This article first appeared in Capital, The Edge Malaysia Weekly on August 26, 2019 - September 1, 2019

THE rally in construction stocks this year has been fuelled by the resumption of mega infrastructure projects, including the RM44 billion East Coast Rail Link (ECRL) and RM16.6 billion Light Rail Transit Line 3 (LRT3). The news of the ECRL’s revival cheered the market, but is the pie big enough for all?

Construction Industry Development Board data show that up to June, only RM40 billion worth of construction jobs had been dished out. Annualised, this would translate into a contract value of RM80 billion this year, about 40% lower than the RM134 billion achieved last year.

With the construction order book at an all-time high and positive news flow on mega projects seemingly reaching its peak, are the valuations for the sector justified? Will a strong order book replenishment continue for most construction companies?

While analysts generally agree that the sector’s valuations are lofty, they have mixed views on whether the outlook for the sector has turned negative. However, most agree that there are few short-term catalysts to justify the current valuations.

“Most of the construction jobs for the revived mega infrastructure projects were awarded in the first half of the year, so there is not much to look out for in the second half. Therefore, valuations are deemed quite expensive,” says an analyst, who has a “neutral” outlook on the sector.

“At the same time, some of these stocks are being supported by expectations of more mega projects to be revived by the government. And in the case of Gamuda Bhd, shareholders are holding on to the prospect of special dividends,” says the analyst.

For example, Gadang Holdings Bhd reported a net loss of RM3.4 million for the fourth quarter ended May 31, 2019 (4QFY2019), compared to a net profit of RM23.3 million in the corresponding quarter last year due to a lower margin from the construction segment and higher finance costs. Although the counter took a beating after the results announcement on July 24, some analysts see market support for the stock as it is expected to be among the contract winners for the local portion of the ECRL.

However, while the government has agreed to go ahead with the ECRL, tender pre-qualification has just been concluded and the local portion of the civil works, amounting to RM17.6 billion, is being sought by 331 subcontractors.

Stiff competition among local players for ECRL contracts would make them less attractive to the big players, says Adrian Ng, an analyst with Kenanga Research who covers the construction sector.

In a July 5 report he says, “We believe this particular space to be overcrowded and competitive as there are 859 Grade 7 classified contractors participating in the pre-qualification exercise — all competing for the 40% civil works portion of the ECRL, possibly valued at about RM18 billion or less.

“Assuming 10% of the Grade 7 contractors are successful in clinching an award from the ECRL, it would translate into an average contract size of RM225 million for each player,” Ng says. He is calling a “sell on strength” for construction stocks.

The revival of the ECRL may be good news for the construction sector, but the fact that many firms are chasing RM18 billion worth of contracts does not really make the project a big catalyst.

“It is like having a cake but the icing may not be as enticing as it was made out to be,” an analyst says succinctly.

At the current level, the Bursa Malaysia Construction Index (KLCON) is trading at 22.68 times trailing 12-month (T12M) earnings, which is almost the same level as in 2017, when the then Barisan Nasional government was ramping up infrastructure projects. The index’s 10-year average T12M price-earnings ratio is 18.1 times.

The high valuation may be the reason why many construction counters have started to fall recently, despite the anticipation of ECRL contracts. KLCON has dropped 6.6% since July 3, reflecting the share price movement of construction companies.

“The dynamic has changed. In 2017, when many contracts were being awarded, construction firms were building up their order books, hence, the valuations were justified. Now, it is already hard to maintain the replenishment rate, let alone grow it,” says the analyst.

Since reaching its year-to-date high of RM4.04 per share on July 2, Gamuda’s share price has lost 8.4% to close last Thursday at RM3.70. IJM Corp Bhd fell 9.96% from its YTD high of RM2.51 on July 2 to last Thursday’s close of RM2.26. This is because the counters have priced in most of the potential upside of securing ECRL contracts.

Apart from IJM and Gadang, investors expect construction outfit Gabungan AQRS Bhd to secure an ECRL contract. AQRS has seen the worst battering among construction counters in recent weeks. Its share price has dropped more than 20% since reaching its YTD high of RM1.54 on July 24 to last Thursday’s closing price of RM1.22.

“For the rally to sustain, construction companies must secure more big contracts and, in this economic climate, only the government can award big contracts. All eyes are on the HSR (high-speed rail) and MRT3 now, whether or not the government will revive these projects,” says another analyst.

On June 28, MyHSR Corp Sdn Bhd announced that it had appointed Minconsult Sdn Bhd and Ernst & Young as the technical advisory consultant and commercial advisory consultant respectively for the Kuala Lumpur–Singapore HSR project.

The advisers’ roles are to study the technical and commercial aspects of the HSR and recommend to the government ways to reduce its scope and budget. It will then have to make a decision on whether or not to continue with the project.

The Malaysian government has secured a delay in the commencement of the HSR development with the Singapore government until May 31 next year. The project costs RM110 billion, which is prohibitive for the Malaysian government.

Meanwhile, there have been suggestions for the MRT3 to be made fully elevated, which would halve the development costs. It was slated to be fully underground and the original cost to develop the line was pegged at RM45 billion to RM50 billion.

“Even if the projects were given the green light by the government, at best the contracts will only be awarded in the second half of next year. For the short term, there are hardly any big contracts on the horizon,” an analyst tells The Edge.

As it is, domestic contracts awarded fell 7% year on year in the first half of this year to RM8.1 billion, according to HLIB Research analyst Yip Kah Ming. About 30% of the domestic contracts awarded in the first half were infrastructure jobs, compared with 58% in the corresponding period last year.

“The decline in contract values and lower proportion of infrastructure works were mainly due to holding back or downsizing of infrastructure projects post-GE14,” he says in a July 3 sectoral outlook report.

Meanwhile, the sector is also grappling with implementation issues, which cause construction jobs to slow down, and an increase in liquefied and ascertained damages (LAD) on delays. For example, some analysts believe some of the novated LRT3 contracts have yet to start.

After the government resumed the LRT3 project at a much reduced price tag, its turnkey contractor MRCB-George Kent Sdn Bhd will have to relook its funding and costs, before the novated contracts can be restarted.

On Aug 13, George Kent (M) Bhd told Bursa Malaysia that it had served Malaysian Resources Corp Bhd with a notice of arbitration with regards to the difference of interpretation of certain provisions within their joint-venture agreement, particularly the financing requirement.

“With the turnkey contractor having disputes on the financing requirements, it is hard for the subcontractors to restart the novated contracts. This has caused some of the subcontractors to toy with the idea of exiting their contracts altogether,” says an analyst who declined to be named.

With the private market still not picking up due to an overhang in the property development sector, and the public market being sluggish with fewer infrastructure jobs and slower implementation, where else should construction companies look for jobs?

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