw declines in their CNP by 5-56% due to: (i) slower progress billings, and (ii) lower contribution from other divisions i.e. overseas contribution or other divisions like property development, and (iii) lower margins due to higher proportion of billings on less lucrative jobs. Although four contractors disappointed in terms of earnings, we have conservatively reduced the sector’s FY18-19E earnings by an average of 5.9-7.8%, driven by the reduction in earnings for 6 stocks within our coverage (SENDAI, GAMUDA, IJM, KIMLUN, MITRA, SUNCON) as a result of: (i) reduced order-book replenishment, (ii) deferrals of progressive billings, and (iii) lower margin assumptions from construction, manufacturing and property development.

Lacklustre contract flows in 1HCY19. For FY18, the total contracts secured by listed companies only amounted to RM18.9b, a drastic drop of 48% YoY, after the conclusion of the cost review in LRT3 and MRT2. Moving into 2019, we hope to see improvement in jobs secured by listed companies, banking on the re-tendering of Klang Valley Double Track works, public hospital works, monorail to Putrajaya, potential infrastructure spending by the Sarawak government, and full rollout of Pan Borneo Sabah. However, we do not expect any news-flow on the abovementioned projects in the near term as we are expecting the contract awards to kick in earliest by 2HCY19. Hence, we believe that contractors would be vying for more private jobs i.e. low-cost housing, high-rise buildings, malls, office redevelopment projects, and private/specialist hospitals in the near term. Hence, we believe that contracts secured by listed companies would be similar if not higher. In the event that contracts secured are lower than FY18, we see minimal downside risks to KLCON’s valuation from here as: (i) now it is already trading at through levels, at 10-year -3SD levels, and (ii) we do not expect more negative news-flow like project cancellation for mega infrastructure projects.

Source: Kenanga Research - 4 Jan 2019