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Construction (OSK Research); Turning less optimistic

Turning Less Optimistic

The Government is expected to unveil the 10MP tomorrow. In view of tight Government coffers, we expect to see a cut in development expenditure, although this shortfall may be partially compensated by more PFI jobs. We expect construction growth to slow down and normalize in 2010-2011. Within the sector, we continue to like the thematic Sarawak play.

Our sector rating is cut to NEUTRAL as we feel that the positive news will be offset by implementation delays and spending cuts. Our top picks are Mudajaya, Sunway and AZRB, all of which have strong earnings growth potential.

No significant spending rise. As shown in Figure 1, nominal construction output is highly dependent on development expenditure, with a correlation of 81.5%. This year, development expenditure is expected to hit RM51.2bn, translating into a marginal 3.4% y-o-y increase compared with the 15.6% witnessed in 2009. In the absence of a significant rise in development expenditure, we expect minimal nominal sector output growth.

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Growth rates to normalize. Real construction output grew by 5.8% last year, thanks to the swift implementation of pump priming efforts in light of the recession. Moving forward, we feel that last year’s strong growth rate is unsustainable. Our economics team at OSK-DMG is projecting for real construction output to grow at 3.1% in 2010 before tapering off to 1.5% in 2011. Real sector growth is expected to underperform Malaysia’s GDP growth forecast of 7% and 5.8% for 2010 and 2011 respectively.

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Potential cut in 10MP expenditure? During the 9MP, a ceiling target of RM230bn was set for development expenditure, from which we expect RM220bn (95.6%) to be achieved. The Government is set to announce the details of the 10MP tomorrow. OSK-DMG believes there
could be a cut in development expenditure, which is a negative for construction. Media sources have previously said that development expenditure for the 10MP may be limited to RM180bn, down 21.7%. We believe this is plausible in view of the Government’s tightening coffers. This year, the Government intends to reduce its deficit/GDP ratio from 7% to 5.6%. Pemandu’s recent calls for a reduction in subsidies are also telling signs of stretched wallets.

What to expect in 10MP. Similar to the 9MP, we believe that most of the construction related announcements will be rather broad-based, without much mention of project specifics. On the potential positives, we think there will be higher infrastructure allocation to East Malaysia, particularly Sarawak, and more jobs to be implemented via Private Finance Incentives (PFI). We discuss these in the following sections. As for the negatives, we see minimal allocation to Penang as the state was left out during the drafting of the 10MP. Based on our tracking of domestic contract flows to listed contractors, there were no job awards located in Penang since the March 2008 General Election. Scrapped projects in Penang such as the Outer Ring Road and Monorail are unlikely to be revived anytime soon, in our

Sarawak play still in motion. East Malaysia has the highest number of poor households in the nation. As the region played an important role in Barisan Nasional’s 2008 General Election win, we continue to see increasing focus being placed there. Part of the development, we believe, will be fuelled by greater infrastructure spending. The best way to play this theme is via Sarawak-based contractors as the state is expected to hold its elections by end-2010/ early-2011. We envisage an increase in infrastructure spending moving closer to the polls to garner “political
brownie” points. As it is, Sarawak job flows are already on the rise, with RM878m awarded to listed contractors from Jan-May, up a strong 56.5% y-o-y. Our preferred pick for thematic Sarawak play is Naim (BUY, TP: RM3.52).

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PFI jobs gain traction. Given our anticipated development expenditure cut for the 10MP, we expect more projects to be implemented on a PFI basis. Recently, 6 UiTM campus jobs were awarded via PFI, suggesting that PFI projects are finally gaining momentum. Under the PFI
scheme, the contractor finances the construction of the asset and maintains it over the concession duration. Unlike conventional construction projects, the contractor does not receive progress payments from the Government. Instead, the contractor receives availability and maintenance charges over the concession period. In essence, PFI schemes are an off balance sheet type of financing for the Government. We see companies with strong balance sheets (ie net cash position) to best benefit from PFI jobs.

Marginal growth in contract awards. From our tracking of domestic contract flows, job awards from Jan-May stood at RM4.2bn, a marginal 4% increase y-o-y. While we believe last year’s total of RM10bn can be met, we do not expect a significant jump. Most contractors we spoke to felt that awards for the much anticipated mega projects are moving at snail’s pace. Among the mega projects, we expect the LCCT terminal (RM750m-RM850m) and satellite tower (RM400m-RM500m) to be awarded this year. As for the Interstate Raw Water Transfer (IRWT), the Semantan intake and pumping station (RM318m) was recently awarded to the Loh & Loh-George Kent-Hamaza JV. We expect the Kelau Dam potion (RM200m) to be awarded soon but the Langat 2 (RM1.5-2bn) may only take place next year.

The proposed MRT. Media reports recently said the Government is evaluating 3 Mass Rapid Transit (MRT) systems worth > RM30bn to be implemented in the Klang Valley. Our view is that the proposed project will not kick off in the near future. To begin with, the RM7bn LRT extension, which has been talked about since 2005, has not even been awarded yet. Secondly, RM30bn is certainly a huge sum for the Government. While the project could be implemented via PFI, financing on part of the contractors is a concern. To put things in perspective, RM30bn is almost equivalent to the net issuance of private debts securities (PDS) last year. Back to the LRT extension, we understand that there could be some problems with its alignment, particularly on the Ampang line. We believe that the entire job is only likely to commence next year.

VALUATION & RECOMMENDATION

Downgrade to NEUTRAL. In our 2H strategy report released yesterday, we downgraded our sector rating from Overweight to NEUTRAL. The KLCON currently trades at 15x on 1 year forward earnings, which is also equal to its long term mean, suggesting that valuations are somewhat fair. We do not expect any significant sector rerating to take place. In our view, the bull factor of more positive news is likely to be offset by the bears in the form of implementation

Our top picks. Despite our rating downgrade, we continue to see value in our top sector picks, namely Mudajaya (BUY, TP: RM7.33) and Sunway (BUY, TP: RM2.22). For the small cap plays we like Ahmad Zaki (BUY, TP: RM1.33). All our top picks have strong earnings growth potential with 3 year CAGRf ranging between 29-37%.


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