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Government contract awards expected to pick up in 2H19

TheEdge Mon, Mar 11, 2019 10:18am - 9 months ago

Construction sector
Maintain neutral:
The government’s review of public sector projects awarded in the past to reduce cost continues. But we understand that the renegotiations of contract prices for major infrastructure projects, such as Klang Valley’s mass rapid transit line 2 (MRT2), light rail transit line 3 (LRT3) and Pan Borneo Highway Sarawak, have been completed for the main contractors.

The review has led to slow progress in certain projects such as LRT3 due to a major redesign and cut in scope of works. As a result, aggregate construction core net profit declined by 37% year-on-year (y-o-y) in fourth quarter of financial year 2018 (4Q18) due to slower progress billings.

Construction companies with substantial contributions from other divisions such as property, plantation and concrete products were also adversely impacted by the weak conditions in these industries.

The government’s development expenditure contracted by 19% y-o-y to RM7.6 billion in 3Q18, the lowest quarterly disbursement since 3Q15. We believe this reflects the effects of a change in government and the project reviews.

We expect the government’s contract awards to pick up in 2H19 as tenders are being called in 1H19. We gather that the projects to be implemented comprise government hospitals, schools, roads, railway and water supply/distribution.

Most of the contract values are likely to be smaller given the nature of the projects and the open tender basis of awards. Hence, we believe the small- to mid-sized contractors and engineering consultants (pure plays) will see more significant benefits from these projects compared to the large construction conglomerates with diversified operations.

The Sarawak government is expected to award contract packages for the RM5 billion coastal highway, RM6 billion second trunk road and RM8 billion water grid phase 1 in 1H19. We believe Sarawak-based contractors and construction material suppliers, such as Cahya Mata Sarawak Bhd (NR — not rated), Hock Seng Lee Bhd (NR) and KKB Engineering Bhd (NR) are potential beneficiaries.

However, we believe the Sarawak government could face financial constraints to implement all these projects simultaneously, given the challenge to issue bonds or use its over RM30 billion reserves, without affecting its credit ratings on existing bonds guaranteed by the state government.

Hence, the implementation of the projects is likely to be on a staggered basis.

We gather that there are also many contractors bidding for the projects including Peninsular Malaysia-based contractors partnering with local Sarawak contractors and competition is stiff for the work packages.

We understand that Pengurusan Asset Air Bhd (PAAB — the government’s special-purpose vehicle to own water assets) is budgeting about RM1.2 billion per annum in 2019-21 for capital expenditure to develop the water supply and distribution systems in the eight states in Malaysia that are under its purview.

The federal government has also allocated RM690 million and RM590 million respectively to improve water supply and sewerage services in Budget 2019. This is positive for contractors involved in water and sewerage projects, such as Taliworks Corp Bhd (NR), Salcon Bhd (NR), Gamuda Bhd and HSS Engineers Bhd.

Water pipe suppliers, such as Engtex Group Bhd (NR) YLI Holdings Bhd (NR) and Fitters Diversified Bhd (NR) are also expected to benefit from the government’s plan to roll out pipe replacement projects to reduce non-revenue water (NRW).

Under the 11th Malaysia Plan, the government targets to reduce NRW to 31% by 2020 from 35% currently.

We believe the proposed water tariff increases by the National Water Commission will have to be implemented in 1H19 to ensure the sustainability of the water industry and support the issuance of bonds to fund the capital expenditure required to achieve the target. However, this is seeing some resistance from certain state governments.

The government is retendering the Klang Valley double-tracking (KVDT) project and it was reported that the cost could be reduced to RM3.8 billion from RM5 billion awarded earlier. Large contractors, such as Gamuda, IJM Corp Bhd and Sunway Construction Group Bhd (SCGB), and engineering consultants such as HSS are potential beneficiaries of the KVDT project.

The east coast rail link (ECRL) may also be revived but at a lower cost than the initial value of RM55 billion. We understand that the government will likely decide after Prime Minister Tun Dr Mahathir Mohamad’s visit to China in April.

If the project is revived, HSS and Lafarge Malaysia Bhd (Hold), which had won contracts, will see earnings contributions as the works resume.

Local contractors will also benefit if the requirements for higher local participation are increased from the initial 30% of works to be awarded by the main contractor, China Communications Construction Co Ltd.

The contractors that are vying for ECRL sub-contract works include IJM and Gabungan AQRS Bhd given their established presence in the east coast of Peninsular Malaysia.

The impending acquisition of Gamuda’s 40%-owned Syarikat Pengeluar Air Selangor Sdn Bhd (Splash) concession for RM2.55 billion by Pengurusan Aset Air Bhd (PAAB) this month will allow the Selangor state government to restructure the water assets in the state and accelerate its capital expenditure programme to increase the water reserve margin that is close to zero currently.

 In 4Q18, six construction companies under our coverage reported earnings within our expectations, that is AQRS, Gamuda, IJM,  Malaysian Resources Corp Bhd (MRCB), Pintaras Jaya Bhd and SCGB.

Only two companies, HSS and WCT Holdings Bhd, reported earnings below our expectations. It is positive to note that the construction earnings downgrade cycle since 2017 seems to be bottoming and market expectations are aligned.

The aggregate core net profit for the construction sector saw a 37% y-o-y plunge in 4Q18 due to the ongoing review of projects by the government to reduce cost. Progress billings for major infrastructure projects such as LRT3 and Pan Borneo Highway Sarawak were slow.

Construction companies with property projects generally saw weaker sales and lower profit margins in 4Q18 due to the sustained weak property market conditions. WCT had to adjust its operating profit margins for ongoing construction projects, which led to a sharp decline in 4Q18.

Several companies recognised impairments for company acquisitions and property stocks that led to depressed earnings or losses in 4Q18.

We believe construction weighted-average core earnings per share bottomed in 2018 (-15% y-o-y) and expect a moderate rebound with growth of 9% y-o-y in 2019E and 12% y-o-y in 2020E (estimate).

The high construction order book of the construction companies under our coverage provides good earnings visibility for the sector.

Average construction order book/annual revenue is 4.6 times for the sector.  The current construction sector weighted-average 2019E price earnings ratio of 14 times is undemanding, considering the sector earnings are expected to rebound this year.

The prospects for order book replenishment are also expected to improve in 2H19.

We favour contractors that have been securing projects on an open-tender basis, which is the transparent process favoured by the new government. We remain ‘neutral’ on the sector as there are still government policy risks relating to the planned takeover of tolled highway concessions starting with those controlled by Gamuda.

Our top “buys” are SCGB, AQRS and HSS, pure construction plays that will likely benefit from the pick-up in government infrastructure spending in 2H19. We also have a “buy” call on MRCB as a deep value exposure, given the sharp discount to revalued net asset value.

The key upside risk is an acceleration in public infrastructure spending and the key downside risk is further cuts in spending and unfavourable terms in the renegotiation of tolled highway concessions — Affin Hwang Capital, March 8

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