Maintain NEUTRAL on the Construction sector. Jobs replenishment for contractors under our coverage has been mixed with the ones that have successfully lifted their outstanding order-book to above pre-Covid level include GAMUDA, KERJAYA and KIMLUN. Meanwhile, IJM, WCT and SUNCON saw depleting order-book levels. While local replenishment prospects are lifted by the proposed MRT3, the government’s weak fiscal position coupled with less private projects on reduced office space demand (post Covid) and oversupply of residential high-rises will limit future replenishment prospects. Contractors’ two main headwinds under the current climate includes shortage of labour and elevated material costs, keeping a lid on margins. Valuation wise, contractors under our coverage are neither dirt cheap nor expensive. However, we see valuations potentially rerate post General Election on higher political stability and increased project implementations. For now, we still prefer the smaller contractors given their more appealing PERs while any upside surprise to replenishment can materially move their earnings. Such names are KIMLUN (OP; TP: RM1.00), and KERJAYA (OP; TP: RM1.50).

Construction sector FY22E replenishment prospects anchored by GAMUDA. For FY22, we are expecting contractors under our coverage to cumulatively see strong replenishment growth of 208% YoY, anchored by GAMUDA’s sizeable target of RM12.5b. GAMUDA’s replenishment growth is attributed to international contract award wins in Australia and Singapore worth RM7.4b in 1QCY22. Removing GAMUDA out from the equation, we note that other contractors under our coverage which are more reliant on domestic jobs would likely only see flat YoY replenishment of RM6b in FY22 (refer table 1).

We are less optimistic over domestic job prospects as public project roll-outs remain hindered by government’s weak fiscal position while private projects flow is expected to be subdued on reduced office workspace requirement (post pandemic) and oversupply of residential high-rises. Due to limitation of the government’s balance sheet, we foresee implementation of public projects to be broken down into smaller phases and also be more reliant on contractors’ balance sheet for funding i.e. PPP/PFI. While the recent MRT3 news flows indicate the possibility of packages being tendered out by 2QCY22 and awards being dished out by 4QCY22, we are less optimistic over this aggressive timeline given that this large-size urban project would require more time for land acquisition negotiations, public display of documents, contractors’ prequalification and evaluation period. Hence, we believe MRT3 awards would likely be announced in CY23.

Outstanding order-book mixed among contractors. The ones that have successfully lifted their outstanding order-book to above pre-Covid level include GAMUDA, KERJAYA and KIMLUN. GAMUDA has pivoted into the international space (Singapore, Australia and Taiwan) for more contracts while KERJAYA has been more reliant on RPTs (related party transactions from E&O and KPPROP). KIMLUN’s smaller order-book base makes it easier for them to regain order-book size. Meanwhile, IJM, WCT and SUNCON’s order-books remain weaker than pre-Covid levels as replenishment these past two years has failed to surpass execution drawdown.

The sector’s two key headwinds will put a lid on margins. The two main headwinds in the current climate include shortage of labour and elevated material costs (which is unlikely to abate this year). We believe steel ASPs will remain elevated due to the higher raw material costs needed for steelmaking i.e. iron ore, coke, and scrap amidst the geopolitical tensions and supply disruptions. As for cement, we opine that prices will no longer be as volatile but will be sticky upwards given that MCEMENT now has over 60% market share in the local market – allowing for a strong pricing power. Prices of other key construction materials such as copper, aluminium and others 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 heavily onto contractor’s balance sheet and lead to higher financing requirements.

Consequent to the current backdrop, while we expect margins to be stronger than pandemic years (upon more efficient operations given the absence of lockdowns), we do not expect margins to revert back to pre-Covid times.

Valuation wise, contractors under our coverage straddles between -0.5SD to +0.5SD of 5-year mean - neither dirt cheap nor expensive. Thus, maintain Neutral at this juncture. However, we see valuations potentially rerate post elections on higher political stability and increased project implementations. There are market talks that elections could be held in 2HCY22. If so, and assuming the existing government comfortably secures a majority, there may be stronger political willpower to alleviate fiscal constraints (by imposing GST, implement targeted subsidies) and thus providing more headroom for construction-related spending. Besides, assuming election is done by 2HCY22, contractors' earnings would have established a floor base by reflecting the high raw material costs in 1HCY22 and could potentially see QoQ earnings growth in 2HCY22 on easing of labour shortage. Note, some stocks under our coverage (GAMUDA, KERJAYA, KIMLUN, WCT) are trading at relatively discounted valuations compared to peak PERs seen in 2017 (pre-GE 13 election) – providing good upside.

Meanwhile, we do not anticipate any major job awards prior to general elections which would induce a potential rerating. Case in point, there were no job awards prior to the Malacca and Johor State Elections. For now, we still prefer the smaller contractors given their more appealing PER while any upside surprise to replenishment can materially move earnings. Such names are KIMLUN (OP; TP: RM1.00), KERJAYA (OP; TP: RM1.50).

Source: Kenanga Research - 5 Apr 2022