As highlighted in our previous strategy report, the construction sector lacked catalyst and we currently still do not see much infrastructure spending from the government after the major cost reduction in two mega projects, i.e. LRT3 & MRT2 except for the development in Sarawak state and potential revival of ECRL. Following the strong rebound (12-46%, QoQ) over Dec-18, we believe upsides are limited at this juncture given the lack of catalyst. As such, we no longer have any OUTPERFORM recommendation for the stocks under our coverage, and we strongly believe that the sector’s re-rating catalyst is premised on the government’s firm direction on the future development plans like the potential continuation of MRT3 and High-Speed Rail.

For 2QCY19, we expect more news flow on potential re-tendering of works from LRT3 while contractors are hopeful for positive news flow on ECRL and KVDT.

Currently, KLCON is trading at 1-year Fwd. PER of 11.7x at -1SD level to its 10-year average, staging strong rebound of 52% from its weakest level of 7.6x (-3.0SD to the 10-year average). KLCON’s 10-year average PER is at 13.3x.

As such, we no longer have any OUTPERFORM recommendation for the stocks under our coverage, and we strongly believe that the sector’s re-rating catalyst is premised on the firm direction from the government on the future development plans like the potential continuation of MRT3 and High-Speed Rail. To recap, the uncertainty in the local construction scene has driven contractors with strong execution capabilities to look overseas for more jobs in order to sustain their overheads.

A rebound! At our report cut-off date of 22-Mar-2019, we saw better performance for the sector as average capital changes for stocks under our coverage registered a positive return of 19.8% for the quarter compared to the negative return of 20.8% QoQ in 4QCY18. Compared to the small-mid-cap players, the big-cap registered higher average return of 26.9% vs. 19.8% registered by the small-mid cap players except for MITRA, which registered a return of 46.3% (refer to Appendix for details). Year-to-date, KLCON Index outperformed KLCI with a positive return of 22.9% compared to KLCI’s year-to-date loss of 0.1% thanks to the recent rebound as there are more certainties with no further reviews on infrastructure project costs and projects like MRT2 and LRT3, which are now able to proceed after their negotiations with the government.

Results review. For 4QCY18, we saw a similar number of disappointments compared to 3QCY18, which is 4 disappointments out of 11 stocks under our coverage while the remainders came in within expectations except for 1 that came above.

The four stocks that came below expectations are GKENT, HSL, IJM, and MITRA, which were affected by project cost review and hence resulted in lower progress billing and compression in margins. As for IJM, it was also dragged by its IJMPLNT’s results, which have been disappointing in the past few quarters. Positively, KIMLUN came in above expectations thanks to higher-than-expected billings from Pan Borneo and delivery of Segmental Box Girders for MRT2 and IBS components.

YoY, bulk of the contractors’ CNP were down 6.9-52.7% except for SENDAI, HSL, KERJAYA, MUHIBAH and SUNCON which registered growth of between 4.4-31.4% driven by better billings progress backed by the growth in order-book size in recent years, while MUHIBAH benefited from the performance of its crane division and airport concession in Cambodia. (Note that GKENT and GAMUDA have odd financial year ends and the results review does not reflect its recent results.)

Contract flows making a comeback? Year-to-date, RM4.5b worth of jobs were awarded to listed companies apart from contractors. This includes SUNCON’s contract award from TENAGA for the redevelopment of their Headquarter campus amounting to RM781.3m. During GAMUDA’s recent results briefing, they sounded more hopeful compared to last year due to the potential revival/re-tendering of projects like ECRL and KVDT, possibly take place this year - we believe a more realistic timeline would be 2HCY19. That aside, we also do not rule out the possibility of “re-awarding” of LRT3 contracts given that recently SUNCON managed to bag some piling works from MRCB-GKENT’s subcontractor (i.e. S.N. Akmida Holdings Sdn Bhd), which means there is potential for SUNCON or other contractors to take over the entire GS10 or more contracts from LRT3 should MRCB-GKENT decide to change their sub-contractor based on performance.

In terms of the water-related infrastructure projects, it was reported in Budget-2019 that the government is allocating RM738.0m for the improvement of water supplies to the rural area. We believe that there could be more given that the Ministry of Water, Land and Resources has a development expenditure budget of c.RM3.0b from the Ministry of Finance. That aside, should the government is able to raise water tariffs to upgrade the infrastructure or replacement of water pipes in effort to reduce NonRevenue Water, we might potentially see more project awards for the sector. However, we are less optimistic with the execution timeline for water-related projects as there has been minimal news flow on the sector other than the privatisation of SPLASH. That aside, a water tariff hike could be a challenge given that it requires state consent. If this play comes back, players like HSS (NR), TALIWRKS (NR), SALCON (NR), FITTERS (NR) and ENGTEX (NR) that are already operating in the water scene could be the major beneficiaries.

Opportunities from the East? While the prospects and opportunities in West Malaysia might sound tepid at the moment, East Malaysia could be a brighter spot due to the Sarawak state government’s strong will and mandate in improving the basic necessities for the people through the development of infrastructure like road and water-related projects. To recap, players like CMS recently bagged a coastal road bridge contract for RM466.7m, while KKB bagged a water supply contract amounting to RM110.8m from Jabatan Bekalan Air Luar Bandar Sarawak. Hence, we believe that there could be more contracts with sizes between RM200.0-1,000.0m from Sarawak that would benefit local players (HSL, KKB (NR), NAIM (NR), and TRC (NR)) should the state government speed up their contract award process for its coastal road project (c.RM5.0b). However, we have an UNDERPERFORM call on HSL largely due to its valuation, which is currently trading at 11.6x, close to KLCON’s current trading multiple of 11.7x.

What next post rebound? Currently, KLCON is trading at 1-year Fwd. PER of 11.7x slightly above its -1SD level to its 10-year average of 11.2x, after staging a strong rebound of 52% from its weakest level of 7.6x (-3.0SD to the 10-year average). KLCON’s 10-year average PER is at 13.3x. This came as no surprise to us as we had previously highlighted that the sector had been grossly oversold. The PER trading discount between KLCON to KLCI had also narrowed from -53% (at -3SD levels) to - 29% (-1SD levels). We reckon that for its discount factor to narrow up its average levels of -15% the sector would require strong catalysts like the continuation of MRT3 and HSR or firm direction in the infrastructure development space by the government which should be more than just re-tendering of projects from LRT3, KVDT and potential revival of ECRL. Should the ECRL project is revived, we opine that participating players may carry a higher execution risk due to the massive scaled-down cost coupled with the mobilisation cost incurred by the Chinese contractors previously, which could be passed down. Based on our on-ground checks with some of the vendors in the construction sector, the current competition in the market is at unhealthy levels as certain vendors or sub-contractors are willing to bid at cost or below cost for jobs due to the recent slowdown; this is a concern for those looking to participate in the ECRL, for which we are cautious for players (GBGAQRS (NR), IJM, GAMUDA, and HSS (NR)) looking to participate in ECRL. We opine that while the securing of contract is important at this juncture, the ability of a contractor to preserve their margins is much more critical at this point as we would be expecting receivables to build up especially for private development projects.

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 growing demand for human capital in the sector lead to higher overheads for contractors, and unexpected margin compressions.

NEUTRAL maintained. Following the strong rebound (12-46%, QoQ) over Dec-18, we believe upsides are limited at this juncture given the lack of catalyst. As such, we no longer have any OUTPERFORM recommendation for the stocks under our coverage, and we strongly believe that the sector’s re-rating catalyst is premised on the government’s firm direction on the future development plans like the potential continuation of MRT3 and High-Speed Rail. To recap, the uncertainties in the local construction scene have prompted contractors with strong execution capabilities to look overseas for more jobs in order to sustain their overheads. Under current circumstances, we opine that investors should take the opportunity to do some top slicing.

Source: Kenanga Research - 4 Apr 2019