We laud the government for their relentless effort in bringing down the cost of ECRL to RM44.0b. However, as highlighted in our previous sector report, we remain less excited with the revival of ECRL as we have concerns on potential execution risk and thin margins that may not bode well for potential ECRL participants. Hence, we reiterate our NEUTRAL call on the sector. Currently, KLCON Index is trading at 1-year Fwd. PER of 12.2x, close to its 10- year average of 13.3x, after staging a strong 60% rebound from its weakest level of 7.6x (- 3.0SD to the 10-year average). Hence, we recommend a top-slicing strategy. We strongly believe that the sector’s re-rating catalyst is premised on the government’s direction on the future development plans like the potential continuation of MRT3 and High-Speed Rail.

ECRL finalised. Yesterday, YAB Prime Minister Tun Dr Mahathir made an official announcement that the Eastern Coastal Rail Link (ECRL) has been finalised with a total construction cost of RM44.0b (lowered from RM65.5b). The news did not come as a surprise to us given our confidence in the Malaysian negotiation team led by YAB Tun Daim coupled with China’s understanding and willingness in negotiating for a deal that is viable for both parties. The newly proposed 640km East Coast Rail Link (ECRL) project will be operated under a joint-venture (JV) between Malaysia Rail Link Sdn Bhd and China Communications Construction Co Ltd. The new alignment will avoid the construction of the 17.8-km long Genting Tunnel from Bentong to Gombak. That aside, it aims to improve connectivity to other parts of the West Coast as passengers on ECRL will be able to interchange with KTM Komuter and KTMB ETS (Electric Train Service) in ECRL Bangi/Kajang station.

Increased local participation to 40%. Under the previous contract, 30% local participation for the civil works of ECRL is required. Positively, thanks to the Malaysian negotiation team led by YAB Tun Daim and various working groups, they successfully negotiated for a higher local participation requirement of 40%. However, we opine that the total contract value for local contractors could be lesser due to the overall reduction in project cost. Illustratively, 30% of the original contract of RM65.5b implies c.RM19.7b value available for local participation, while 40% of the newly negotiated contract of RM44.0b would mean a smaller pie for local contractors at c.RM17.6b. Nonetheless, we laud the government for their relentless effort and consideration for the local players in their negotiation with China. Note that the actual civil work packages might worth even lesser compared to our illustrative value, as our illustration is based on total project cost.

What’s next? All-in, as highlighted in our previous sector report dated 4th April 2019, we are not overly excited with the revival of ECRL as we opine that participating players may carry a higher execution risk due to the massively scaled-down cost coupled with the mobilisation cost incurred by the Chinese contractors previously, which could be passed down. This is a concern for those players who are looking to participate in the ECRL (e.g. GBGAQRS, IJM, GAMUDA, and HSSEB). We would expect contract award news flow for ECRL to take place by 4QCY19 or 1QCY20, should the tenders be called in 2QCY19. We opine that while the securing contract is important at this juncture, the ability of a contractor to preserve their margins is much more critical at this point.

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. Currently, KLCON Index is trading at 1-year Fwd. PER of 12.2x close to its 10-year average of 13.3x, after staging a strong rebound of 60% from its weakest level of 7.6x (-3.0SD to the 10-year average). We strongly believe that the sector’s re-rating catalyst is premised on the government’s 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. While there are no changes in Target Price for stocks within our coverage, we are downgrading our call for GAMUDA, GKENT and WCT from MARKET PERFORM to UNDERPERFORM due to the recent run-up in their share prices, while upgrading SENDAI from UNDERPERFORM to MARKET PERFORM. As for MUHIBAH, we are upgrading it from MARKET PERFORM to OUTPERFORM, underpinned by its growing prospects in Cambodia (thanks to its associate stake in Cambodian Airports).

Source: Kenanga Research - 16 Apr 2019