Maintain NEUTRAL on the Construction sector. We opine that the sector’s outlook remains muted due to: (i) soft order-book replenishment prospects for FY22, (ii) dwindling outstanding order-book, (iii) elevated building material costs, and (iv) labour constraints. Against numerous headwinds, valuations for construction stocks under our coverage have held up well (.0in terms of PER). Hence, we choose to remain selective for our construction picks and caution that it may be still too early to adopt a broad-base bottom picking approach for the sector. We prefer counters that have a predictable set of catalysts lined up coupled with robust execution and earnings delivery capabilities. Also we prefer the smaller contractors that have appealing PER with low expectations as any upside surprise to replenishment targets can materially move earnings estimates. Names matching our criteria within our coverage are Kimlun (OP; TP: RM1.25) and Kerjaya (OP; TP: RM1.50).

YTD, contractors’ order-book replenishment has come off YoY. Order-book replenishments for individual contractors under our coverage have been weaker YoY (refer Table 1 below – orange column) with exception to KIMLUN which managed to clinch a lumpy RM780m contract from Sarawak-Sabah Link road project. We opined the reduced overall replenishment this year is attributable to the prolonged pandemic which has weakened the government’s balance sheet as well as shattered the private sector confidence. Expectation-wise, HSL and Kerjaya missed our FY21 replenishment targets while Gamuda is tracking behind their FY22 target (refer Table 2 Below). Consequent to the weaker replenishment this year, outstanding order-book of contractors under our coverage has declined further 8% YoY (refer table 3 in next page).

Replenishment prospects. With a recovery in sight moving into FY22, we are expecting a YoY replenishment growth. That said, we believe the growth would be more of a mild one instead of a strong rebound*. Our rationale is as such; public projects are still hindered by government’s weak fiscal position while private projects flow is expected to be less on reduced office workspace requirement (post pandemic from increased WFH arrangements) and oversupply of residential high rises. Due to government’s weaker balance sheet, we foresee implementation of public projects to be broken down into smaller phases/quantum and also more reliant on contractors’ balance sheet for funding i.e. PPP/PFI.

*Note, despite the strong growth reflected in our FY22E replenishment, we highlight that it is mainly driven by GAMUDA which hinges on the success of only 2 key projects: (i) Sydney Metro West - Western Tunnel, and (ii) Penang South Islands. Hence, the replenishment target could be met or be entirely missed. Without the wins from Gamuda, YoY growth would only be +3%.

Also, expect public spending to pivot towards less developed states namely Kedah, Kelantan, Perlis, Sabah, Sarawak and Terengganu as revealed in the 12MP and Budget 2021. Key projects to be implemented include construction of schools, hospitals, roads and industrial areas. We believe projects would generally benefit the smaller sized contractors.

Industry headwinds still persist. Besides the soft replenishment prospects, the industry is still faced with other issues which could impede earnings delivery/margins. Such issues include: (i) higher building material prices, (ii) labour constraints, and (iii) increased SOP compliances which could impede optimal productivity.

High building material prices to stay. While we expect steel ASPs to soften from this years’ rally, prices will still be relatively elevated compared to historical means (currently c.RM3k/tonnes). We do not expect steel prices to revert back to pre-Covid levels (of c.RM2k/tonnes) due to the higher raw material costs needed for steelmaking i.e. iron ore, coke, and scrap.

As for cement, we opine that prices will no longer be as volatile and will be sticky upwards given that MCEMENT now has over 60% market share in the local market – allowing for a strong pricing power. Other key construction materials such as copper, aluminium etc have also risen in tandem driven by inflation and the tight supply-demand dynamics globally (partially due to logistical issues). While contractors would price in the overall price increases of these materials into their newly tendered contracts, we note that there will be imminently higher working capital needs which would weigh heavier onto contractor’s balance sheet and lead to higher financing requirements.

Valuations not at bargain levels yet. Given that the industry prospects and expected earnings pick-up are rather muted at this stage, we opine that it is only appropriate to position into stocks with depressed valuations. However, based on our compilation (tabled below), we observe that most of the stocks’ valuations have held up rather well against historical means (in terms of PER wise – refer to green column in table below). Hence, we choose to remain selective for our construction picks and caution that it may be still too early to adopt a broad base bottom picking approach for the sector.

Maintain NEUTRAL. All in all, we prefer counters that have a predictable set of catalysts lined up coupled with robust execution and earnings delivery capabilities. Also we prefer the smaller contractors that have appealing PERs with low expectations as any upside surprise to replenishment targets can materially move earnings estimates. Such names which match the above criteria within our coverage are Kimlun (OP; TP: RM1.25) and Kerjaya (OP; TP: RM1.50).

Source: Kenanga Research - 29 Dec 2021