Construction - Taking a break for now…

We are downgrading our sector recommendation from OVERWEIGHT to NEUTRAL as we see rising uncertainties and risks closer to the upcoming 13^th  General Election and lack of fresh leads for new infrastructure projects in Budget 2013. We believe that the upcoming Budget 2013 will not be able to maintain the bullish momentum on the construction sector as its focus is gravitating towards a “people-centric” budget rather than infrastructure. Based from the ongoing contract flows, a few big ticket items are likely to be awarded after the election like the WCE highway  concession, MRT circle line and Gemas-JB electrified double track railway project. Factoring in the timing of the contract awards and its viability, the construction sector could take a breather for the next six months with the delivery and execution of ongoing projects likely to be more crucial in the current environment of cost escalations to maintain earnings visibility. As such, we are opting for fundamentally strong contractors with manageable balance sheet position and sufficient capacity like WCT (RM3.09) and Gamuda (TP RM: 4.13) that are able to execute larger and significant projects including PPP based projects. For more niche and high news flow driven counters, we like Benalec (OP; TP: RM1.71) following the recent development with its 99-year concession agreement with the Johor state government in land reclamation projects at Tanjung Piai and Teluk Penggerang. We expect more positive news on its Johor land development project from 4Q12 to 1Q13 and we expect the EIA report and off-taker agreement to be finalised during the period. 

1Q12 results within expectations.  Most of the big cap contractors under our coverage  have reported results that met expectations in their 2Q12 results. The sector’s underperformers were mainly the smaller contractors like Bina Puri, Fajarbaru and TRC. This was mainly due to longer than expected delays in the LRT extension project and a  higher tax bracket charge seen for the year. There were also gaps in recognising the revenues from the newly secured contracts (of 3 to 6 months) although we expect the recognitions should pick up pace soon in 2H12 for companies like TRC Synergy and Fajarbaru.      

What to expect in 3Q12 earnings?  We have already trimmed down our earnings for the underperformers due to their longer-than-expected project delays while maintaining our forecasts for the contractors whose results came in generally in  line. We however expect a hefty recognition of revenue for the small contractors especially for TRC as its LRT construction activities have now started up upon the release of the Development Order (D.O) in May 2012. On the other hand, we do not expect any earnings surprises for the big boys.          

What’s there for contractors in 4Q12?  The contracts that are on contractors’ radar in the near term will be TRX infrastructure works (RM2b) and RAPID earthworks (RM2b). We believe that these contracts are at their final stages of award, likely to be finalised in 4Q12. The prime beneficiary will be WCT due to its available capacity to execute a few more sizeable projects of up to RM2.5b. We think that the long awaited Gemas-JB EDTP project and WCE highway project will likely take off after the elections and this will benefit WCT, Gamuda and IJM Corp. Based on the feedback from contractors, labour and cement costs are expected to escalate at c. 20% and 10% respectively in the near term. This is mainly due to the higher demand  for manpower in the construction of MRT SBK Line and the recent revision in cement prices. The small to medium contractors is likely to take the brunt of the increase (sub-contractors) as there is limited room for them to absorb the cost hikes. 

Budget 2013 will not hold up the sentiment.  We do not have high expectations on the upcoming budget for the contractors as we expect the budget will likely focus on “people-centric” theme rather than infrastructure ie: an “election budget”. To recap, there was a strong rebound in the KL construction index after the 2012 budget announcement, underpinned by the surprised announcement of the MRT project. Moving forward, should the there is a surprise of major project announcement we expect the sentiment to be reserved due to the elections risk ie: execution risk.     We are downgrading our recommendation on construction sector to NEUTRAL from OUTPERFORM and our Top Pick is WCT (OP; TP RM: 3.09).

Source: Kenanga