Despite current headwinds, we keep our OVERWEIGHT call for the sector, underpinned by vaccination efforts which will strengthen the economic recovery play coupled with FY21 being the year where contract awards gather steam. We also find KLCON valuation which is still trading below its 5-year mean appealing. Our preferred picks lie within the small mid cap space which are under-owned and command low market expectations – providing room for upside surprises. These name under our coverage include: Kimlun (OP; TP: RM1.30), MRCB (OP; TP: RM0.65), Kerjaya (OP; TP: RM1.50) and WCT (OP; TP: RM0.675). As for the big caps, we like Gamuda (OP; TP: RM4.17) for their lead role in MRT3 and growing exposure in Australia.

Still a laggard. While some cyclical sectors have already clawed back most of their losses to pre-pandemic levels, the construction sector’s performance has not been as great due to various overhangs namely: rising steel prices, a ballooning federal balance sheet, foreign labour restrictions, a looming general election, political uncertainties and the numerous unforeseen MCOs. Meanwhile, key catalysts which should have propelled the sector such as contract awards and the announcement of 12th Malaysian Plan have been kept at bay as the governments’ focus was still very much pandemic-driven.

But bright spots emerging. Nonetheless, construction share prices have rebounded off their lows since early Feb and have been gaining further traction of late. We believe the recent strength exhibited were underpinned largely by macro factors namely: (i) the rising bond yields which favours value and cyclical sectors over growth sectors leading to a rotational switch, and (ii) the growing prominence of an economic recovery play theme with gradual roll out of vaccines since late Feb. This begs the question whether this rally would be a short lived one? Or is this only the beginning for more to come?

Our take. Taking multiple factors into consideration, we opine that the sector should be able to sustain its upward trajectory, albeit in a choppy fashion. For the year ahead, we believe the sector tailwinds would gain strength and overwhelmed the headwinds. Coupled with sector valuations (KLCON Index) which is still below its mean, we see room for further appreciation.

Vaccines will boost sector confidence. Anchoring the sector forward would be the recovery backdrop which should persist as Malaysia gradually achieves herd immunity from the vaccine drives. According to experts, herd immunity (i.e. 80% of Malaysian population vaccinated) could happen as soon as October 2021 (targeted by Feb-22). Coupled with the recent commitment by Tan Sri Muhyiddin Yassin that no broad MCOs will be implemented, this alleviates a key concern which had brought the construction sector to its knees in early January during the unexpected implementation of MCO 2.0.

Contract roll-outs to pick up momentum. Secondly, we see contract-flows picking up due to backlogs (from the pandemic) and implementation of mega projects to gain further traction. We believe key domestic projects should see further material developments this year especially after the 12th Malaysian Plan gets tabled when parliament reconvenes. Our expectations of key developments for new projects are as below;

All being said, we do expect headwinds to be present in the immediate term:

Earnings weakness in 1QCY21 results. First off, there will most likely be earnings setbacks in 1QFY21 reporting season due to the decreased productivity levels arising from MCO 2.0 (13th January – 18th Feb). Channel checks with contractors under our coverage indicate that the decrease in productivity levels differs across respective contractors with some seeing productivity decline of up to 50%.

High long steel prices impact. The 30% surge in long steel prices (from RM2,100/tonne to RM2,700/tonne levels) since the start of the year is likely to inflict some form of margin squeeze to contractors. That said, we believe such increase in steel prices is still manageable as high steel usage is typically only required during the structural phase of construction. Moreover, based on the previous steel uptrend witnessed in 2016 - 2018, we note that contractors under our coverage have weathered it well with not much impact towards construction margins (as seen in table below). Also, we think that such spike in steel prices are unsustainable as global long steel supply (which were idled during the pandemic) would increase in tandem with the prices – leading to normalisation of prices in the medium term.

Election outcome will not have drastic impact on sector dynamics. While a fear of an impending general election would ultimately dent sentiment, we do not foresee drastic re-negotiations or delays for ongoing and new projects should a switch in government occur (unlike what happened in 2018). The only project that could potentially be affected is ECRL’s section C (connecting Mentakab to Port Klang) which route alignment has been switched back and forth in accordance to the government in power.

Favouring the under-owned. At current valuation levels, we prefer small-mid cap names which command low market expectations and are under-owned which consequently provides room for upside surprises. Such names within our coverage include: Kimlun, Kerjaya, MRCB and WCT. That said, amongst the big caps, we like Gamuda given their rising exposure in Australia and front lead for MRT3. Overall, we make no changes to our calls and TPs. Maintain OVERWEIGHT on the construction sector.

Source: Kenanga Research - 2 Apr 2021