Be selective with construction stocks


  • Business
  • Wednesday, 12 Jul 2006

There is some excitement among players in the construction circlethat projects identified under the Ninth Malaysia Plan (9MP) will berolled out soon. In its update, AmResearch Sdn Bhd maintains itsneutral stance on the sector but advocates a stock selection strategyfor investors seeking exposure to 9MP construction play. 

 

9MP: LET THE GOOD TIMES ROLL? 

In recent weeks, we sense more urgency in the government’s stance to expedite the 9MP projects.  

Factors that support our view include

i) The Prime Minister being recently quoted in the press as saying that he would be “rolling out projects to be implemented under the 9MP from July onwards.” 

ii) Construction GDP still behind the curve. In 1Q06, construction GDP contracted by 1.8%. In order to meet the official 2006 construction GDP target of 3%, we believe an acceleration in construction activities is imperative for the remaining three quarters of 2006. 

This is also vital to support the government’s five-year average construction GDP growth target of 3.5% under the 9MP. Based on our estimates, only RM2.6bil worth of 9MP-related projects have been awarded so far. 

iii) General election by 2008? We believe the government may call for a general election by 2008. Traditionally, there is an increase in development spending leading up to the general election. This also supports the industry view that the bulk of development allocation is normally spent in the first two to three years of five-year plans. 

The 9MP projects are to gradually take off by 2H06. Taking the cue from this, we expect an increase in projects to be awarded by 2H06. However, we believe priority will be accorded to (i) revived/deferred projects under the previous plans; and (ii) those to be undertaken on a private financing initiative (PFI)-related basis.  

Some of these projects already announced include the RM720mil Kota Kinabalu International Airport upgrading project awarded to WCT Engineering Bhd. 

Meanwhile, we think the “new” batch of 9MP projects are likely to kick off by 2H07. This is to allow for a grace period of six to nine months for the government to go through a few processes before projects are finally awarded.  

These include endorsement from the Cabinet/Parliament; due diligence/screening of projects; disbursement of warrants (monies) to the relevant ministries; and finally the tendering/awarding of the projects. 

Among the big-ticket projects, we estimate that RM13.3bil of projects have yet to be awarded. We also expect another RM15.5bil worth of road projects to be carried out under the privatised scheme. 

PFI – the new buzz word in town. In a nutshell, PFI simply means projects that involve private sector funding. In return, the government pays rent/leases for the use of the project/facility on a long-term basis (typically up to 25 to 30 years). The PFI method reduces the government’s holding cost via private sector participation. 

Given this, we believe PFI-based projects could exceed the RM20bil allocated under this method for the 9MP. Recent projects announced under PFI funding include the RM500mil National Institute for National Products Vaccines and Biology project (awarded to the Ekovest-Faber group JV). 

 

9MP THEMES – HOW TO PLAY IT 

Water play: The water-related sector is among the biggest winners under 9MP, with development allocation increasing by a whopping 138.5% to RM16.5bil. The sector involves a whole spectrum of works. This includes Non-Revenue Reduction (NRW) programmes, the upgrading/construction of new water treatment plants and supply systems as well as sewerage works.  

Central to this is the RM3.8bil Pahang-Selangor interstate raw water transfer project, widely seen as the solution towards Selangor’s water deficiency. The key water-related players include IJM Corporation Bhd. 

State play:  

East Malaysia: We remain excited with the booming infrastructure scene in East Malaysia, where development allocation under the 9MP has risen 12% to RM29bil. Given that priority will be given to local East Malaysian contractors, the likely winners include home-grown contractors such as Hock Seng Lee Bhd, Naim Cendera Holdings Bhd, Cahaya Mata Sarawak Bhd and Zecon Engineering Bhd.  

In addition, two peninsula-based contractors which have carved a niche in East Malaysia – TRC Synergy Bhd and Bina Puri Holdings Bhd – could also spring a surprise. 

Johor: The obvious attraction is the government’s plans to develop the RM12bil South Johor Economic Region (SJER). The SJER is to be fully equipped with various amenities such as logistics, medical and entertainment hubs. One of the main reasons for the creation of SJER is to woo multinational corporations currently based in Singapore to relocate to Johor, given the latter’s cheaper land and labour cost.  

The development of the SJER is likely to benefit contractors that either have construction and/or property projects in the area. They include UEM World Bhd, UEM Builders Bhd, Malaysian Resources Corporation Bhd, Ekovest Bhd and Gamuda Bhd

Penang: In our view, a few key projects likely to be implemented under the 9MP include the RM3bil second Penang Bridge project, RM1.1bil monorail project and the RM1.1bil Outer Ring Road project. The frontrunners for the state's projects include UEM Builders, IJM and Gamuda. 

PFI play: PFI projects favour the larger contractors, given that the burden of financing lies with the private sector. For this reason, we believe mega projects like the RM8bil KL-Singapore bullet train project recently proposed by the YTL group could come under PFI financing. 

Don’t forget the building materials players! The rollout of infrastructure projects under the 9MP should also stimulate demand for building materials. We believe building companies are a “safer option” for investors seeking exposure to the 9MP. 

Unlike construction stocks, investors of building materials stocks are not unduly concerned with identifying the potential winners of 9MP projects. Within the sector, we like Hiap Teck Venture Bhd and Lafarge Malayan Cement Bhd for exposure to the steel and cement sub-sectors respectively. 

Some red flags to consider: 

i) Financing concerns and the budget deficit. We understand that development expenditure under the 9MP will be funded via a combination of government revenue and domestic borrowings (issuance of Malaysian Government Securities or MGS). 

Nevertheless, increasing macro headwinds may lead to an imbalance in government revenue and expenditure. Recent increases in subsidies (due to rising oil prices) and lease/rental payments under the PFI scheme ultimately drives government expenditure upwards, while government revenue could fall due to a shortfall in tax collection (more so with the deferment in the implementation of the goods and services tax). 

Ultimately, the income-expenditure imbalance in the government’s books may lead to a widening of the budget deficit, and possibly affect the implementation of 9MP projects. Meanwhile, the combination of a shortfall in government revenue coupled with higher borrowing costs may impede the government’s ability to finance development projects. 

ii) Margin compression. With the rising cost of fuel and raw material costs, we believe margin compression may persist in 2H06, albeit at a slower pace. Nevertheless, the cost pressures may escalate again, should the government decide to raise the ceiling prices for steel bars and cement respectively. 

iii) Crowded market. Competition for jobs remains keen with the spawning of many small-time contractors since the mid-1990s. There are over 35,000 Class F contractors in the country. 

iv) Execution risk. Delays in the delivery system (e.g bureaucratic red tape) may hinder the pace of 9MP projects. Also, the government’s decision to apportion many large jobs to a few sub-packages extenuates execution risk, as the main turnkey contractor has less control over the entire project.  

For instance, we understand that the RM2.1bil East Coast Expressway (Phase II) project is to be subdivided into 12 packages. Another grey area relates to cost overruns. As an example, Gerbang Perdana (the contractor for the aborted half-bridge project in Johor) is seeking RM360mil compensation from the government. 

Action: While the 9MP offers pockets of opportunities, we remain mindful that the local construction environment remains tough (due to factors highlighted above). At 12-13x fully diluted calendar year 06-07 PE, we also believe that the construction sector is fairly valued compared to our 2006 target market PE of 14x. 

Hence, we maintain our neutral weighting on the sector, but advocate a selective, stock selection strategy for investors seeking exposure to 9MP construction play. Our top picks for the sector are WCT, Hock Seng Lee and Road Builder for their attractive valuations and diversified earnings base (especially from concession-based income).  

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