We maintain OVERWEIGHT for the sector ahead of the 15th General Election (GE15). The 2QCY22 results for companies within our coverage universe deteriorated slightly against last quarter, but were not alarming. The margins realised by most contractors in 1HCY22 were still below those of the pre-Covid levels due to labour shortages and the soaring cost of building materials, particularly steel. We believe the sector has seen the worst and should be poised for improved earnings in 2H given the gradual return of foreign workers and recent easing in base metal prices. We also foresee better job replenishment prospects with the imminent rollout of MRT3 and Pan Borneo Highway (Phase 2), plant expansion in the semi-conductor space as well as the proliferation of new data centres. Our top pick for the sector is GAMUDA (OP; TP: RM4.20) given its strong chances of it emerging as the tunnelling contractor for MRT3, recent job wins in Australia and Singapore, as well as a larger war chest after the disposal of its toll highways.

Marginal deterioration sequentially. Construction counters under our coverage saw marginal deterioration in 2QCY22 earnings with 17%, 50% and 33% coming in above, within, and below our forecasts, versus 17%, 67% and 17% during the last quarter (see table on Page 2), respectively, but the situation was not alarming. GAMUDA was the only company that beat on stronger-than-expected property and construction margins while on the disappointing-end we have: (i) WCT which saw weak contribution from its property unit which struggled to cover overhead costs, and (ii) KERJAYA which was affected by slower billings on labour shortages.

Margins are mostly below pre-Covid levels. The margins realised by most contractors in 1HCY22 were still below the pre-Covid levels due to the soaring cost of building materials, particularly steel, and labour shortages that hampered work progress. GAMUDA is the only exception which saw construction margins being stronger than pre-Covid levels due to cost savings recognition from its MRT2 project which is coming to an end.

Depleting orderbook on weak replenishment. Amidst a slow job market, YTD, IJM and WCT have yet to secure any new work packages. Similarly, KIMLUN and SUNCON are trailing their replenishment targets. Consequently, orderbook levels of most players are depleting. However, we foresee better job replenishment prospects with the imminent rollout of MRT3 and Pan Borneo Highway (Phase 2). As MNCs diversify their manufacturing bases geographically (away from China) to de-risk, there are opportunities in the construction of new semi-conductor plants and data centres locally where the contract size could range between RM1b to RM1.5b each. We understand that KERJAYA and SUNCON are eyeing a slice of the pie.

The worst is behind us. We believe the sector has seen the worst and should be poised for improved earnings in 2H given the gradual return of foreign workers (thus far, we understand that KERJAYA and SUNCON have secured some workers) and the recent easing in base metal prices. Since end June, certain key building material prices such as steel and aluminium have come off substantially due to the intermittent lockdowns in China. So, are diesel and bitumen on the back of weaker oil prices. Meanwhile, most new contracts being negotiated currently would have priced in the current market prices (which are higher) and have an element of price variation built in – to protect contractor’s margins in the event of the huge swing in material prices. Hence, we believe the overall margins should gradually improve as the low-margin old jobs tail off and the new projects adjusted for higher input costs start to contribute.

Reiterate OVERWEIGHT. Aside from the better earnings trajectory projected for the subsequent quarters, we believe a sector re-rating is in the making on expectations of the award of public infrastructure jobs ahead of the GE15, due by September 2023. Our top pick for the sector is GAMUDA given: (i) its strong chances of emerging the tunnelling contractor for MRT3, (ii) its recent job wins in in Australia and Singapore that speak eloquently for its competitiveness in the international market, and (iii) the lumpy proceeds from the disposal of its toll assets, putting it in a strong position to participate in public infrastructure projects on a private finance initiative (PFI) model, or even giving out a special dividend.

Source: Kenanga Research - 6 Sept 2022